Options and the Variables That Make Them What They Are.

Note: For generalization and example purposes, unless otherwise stated, we will be referring to equity (stock) options.

In the simplest terms, we can state that there are two types of options: Calls and Puts.

Calls

Definition: A call option is a legally binding contract that allows the purchaser the right (but not the obligation) to purchase a particular number of shares of stock (100 shares per contract) at a specified price (the strike price) any time prior to its expiration (the expiration cycle/month).

Call Option Buyer: The buyer of the call option owns the right to purchase the stock any time he chooses prior to expiration of said option. The buyer has paid a premium for the right to buy 100 shares (per contract) of stock for the strike price (the agreed to price). The buyer has ALL the rights and no obligations.

Call Option Seller (Writer): The seller of the option has the obligation to deliver the stock should the call be exercised by the owner of the option. The seller has traded an obligation to deliver/sell the stock (at the strike price) for the premium he received at the time of the sale.

Question: If we were to buy-to-open (we do not currently have an option position) one contract of the Disney, July 25 strike call for a debit (cost to us) of $1.00, what would we own? What would it cost us? What rights do we have? What obligations do we possess?

Position: Long 1 (contract) of the DIS, July 25 strike call, for $1.00 (per share).

Answer: We would have the option to buy 100 shares of Disney (NYSE ticker symbol: DIS) stock for $25 regardless of where the actual stock is trading. If the following day (and it was prior to expiration) DIS stock were trading at $35 per share, then by owning the call we would have the right to buy the stock for $25 ($10 lower than were it is currently trading), provided that we exercise our right prior to the option’s expiration date. This right cost us $1 per share, and every option contract controls 100 shares; this one contract originally cost us $100 ($1 per share X 100 Shares = $100). Equity options have an American exercise, meaning we can exercise this option at any time prior to its expiration.

In this example we made a $900 profit on the trade. We own the right to buy the stock at $25 per share. It is now trading at $35 per share. We can exercise our right to buy the stock for $25 per share, and simultaneously sell the stock out at $35 per share. We would make $10 per share (35 – 25 = 10) X 100 shares = $1,000; however, this right cost us $1 per share or $100. We end up netting a $900 profit. Not bad on a $100 investment!

Puts

Definition: A put option is a legally binding contract that allows the purchaser the right (but not the obligation) to sell a particular number of shares of stock (100 shares per contract) at a specified price (the strike price) any time prior to its expiration (the expiration cycle/month). This is regardless of whether or not the owner of the put currently owns any stock.

Put Option Buyer: The buyer of the put option owns the right to sell the stock any time he chooses prior to expiration of said option. The buyer has paid a premium for the right to sell 100 shares (per contract) of stock at the strike price (the agreed to price). The buyer has ALL the rights and no obligations.

Decay (Theta)

 Definition: Decay is a measure of how much an option loses value due to the loss of time value.

Every second that passes allows less time for our option to make us money. If an option on WIN stock went from $2 to $ 1.85 in a day’s time (with all other variables remaining constant), we could say that the decay of the WIN option is $0.15 per day at the present time.

The problem with decay is that options lose value in a non-linear fashion. The closer an option gets to expiration, the more rapidly it loses value. As a matter of fact, decay is a function of the square root of time. We will go into this more thoroughly in a later chapter, but is not necessary for understanding how options work.

Put Option Seller (Writer): The seller of the option has the obligation to buy the stock should the owner of the option exercise the put. The seller has traded an obligation to possibly buy the stock (at the strike price) for the premiums he received at the time of the sale.

Question: If we were to buy-to-open one contract of the DIS, July 25 strike put for a debit (cost to us) of $0.75, what would we own? What would it cost us? What rights do we have? What obligations do we possess?

Position: Long 1 (contract) of the DIS, July 25 strike put, for $0.75 (per share).

Answer: We would have the option to sell 100 shares of Disney (NYSE ticker symbol: DIS) stock at $25 regardless of where the actual stock is trading. If DIS stock then traded at $15 per share, by owning the put we would have the right to sell the stock at $25 ($10 higher than were it is currently trading), provided that we exercise our right prior to the option’s expiration date. We could then go into the open market, and buy back the stock at a lower cost. This right cost us $0.75 per share, while every option contract controls 100 shares; this one contract would cost us $75 ($0.75 per share X 100 Shares = $75). Because equity options have an American exercise (see chapter on Terminology or section on Exercise of Options), we can exercise this option at any time prior to its expiration.

In this example we made a $925 profit on the trade. We own the right to sell the stock at $25 per share, and it is now trading at $15 per share. We can exercise our right to sell the stock at $25 per share, and simultaneously buy the stock back for $15 per share. We would make $10 per share (25 – 15 = 10) X 100 shares = $1,000; however, this right originally cost us $0.75 per share or $75. We end up netting a $925 profit. Not bad on a $75 investment!

Call And Put Variables

The variables that comprise an option’s value, and differentiate one option from another are strike price, time until expiration, interest rates, volatility, decay, the price of the underlying (and the option’s intrinsic value), and to a lesser extent, the method by which the option is settled (cash, futures, stock, American exercise, European exercise, etc.).

We will briefly touch on those variables before going into the fundamental functions of calls and puts.

Intrinsic Value

Definition: Intrinsic Value is the value of an option after its time value has been removed. It is an option’s worth at the moment of expiration.

Intrinsic value is an option’s real value. An example that relates well to this is that of an option on real estate. If someone were to sell you (for $1,000) an option to purchase (a call) a piece of land for $200,000 (strike price) any time before next year, what is that worth? Not being an expert in real estate you have an appraisal done. If the appraiser came back and said that not only is the land worth $300,000, but he also knows of a buyer for it, your option would have $100,000 in intrinsic (or real) value. You could immediately buy the piece of land by exercising your option and turn around and sell it to the appraiser’s friend, thus netting a $100,000 profit ($300K sale price – $200K purchase price = $100K profit). It can be said that that option has intrinsic value.

What if the appraisal came back and the land was only worth $150,000? Would it make sense to exercise your right to buy the land for $200,000? Of course it wouldn’t. In this case the option has no intrinsic value. This does not mean that it may not make sense to purchase the land contract if you think the land can appreciate above the option strike before expiration.

The easiest way of determining if an option has intrinsic value is to ask oneself:

“If it were expiration, how much better off am I by owning the option?”

In our example above, if it were the last day in which we had to exercise our right to buy the land or let the option expire worthless, what would the option be worth to us? Ask yourself, “How much better off am I by owning the option than if I simply went out and bought (or sold if puts) the stock in the marketplace?” Being the last day to exercise our land option we find that the appraisal is coming in at $300,000. By owning this option (the right to buy it for $200,000) we are saving/profiting $100,000. Because it is $100,000 to our benefit to own this call, we can say that the call has an intrinsic value of $100,000. Intrinsic value can never be less that zero. If it were, one would simply walk away from the option and not exercise it. If the land were worth less than the option to buy no one would exercise their option. They simply would buy the land for the going rate and let the option expire worthless.

Formula (for Calls and Puts)

Intrinsic Value (Call) Definition: Stock Price minus Strike Price

Intrinsic Value (Put) Definition: Strike Price minus Stock Price
Often traders on the floors of an exchange will refer to an option in terms of its intrinsic value. There are three terms that all options (calls and puts) are called depending on the amount of intrinsic value that they have. These terms are as follows:

Examples: You own the 70 strike call and the 70 strike put when the stock is trading at $64 per share. Determine the intrinsic value of both the call and the put?
Call Row
Price of the Stock Strike Price of the Put
– Strike Price of the Call -Price of the Stock
= Intrinsic Value (Call) = Intrinsic Value (Put)
$64 $70
-70 -64
= -6 = $6
(no Intrinisc Value) (has Intrinsic Value)

In-The-Money: An option is in-the-money (ITM) when it has intrinsic value.

Out-Of-The-Money: An option is out-of-the-money (OTM) when it has no intrinsic value.

At-The-Money: An option is at-the-money (ATM) if the stock price and the strike price are close to identical.

Settlement

Equity options are stock settled. An equity option that is exercised on (or prior to) expiration results in a transfer of a stock position with the stock exchanging hands at the strike price. Should the owner of a 55-strike call option on the underlying termed WIN exercise the option, 100 shares of stock will be purchased for $55 per share. This is regardless of what the stock is actually trading for at the present time.

Other option products will have different methods of settlement. Depending on how the contract has been structured, options can be converted into cash, futures, and other types of settlement values.

Strike Price

The “strike” is the Price that the option is converted into long (call) or short (put) stock (cash, futures, etc.). Owning the 35-strike call gives the owner the right to purchase stock for $35 per share any time prior to expiration. Should the stock be trading at $100 per share (or any price for that matter), the owner of the 35 call can exercise the option and own the stock for $35.

It would be undesirable for there to exist as many strike prices as possible stock prices. For the purposes of uniformity and ease of understanding, the exchanges that list options have devised a system to offer customers predictability in their choice of strike prices. A systematic approach in determining the choice of strike prices has been adopted; however, like all rules there are a few exceptions. Stock splits; public demand, and other influences are at work in complicating a good thing. For the most part, however, the rules below are adhered to whenever possible.

Strike Pricing

Stocks trading between $5 and $25 $2.50 Strikes
Stocks trading between $25 and $200 $5.00 Strikes
Stocks trading above $200 $10.00 Strikes

Making the determination as to what the value of the strike will be can be evaluated considering that the strike prices always will start from zero and go up. When looking at a stock that is trading for $24 per share, we can predict what strike prices will exist by starting at zero and working our way up. We are dealing with a stock that has $2.50 strike prices (the stock is trading between $5 and $25 per share), and because options generally do not have strike prices below $5 we will see the strikes looking as follows: $5, $7.50, $10, $12.50, $15, $17.50, $20, $22.50, $25, etc.

A $50 stock, according to the rules above, would have $5 strike prices. An example may be strikes as follows: $35, $40, $45, $50, $55, $60, and $65.

How many strikes any particular security may have is contingent on several variables such as the stock’s volatility, recent range the stock has seen and public demand.

Expiration

The cut off date on which the right to exercise the option ends. Options generally expire at the close of trading (4:02pm. Eastern Standard Time) on the third Friday of the named month. For example, July options will expire on the third Friday of July. If that day is a holiday, then the option will expire the third Thursday of the month.

Expiration Cycles: Most options are traded with a standardized expiration cycle. This is to add uniformity and predictability in finding expiration months. The major cycles are:

Cycle Number 1: January, April, July and October
Cycle Number 2: February, May, August and November
Cycle Number 3: March, June, September and December
(This cycle is also known as triple witching)

In addition to the cycle, stocks will have option expirations for the closest two months regardless of the cycle. Usually, after the closest month in a particular cycle expires the next month will be added. In cycle number one, as the January options expire, February options will already exist and March will be added. At first this does not make sense when looking at the individual cycles; however, the cycles are designed to be able to predict which options exist more than a couple of months out. Our choices of expiration months will be February, April, July and October. After February expiration we will see March, April, July, and October options.

Example of how this works:
Suppose it is the last day of trading for January options (regardless of which cycle it is on) and a stock trades on the first cycle rotation. The two tables below show what happens. The first table is the last day of trading on January. The second is what will be available the first day the market opens after the weekend (almost always the following Monday unless it is a holiday).

Cycle One Stock Option Expiration

Last Day of First Day After
Trading for Jan. Expiration Months
January (Gone)
February February
April March*
July April
October July
October

* month added

Interest Rates (Rho)

Interest rates play a function in determining the value of an option. In simplest terms, when an option is bought, money is taken out of an account and used to pay for the purchase. Had the option not been purchased, this money could have stayed in the account and collected interest. We have to take any possible income lost from the purchase of the option and compare it to the potential for a profit when owning the option. We will go into more detail on this later, as interest plays a lesser role than most of the other variables.

 Volatility (Vega)

Volatility is a measure of the anticipated price movement that a stock could go through in a given period of time. The greater the potential for a large movement in the underlying, the more we can expect an option to trade for (all other variables remaining constant). Two stocks (named WIN and GOOD) that are trading for the same price ($50 per share); have the same amount of time remaining until expiration (three weeks remaining); share the same strike price (55 strike); experience the same interest rate pressure (assign it 6%); may have options trading at greatly different prices ($4.50 and $0.65 respectively). The reason is that WIN tends to move an average of $6 on a daily basis, while GOOD has an average range of $1½ on a daily basis.

When beginning to trade, most traders quickly learn that the most powerful force in determining the price of an option is volatility. All the other variables that impact the price of your option can be moving in the direction that you need; however, volatility can move against you and the trade becomes a loss.

Additional Resources

See also:

The Players

Time Spread

Free Option Trading Basics Video & Book