Intro To Options and Placing Trade
Intro To Options - John Howell

Buying and selling options PLUS Time Decay Explained

INTRODUCTION:

There are many types of trading instruments present in the markets. Options are one of them. Options are well-known for the risk and reward it pays to the trader. Traders willing to risk their capital for some substantial returns trade Options. Without knowing about Options, it is quite difficult for a person to make money trading Options. The important terms to take care of while trading options are:

  • 1. Strike price: Every contract has a strike price associated with it. The difference between two alternate strike prices is constant. For every strike price, there is an associated premium, let it be a call or a put.
  • 2. Expiration Date: Each and every contract has to start and to end. Expiration date is the date on which a contract ends and the positions held, if any, will get squared-off. Expiration date is important from a trader’s point of view because a trader must keep an eye on the time decay.
  • 3. Lot size: Every stock has a particular size, i.e., there are a minimum number of quantities that you need to buy or sell. Buying or selling is done in lots, integral multiples of the minimum quantity.
  • 4. Premium: Premium of a stock is the total value of the particular call or put contract. The premium depends upon many factors such as expiration date, Strike price, current market price of the stock and some others. Premium is the amount that you need to pay when you buy an option.
  • 5. Time Decay: Time decay is an important thing to watch out for by any trader, because as time passes on, the premium of an option comes down assuming that the stock remains at the present level. The value of a premium is calculated based on various factors like Gamma, Beta, volatility, etc. As time passes by, the premium of the stock decreases as there are less number of days for the contract to expire. Number of days required for a contract to expire is the difference [working days] between the contract expiry date and the present date.
  • 7. Intrinsic value: When an option contract is ‘In the money’, Intrinsic value comes into effect. Intrinsic value is the difference between the current market price of the particular stock and the underlying strike price.

TYPES OF OPTIONS:

There are two types of OptionsCall option and a Put option. A call option is the one which is bought by traders if they foresee an increase in the current market price of the underlying security from the present level. Put option is quite opposite. Traders buy put options when they feel that the underlying stock is going to fall from the current level in the nearby future until expiry.

ATM, OTM and ITM:

ATM stands “At the money” and an option is said to be at the money when the current market price of the stock is at the option’s strike price. In a Call option, out of the money is when the strike price is above share price and ‘In the money’ is when the strike price is below the share price. For example, let’s say a stock is trading at $100. The main Strike prices are: $95, $100 and $105.

  • 1. Here, $95 strike price Call is in the money because the strike price is lower than the current market price whereas the $95 put option is out of the money as we discussed that for puts, the strike price must be lower than the current market price to be out of the money.
  • 2. $100 Call and Put options are said to be in the money because the strike price is equal to the current market price.
  • 3. $105 Call is out of the money as the trader’s intrinsic value is negative. $105 Put is in the money as the strike price is higher than the present market price.

EXAMPLE

It’s November 14th and a stock “ABC” is trading at $14. The well-traded strike prices are 13, 14 and 15. The expiry date is 29th November. The lot size is 100.

  • 1. 13 Call is trading at $1.21[Here, $1.21 is the premium] and this call is in the money. 13 Put is trading at $0.11 and is out of the money.
  • 2. 14 Call is trading at $0.44 which is called the premium and 15 Put is, too, trading at $0.44. Here, the premium of both the options is the same because the stock is currently trading at the strike price itself. Both the Call and put are at the money.
  • 3. 15 Call is trading at $0.11 and is out of the money. 15 Put is trading at $1.21 and is in the money.

Let’s say a trader buys a call option, strike price – 15, the profit and risk graph of his capital is shown below.

The breakeven point of his trade is 14.43 $. Anything above 14.43 $ will be his profits. At present, his call option is at the money call option. This type of trade is called buying a naked call or “Long Call”.

Suppose he buys a put at the same strike price, then he will be profitable once the stock reaches or scales down the value of 13.57 $.

Similarly, there are many strategies which can be implemented during option trading. These strategies govern the risks and rewards in your portfolio.

Some more clarity on Options will emerge once you see the below table. Let’s say, a trader “X” bought 14 Call option of “ABC” at ‘0.67’. Today is the first day of the month and the contract has just started. That is the reason the premium is a bit higher. Altogether there are 4 weeks in a month. The breakeven price of the trader would be ‘14.67’ as we discussed above.

Current market priceIntrinsic ValueOption valueDays to expireProfit/Loss
Contract starts$14$0$0.6719$0
End of 1st week$14.5$0.5$0.8614$19
End of 2nd week$14.3$0.3$0.639-$4
End of 3rd week$14.8$0.8$0.994$32
Contract ends$15.4$1.4$1.40$73

The trader is making some good gains as the stock has steadily moved up in the month. Here, you could see that when the stock is up by ‘$0.3’ from the day the contract started, the trader is still in a loss. Here, the time value has decayed faster and hence, the trade is making a loss. You will learn about time value later in this article. He could square-off his positions on any day in the month.

  • 1. As the days to expire are becoming less, the intrinsic value is coming near to the option value. That means that the time is decaying and the time value is nearing to ‘0’ as it must become ‘0’ on the day of expiry.
  • 2. Intrinsic value = Current market price – Strike price.

BUYING AND WRITING:

There are altogether 4 types of trades a trader can perform while trading options:

  • Buying a Call.
  • Selling (Writing) a Call.
  • Buying a Put.
  • Selling (Writing) a Put.

So, when a trader is bullish about the market, he/she can buy a call or sell a put and when he/she is bearish, he/she could buy a put or sell a call. Generally, when you write a call or a put, your risk is infinite. But, even if the stock moves sideways, factoring time decays, you will be in a profitable position because the time decay will favor you. As time goes on, the premium of a stock comes down assuming that the stock moves nowhere.

OPENING AND CLOSING POSITIONS:

  • Buy to open: A position is opened or created by buying a particular option. Here, the trader is holding the position. This is termed as buying to open.
  • Sell to close: A position which is closed or squared-off by selling the existing quantity or the quantity held is known as sell to close.
  • Sell to open: Here, the trader is writing an option, i.e., he is selling an option. So, he is creating a position or opening a position by selling. This is termed as selling to open a position.
  • Buy to close: In the previous case, a position is made by writing an option. Now this position is squared off or cleared by buying the position and hence, is termed as buying to close.

CALCULATING PREMIUMS AND INTRINSIC VALUE:

The premium of an option is the sum of Intrinsic Value and time decay at any point during the contract.

PREMIUM=INTRINSIC VALUE+TIME DECAY

As specified, the intrinsic value of an option is equal to the difference between the current market price and the strike price. But, what if the Option is out of the money? You get negative value for intrinsic value. So, to overcome this difficulty, it is said that the intrinsic value of an option is always non-negative. So, if it is negative, the intrinsic value is taken as ‘0’. As the name suggests, Time decay is the value of the option which decays with time. As time passes by, the value of this time decay nears ‘0’.

CONCLUSION

So, Options are quite risky trades and a trader needs to know everything about them to trade these instruments. There are many strategies in which a trader buys a particular strike price’s call and sells another strike price’s call. These strategies will make your risk a little bit low. But buying or selling naked calls or puts is highly risky. While buying a call or a put, the maximum risk you will bear is the amount of capital invested. But when you write options, the risk is infinite if the trade doesn’t favor you.