Option contracts are instruments derived from one financial asset since their value depends on the value of this other asset, which is referred to as the underlying asset. The underlying asset of the options can be stocks, indices, currencies, commodities, bonds, etc. We will look at stock options, since once you understand the subject you can understand any other, what changes is the underlying asset. Options contracts on a company’s Stocks depend on the value of the company’s Stocks.
Option contracts have an expiration date and a target price called a “strike”. Therefore, an option contract represents that the Stock price will reach that price (strike) within a certain period of time (until the expiry date).
Option contracts are an agreement in which the holder obtains the right to buy or sell an asset at a given price (strike) during a given period or on a given date (expiry).
Main characteristics of options
- They are priced well below the value of the underlying asset.
- High leverage.
- They have a maturity date, therefore the price of the contract will decrease as time goes by if the underlying asset does not register significant changes in price (e.g. when the Stock price remains sideways in the range of U$S1, the contract will depreciate in value).
- Its price varies based on changes in the value of the underlying asset.
- Ideal for trading both upwards and downwards.
- Ideal to be used to cover losses, for example if we have the Stock and we see that it is going down, we can make money with the down option and thus cover a little of the losses.
- They can be bought or sold on the American market at any time, up to the day of expiry.
Summary of financial terms:
Specific price at which the Stock should reach, so that the contract becomes effective, i.e. the price at which we want to buy or sell the underlying asset (Stocks in our case).
Price paid for the acquisition of a contract.
It is only priced upwards, i.e. when the Stock or underlying asset rises in price. This contract gives the buyer the right to buy, and therefore the seller the obligation to sell, the underlying asset (the Stocks) at the strike price until the expiry date, in exchange for the payment of a premium to the seller by the buyer.
It is valued when the Stock price falls, it is for bearish scenarios. This contract gives the buyer the right to sell, and therefore the seller the obligation to buy, the underlying asset (the Stocks) at the strike price until the maturity date, in exchange for the payment of a premium to the seller by the buyer.
All this is expressed in a symbol that is easy to read when one invests in them in order to be able to identify them. We will take as an example a Netflix call contract with strike u$s385 that expires on 20 September 2019:
- .NFLX: ticker of the company.
- 190920: is the expiry date, in English it is the other way round, so it is 19/09/20, i.e. 20 September 2019.
- C: type of option, in this case CALL
- 385: strike
If the NFLX Stock price rises, the premium value of this option contract will also rise, and whoever holds the contract will be able to sell it on the market even if the expiry date has not yet arrived.
As the Stock price changes, the price of the contract also changes, but to a lesser extent. The terminology ATM, ITM, OTM is known for this and is related to the strike.
- ATM (at the money): the strike of an option contract is equal to or very close to the value of the stock. The value of the contract will vary by 50% of how much the Stock price varies.
- ITM(in the money): the strike of a CALL option contract is below the value of the stock; or above in the case of a PUT contract. The value of the contract will vary by more than 50% of what the Stock price varies.
- OTM(out of the money): the strike of a CALL option contract is above the value of the stock; or below in the case of a PUT contract. The value of the contract will vary by less than 50% of what the Stock price varies.
If the price of a Stock of X company is U$S79, and a CALL option with strike 80 is bought at U$S2 a contract, the valuation of the contract would be:
- STOCK: if from U$S79 its price increases by U$S2, its value is now U$S81.
- CONTRACT: since it is ATM, it goes from being worth U$S2 to U$S3, since I earn U$S1 due to the fact that I earn 50% of what the Stock earned.
With the same example as before, being the Stock price U$S79, and a CALL option with strike 65 is bought at U$S1.38 the contract, the valuation of the contract would be:
- Stock: if from U$S79 its price increases by U$S2, its value is now U$S81.
- CONTRACT: given that it is OTM, it goes from being worth U$S1.38 to U$S2.08, as it gained U$S0.70 due to the fact that it gained less than 50% of what the Stock gained. The strike was less than the Stock price.
With the same example as before, being the Stock price U$S79, and a CALL option with strike 85 is bought at U$S3.90 the contract, the valuation of the contract would be:
- STOCK: if from U$S79 its price increases by U$S2, its value is now U$S81.
- CONTRACT: given that it is ITM, it goes from being worth U$S3.90 to U$S5, as it gained U$S1.10 due to the fact that it gained more than 50% of what the Stock gained. The strike was higher than the Stock price.
IMPORTANT: 1 contract is equivalent to the “movement” of 100 Stocks, therefore if we buy a contract at U$S2, we will pay U$S200 (U$S2x100).
As you can see, option contracts have the same characteristics for any financial instrument that has them. What we have explained applies to any option contract.
Bid and Ask
Each option contract has 2 prices, which are:
- BID: highest bid price, i.e. it is the highest price the buyer is willing to pay. It would be the best bid to buy.
- ASK: lowest asking price, i.e. the lowest price at which the seller is willing to sell. It would be the best offer to sell.
The difference between them is called SPREAD. That is, ASK-BID=SPREAD.
It is very important that you always keep this in mind as the spread can be small or large. It is convenient that it is small, which indicates that there is a lot of demand for the purchase and sale of these option contracts, and that there is a lot of volume. Otherwise, spreads are wider.
Market makers are the ones who profit from the spread differences, as their objective is that you buy at the ASK price and someone else is willing to sell to you at the BID price.
Greeks are a ratio that measures the price sensitivity of option contracts to factors that influence them, such as the term to maturity and the volatility of the underlying asset. They help us to manage the position.
The ideal is to choose 1 or 2, depending on what suits you best, however we will name several, although we will delve into Delta as it is the most used.
This Greek indicates how much an option contract loses over time in 1 day. It has a negative sign when we buy as we lose value over time and a positive sign when we sell a contract.
It loses more value the closer we are to expiration, for example if we have bought a CALL option contract that expires in 50 days, the Theta will be -0.009 at that time, but if there are 5 days to expiration it will be -0.025. The Theta value decreases rapidly in value if the expiry is in the short term.
This Greek indicates the change in the value of an option contract with respect to volatility. Option contracts can also be volatile, regardless of the volatility of their underlying asset. By this we mean that the asset may move little, but the prices of the contracts move a lot.
Of course, if the value of the underlying asset increases, the value of the contract will also increase, so Vega indicates the value by which the contract price changes compared to a unit increase in the volatility of the stock.
This is one of the most commonly used Greeks as it represents the change in the price of an option contract when the price of the underlying asset changes by US$1.
For example, if a PUT option has a delta of 0.42, it is telling us that if the underlying asset goes down U$S1, the price of the PUT contract will increase by U$S0.42. And if a CALL option has a delta of 0.42 it is telling us that if the underlying asset goes up by US$1, the price of the CALL contract will increase by US$0.42.
IMPORTANT: CALL option contracts always have a positive delta because a rise in their underlying asset implies a rise in the contract price; and PUT option contracts always have a negative delta because a rise in their underlying asset implies a fall in the contract price. This is the case when buying contracts. If we were selling and then buying (we will see later) the signs are reversed.
The following must be taken into account:
- Delta is higher as the options contract is more ITM (tends to 1).
- Delta is lower as the options contract is more OTM (tends to 0)
- Delta is close to 0.50 if the contract is ATM, with its respective sign.
That is, delta moves between 0 and 1 (its absolute value would be the delta of the underlying asset). The more ITM the contract is, the more expensive it is, but the more it captures the movement of the underlying asset.
In conclusion, the higher the delta, the more profit we will obtain if the movement is the one we expect, and if it goes the other way, the greater the loss.