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Basics on Equity Options
If you are new to investing, you may not be familiar with equity options. Equity options are contracts that give the buyer the right, but not the obligation, to buy or sell a certain number of securities or assets at a predetermined price (strike price), within a specified period of time (expiration date). They are similar to stocks, except that the buyer does not acquire ownership of the underlying asset.
Put options contracts give the buyer the right to sell the underlying asset at a predetermined price, within a specified period of time. Call options contracts give the buyer the right to buy the underlying asset at a predetermined price, within a specified period of time. The value of an option is determined by the underlying equity price, volatility, as well as the expiration date and the difference between intrinsic and extrinsic value. The buyer or seller of an options contract does not acquire ownership of the underlying asset until the contract is exercised.
Intrinsic Value
Intrinsic value is the difference between the option's strike price and the price of the underlying asset. For example, if the underlying asset is trading at $50 and you enter a call option with a strike price of $45, the intrinsic value of the option is $5. Extrinsic value is the remaining value of the option after the intrinsic value has been subtracted. This value is determined by the time left before expiration. So, an option for the $45 strike that expires in 6 months when the stock is at $50 may cost $8.00 ($5 intrinsic + $2 for the time, and $1 for the volatility.
Strike Price
The strike price of an equity option is the predetermined price at which the underlying asset can be bought or sold. The strike price is determined when the option is written and cannot be changed. It is important to note that the option holder does not have to buy or sell the underlying asset at the strike price; they simply have the right to do so.
Open Interest
Open interest is the total number of outstanding contracts for a particular option. It is an important indicator of market liquidity and is used by traders to gauge the popularity of a certain option. Open interest can increase when new contracts are bought or sold, or decrease when contracts are closed.
Implied Volatility
Implied volatility is the estimated volatility of the underlying asset based on the market price of the option. It is an important factor in pricing options, as investors will generally pay more for an option when the implied volatility is higher. Implied volatility is calculated using a variety of models and is an important indicator of market sentiment.
Equity options are generally correlated to the price of the VIX, which is a measure of expected volatility in the stock market. When the VIX is high, equity options tend to be more expensive, as investors are willing to pay a higher premium for the extra protection that options provide in volatile markets. On the other hand, when the VIX is low, equity options tend to be cheaper, as investors are less willing to pay a premium for the protection that options provide in stable markets.
Some traders believe it's better to be an options seller when volatility premium is high and a buyer when volatility premium is low. The problem is that there is a reason why the premiums are either high or low. Volatility can stay higher longer than anticipated and continue rising when market risk goes up.
The difference between buying equity options contracts and selling equity contracts.
When it comes to buying or selling equity options contracts, there are two key differences to consider. The first difference is the risk involved. When buying an equity option, the maximum loss is limited to the premium paid, meaning that the buyer will never lose more than the premium paid for the option. On the other hand, when selling an equity call option, the potential loss is unlimited. This is because the underlying asset's price can increase without any limit. When selling a put option the loss is limited because the asset cannot go below zero. However, there have been instances where assets have gone below $0 like in 2020 when crude oil futures when to negative $50 dollars a barrel. That was an unprecedented historical moment in the market.
The second difference is the time frame involved. When buying an equity option, the buyer has to wait for the underlying asset's price to increase in order to make a profit. This means that the buyer may have to wait for a long period of time before the option is profitable. On the other hand, when selling an equity option, the seller can immediately realize a profit if the underlying asset's price decreases.
When it comes to buying equity options contracts, leverage can be both a benefit and a risk. The benefit is that the buyers only has to pay a fraction of the total cost of the underlying asset. This means that the buyer can gain exposure to a larger position than would be possible with just the amount of capital available. The risk is that if the underlying asset's price moves adversely, the buyer may lose more than the premium paid for the option. When it comes to selling equity options contracts, there are margin requirements to consider. This means that the seller must have the sufficient funds in their account to cover any losses that may occur. The margin requirement is determined by the broker and is based on the option's risk level.
In additional to time frame and price appreciation there is a third factor that determines the price of an equity option. Volatility premium is the amount of premium paid for an option due to the volatility of the underlying asset. Volatility is a measure of how much the underlying asset is expected to fluctuate in price over a given period of time. The higher the volatility, the higher the premium paid for the option.
Keep in mind, approximately 80% of equity options contracts expire worthless. This is because the underlying asset's price usually does not move enough for the option to become profitable before the expiration date.
To give you another idea of how equity options contracts works consider a buyer and seller of a home who come into a contract before the asset exchanges owners. The buyer of a home is comparable to the buyer of an options contract, whereas the seller of a home is comparable to the seller of an options contract. In the contract the home buyer agrees to pay 10% above market value for the home. In both cases, the buyer of the home contract and the equity option contract is paying a premium to obtain the right, but not the obligation, to buy or sell the asset at a predetermined price. The seller is receiving the premium in exchange for taking on the risk that the buyer may exercise their right to buy or sell the asset. So, even if the buyer of the home decided not purchase the seller gets to keep the 10% premium baked into the contract.
Who writes an equity options contract?
An equity options contract is written by a market maker, such as an investment bank or broker. The market maker is responsible for providing liquidity to the market by writing options contracts and buying and selling them to buyers and sellers.
The trader initiates the equity options trade by selecting the underlying asset, strike price, expiration date, and number of contracts. Once the trade is initiated, the market maker writes the option and it can be bought or sold on the market.
Who are the typical equity options sellers?
The typical equity options sellers are professional traders, institutional investors, and hedgers. Professional traders typically sell options contracts to make a profit from the premium received. Institutional investors and hedgers typically sell options contracts to reduce their risk exposure.
What are the requirements to sell equity options contracts?
To sell equity options contracts, you must have a margin account with a broker and meet the margin requirements set by the broker. You must also understand the risks involved with selling options contracts and be aware of any exchange and financial regulations.
The risks in trading equity options include the risk of a total loss, the risk of the underlying asset's price moving adversely, and the risk of illiquid markets. The risk of a total loss is the risk that the option will expire worthless, resulting in a loss of the entire premium paid. The risk of the underlying asset's price moving adversely is the risk that the underlying asset's price will move in a way that is unfavorable to the option holder, resulting in a loss. The risk of illiquid markets is the risk that the option may not be able to be bought or sold at the desired price due to a lack of buyers or sellers.
What are some of the advance options strategies?
Some of the advanced options strategies include straddles, strangles, spreads, and collars. A straddle is a strategy that involves buying both a call and a put option with the same strike price and expiration date. A strangle is a strategy that involves buying both a call and a put option with different strike prices and the same expiration date. A spread is a strategy that involves buying and selling options with different strike prices and the same expiration date. A collar is a strategy that involves buying a put option, selling a call option, and investing the premium received from the call option into a risk-free investment.
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Equity Options in January