Stock Options: Explained

Options are defined as a “Contract that gives the buyer the right to buy or sell the underlying stock”

These contracts are issued by the Chicago Board Options Exchange and they offer 2 types of option contracts, a call option and a put option.

• Call options gives the buyer the right to buy 100 shares of the underlying stock at a set price, known as strike price, for a predetermined number of days.

• Put options give the buyer the right to sell 100 shares of the underlying stock at a set price, known as strike price, for a predetermined number of days.

The pricing of options contracts by market makers will take into consideration the current stock price, the intrinsic value (difference between strike price and stock), time to expiration or the time value, volatility, interest rates, and cash dividends paid and is calculated using the Black-Scholes Formula.

Given the complex nature of options, options are highly versatile. Investors can combine different types of options, with different strike prices and different expiry dates and take advantage of these contracts as a means to leverage, hedge or to bet on the change in volatility of a stock etc.

For example, speculators often purchase options if they foresee a significant change in price. Options contracts give buyers the opportunity to obtain significant exposure to a stock for a relatively small price. Thus because of the leverage they provide, significant gains can be made if a stock rises. However, speculation can be detrimental when considering George Soros led to the collapse of the Thai baht and the depletion of the central bank reserves in 1997.

Suppose that as a new year's resolution for 2021, you decide to buy Gamestop shares, which trade at $19 per share at open, and you believe they will increase in value. You decide to buy a call option to benefit from an increase in the stock's price. You purchase one call option with a strike price of $20 for one month in the future for $2.46 per contact. Your total cash outlay is $246 for the position plus fees and commissions (2.46 x 100 = $246).

Fast forward a few weeks, on the 28th of January 2021, Gamestop traded at a high of $483, since you could exercise the option to acquire the stock for $20 a share and quickly sell it for $483 per share, your option will now be worth $463 (483 - 20 = $463), excluding extrinsic value.

The profit on the option position will now be 18,821% since you paid $2.46 and earned $463, which is much higher than the 2,415% gain in the underlying stock price.

Thus, your net profit for your outlay of $246 will then be $46,054.

Call options can also limit your risk, if the stock crashed and fell to $10, your option would expire worthless, and you would have lost $246. This is instead of a $900 loss, if you were to buy 100 shares instead of the call option.

However, despite how simple it may sound above, option trading is also a double edged sword, due to the highly efficient pricing of options using various mathematical models based on probability and volatility. The projected growth of an option would have been priced in by market makers and it would usually require a larger than the predicted increase in the price of the underlying stock for an option buyer to profit.

Secondly, the value of an option decreases exponentially as time passes, this is known as “time decay” or “theta decay”. Time decay would accelerate as the expiration date gets closer because there would be a lower probability that an investor would turn a profit. This would eat into the profits of the buyer and could potentially cause the buyer to lose money despite and increase in the underlying stock.

Thirdly, there is a potential for the price of your option to get “iv crushed”, this is when a fast, sharp drop in implied volatility will cause the price of an option to decrease, despite the underlying asset moving in the desired direction. This often happens after a major event for the stock, like financial reports, regulatory decisions, new product launches, or quarterly earnings announcements.

For example, if a trader were to buy a call option shortly before a earnings report, it would be more expensive to buy stock options as the implied volatility would be higher than usual. However, after the event, if the price of the stock didn’t rise as much as the analysts expected, this would cause the price of an option to decrease instead, due to implied volatility being a factor in the pricing of an option. Therefore, the option price drops, and even though the stock may be rising, the option is not. The disconnect between the stock movement and implied volatility would thus “crush” the options market.

References

Hargreaves, Rupert. “Here’s How George Soros Broke the Bank of Thailand.” Business Insider, 2016. https://www.businessinsider.com/how-george-soros-broke-the-bank-of-thailand-2016-9. (Accessed Mar 1, 2021).

“Stock Option.” Corporate Finance Institute, n.d. https://corporatefinanceinstitute.com/resources/knowledge/finance/stock-option/. (Accessed Mar 1, 2021).