Options simplified

Suppose your company is considering moving to Berlin and you need to move as well. You could buy a house in the new city, but that may not be the best use of capital. And if the company decides not to move, then you will have a house that you do not need. But, what if you could buy an option on a house in Berlin? You will need to pay the landlord of the house for this “right” and the cost of that right is called the “option premium”. If the company moves, you would exercise your option to purchase the house at the predetermined price. If the company does not move, then you would simply not exercise your right or option to buy the house. When this happens, the owner of the house will still keep the option premium. Translating this into the financial world, imagine you were holding the shares of X company and you have a bullish view on the stock’s performance in the long term, however, there is some current news doing rounds in the market, which are likely to have a negative impact on the share price over the short term. So how can you use hedging to limit your downside? Options trading can be intimidating. The complexities, jargon, and buzzwords surrounding it can be confusing at times. In this blog I will try and cover how you can use options to hedge existing positions through explaining the basic concept of options trading, and when doing that I am hoping that my course materials and books from my Grad school Derivatives classes would come in handy.

What are options?

Options are a derivative product that derives its value from the value of an underlying asset. An option is simply a contractual agreement between two parties, between the buyer and the seller. The price of the option depends on the price of the underlying, plus a risk premium. The strike price is the agreed price at which a transaction will happen if the option is worth exercising. Each option has its own maturity or expiration date. This is the last day on which an option can be exercised. There are two kinds of options, put and call options, which are often referred to as “puts” and “calls”. One option contract typically controls 100 shares of stock, but you can buy or sell as many contracts as you want.

When you buy a call option, you hope that the market price of the stock will increase in near future. Why? If the stock price increases enough to exceed the strike price, you can exercise your call and buy that stock at the strike price, i.e. at a price below the stock’s market value. Then you can either keep the shares or sell them for a profit. But what happens if the price of the stock goes down rather than up? You then let the call option expire and your loss will be limited to the cost of the premium. When you buy an option, you are expecting that the price of the stock is going to fall and you want to lock the value so you are buying put options (insurance) against your shares losing too much value. Now that we know the basics of options, we will use a fictional firm called “Alphaville Inc.” (Hint: my most favorite synthpop band from the 80s).

Options explained through an example

For instance, 1 Alphaville 110 call option gives the owner the right to buy 100 Alphaville Inc. shares for $110 each (that’s the strike price), regardless of the market price of ABC shares, until the option’s expiration date. Suppose Alphaville Inc. shares are trading at $100 today—the owner of the Alphaville110 call option hopes shares rise above $110—any appreciation above that represents the potential payout. If you exercise the call when shares trade at $120, then you buy 100 ABC shares for $110, and voilà: your return is $10 per share for a total gain of $1,000. But all that fun isn’t free. A call buyer must pay the seller a premium: for example, a price of $3 per share. Since the Alphaville 110 call option then costs $300 and paid out $1,000, the net return is $700. By the expiration date, the price tanks and is now $90. Because this is less than our $110 strike price and there is no time left, the option contract is worthless. We are now down by $300, the option premium paid. These examples, for illustration purposes, do not include any commissions or fees that may be incurred, as well as tax implications.

Let’s get into some options concepts

Now that we have covered the very basic definitions of options and how they work, let us go over the concepts of an option being in, out of, or at-the-money. An option that is said to be “in-the-money” is set to make money based on current stock prices, meaning a call option is in the money when the stock price exceeds the strike price and a put option is in the money when the stock price is below the strike price. An option is sometimes said to be “at the money” when the stock price is equal to the strike price. Also, the buyer of an option is known as the holder, while the seller is known as the writer. For a call, the holder has the right to buy the underlying market from the writer. For a put, the holder has the right to sell the underlying market to the writer.

But why do investors trade options? There are a variety of reasons investors use options, and the four main reasons are flexibility, leverage, hedging, and income generation. We are not going to elaborate on each but from the risk management perspective, the use of options for hedging is important, because hedging is about reducing risk. You make trades based on your best judgment, then options can help protect those trades — or your overall portfolio — in case things don’t work out quite as you planned.

When it comes to calculating the option prices there is a certain formula called Black Scholes (which gives a theoretical estimate of the price of European-style options and the equation and model are named after economists Fischer Black and Myron Scholes; Robert C. Merton, who first wrote an academic paper on the subject, is sometimes also credited) and the formula includes components such as current stock price, strike price, type of option, days until expiration, interest rates, volatility, and dividends, however, I will not delve into this in this blog as it is greatly theoretical and may sound like smoke and mirrors for starters. Leaving this topic to another blog, I will now try to help you visualize the potential profit/loss of an option buyer or seller. Before we illustrate the payoffs with diagrams, let us break down what the four terms we briefly touched upon above with the Alphaville example mean.

The 4 options terms

Long Call: It means that we are buying a call option because we are optimistic about the underlying stock’s price.

Long Put: We are buying a put option because we anticipate a decline in the underlying stock price.

Short Call: We are bearish and betting that the prices will go down, hence, a short call means you are selling (writing) calls to collect premium.

Short Put: In this situation, we are selling a put option because we have a bullish outlook on the underlying and would like to earn income by collecting premiums.

Options payoff diagrams

The long call holder will make a profit equal to the stock price at expiration minus strike price minus the premium if the option is in the money. The loss for the long call holder will be limited to the amount of premium paid if the option expires out of the money. The writer of the call will get premium if the underlying stays below the strike price at expiration, however, the loss is unlimited if the underlying stock increases in price.

Similarly, the put option buyer will make a profit when the option is in the money and is equal to the strike price minus the stock price minus premium. And the short put holder (put writer) makes a profit equal to the premium for the option, however, the seller will be exposed to substantial risk if the stock goes down, so the traders must keep a watchful eye on this strategy as it unfolds.

Final thoughts

If you are interested in options trading, this blog could be a good way to start your learning experience. However, options trading is not limited to this and if you wish to continue learning by yourself, I would highly recommend CBOE Options Institute and CME Introduction to Options Course to hone your basic skills and explore concepts to be able to use quantitative techniques as well as option pricing models, Options Greeks and various spread strategies to start your journey into the broad and intriguing world of options. This blog would not be complete without a throwback to the year 2002 and a shout-out to my beloved Derivatives Professor Dr. Malliaris who had taken us to the Chicago Board of Options “Open Outcry” Trading Floor and we had the below picture taken while traders in the back were shouting at the top of their lungs and waving their arms for trading anything from coffee and soybeans to crude oil and natural gas (precious times!). One last comment about options is that it is important to get guidance from investment professionals before opening up an options trading account, and fully understand from your broker the risks and rewards involved to keep your worries more in check. Sure trading can be exciting, but it is definitely not about one-hit wonders, so make your plans in advance and try sticking to them like glue.

_{Disclaimer: This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.}