How to work with stock options

Sometimes, in discussions about investing with friends and acquaintances, I am stunned at how so many people have strange and negative attitudes towards stock options. To try and rehabilitate options from the bad rap they have been getting, here is a brief look at how to work with stock options.

First, we should define what are stock options. I will consider American-style stock options here. The options available on European and other markets differ in ways we will get to shortly.

There are two kinds of options, call options and put options. Each option is a contract between a buyer and a seller.

The buyer of a call option acquires the right but not the obligation to buy a security at a fixed price at or before a fixed date in the future. The seller of the call option is obligated to fulfill the other side of the trade if the buyer exercises their right.

The buyer of a put option acquires the right but not the obligation to sell a security at a fixed price at or before a fixed date in the future. The seller of the put option is obligated to fulfill the other side of the trade if the buyer exercises their right.

There is actually a lot to unpack here but all will become clear as we dive deeper.

A basic call option

It is always going to be easiest to explain options using examples and to keep things simple we will stick with American-style stock options. There are options on commodities and other financial instruments but we’ll ignore that for the moment.

Oh and so I don’t forget, the difference between European style options and American-style options is that European style options can only be exercised at expiry, whereas American-style options can be exercised at any time up to expiry.

Let’s consider that a buyer has bought one call option to buy 100 shares of company XYZ at a fixed price of $110 a share and the option expires in the third week of August this year. This would be called an XYZ August 110 Call. XYZ is the name or symbol of the company and referred to as the underlying, August is the expiry date, and $110 is the strike price. Most options are available on a monthly basis and will expire after trading on the third Friday of the month.

That is a very common type of call option. The large majority of options are to trade 100 shares. In fact, you usually only find options for a different number of shares when there has been a stock split or some other financial restructuring before options expire.

Then those options that were caught in the middle as it were will be for some weird number of shares. You can still trade them until expiry but you will have to run some calculations to be sure of what you are doing.

A call option example

Let’s imagine that the buyer saw that XYZ company shares are trading at $100 on the market, August is six months away and the buyer thinks there is a good chance the stock will reach $120 by August. The buyer saw that the August 110 call option was priced at $4 and thought it was a good bet. Since option prices are always quoted on a per-share basis but traded for 100 shares the buyer would have spent $400 plus any fees and commissions to acquire the right to buy XYZ shares at $110 a share any time between now and the August expiry date.

Before we get into technical details, let’s see why anyone would want to do this and what the benefit would be. Let’s consider the buyer’s choices.

Buy the stock

The buyer could purchase the stock, let’s say 100 shares at $100 so a cost of $10,000. Let’s assume all goes well and by August the stock is trading at $120 a share. Our buyer sells the shares for $12,000 and pockets $2,000 in profit so a 20% gain. Not bad at all.

Buy a call option

Or, the buyer bought the option for $400. Everything goes as planned and by August the stock is trading at $120 a share. The option allows the buyer to purchase 100 shares at $110 a share. So at expiry, the buyer can exercise the option, buy the shares for $11,000 and sell them immediately on the market at $12,000 and pocket $1,000 difference less the $400 cost of the option so a profit of $600. Which is a 150% gain.

Risk considerations

Let’s stick with our example above for a moment.

Let’s imagine that our buyer wasn’t absolutely certain that the predicted outcome would happen. And let’s face it, only a fool would be. Without getting into technical analysis of stock XYZ performance, let’s just imagine that the buyer thinks if the stock drops to $95, i.e. a 5% drop in value then the prediction is going south and it would be time to get out of the trade.

If the buyer had bought the stock and set a stop-loss order at $95 and that stock hit that value then the position would have been stopped out with a loss of $500 out of the $10,000 invested. So a 5% loss. This article explains stop-loss orders.

If the buyer had bought the option and wanted to control the same risk of a 5% drop in the share price then the question is what price would the option drop to if the share price dropped to $95. To answer that question with any precision we would have to know much more about how the option is priced.

For the moment to keep the math simple, let’s imagine that the option has a delta of 0.35 when bought. We’ll have to explain delta a little later but for the moment delta means that for a $1 change in the XYZ stock price, the call option price moves in the same direction by a factor of 0.35, so by $0.35. So if the stock price dropped by 5% to $95 then we would expect the option price to be $4 less 5 x $0.35 in other words $2.25. So the buyer paid $400 for the option and then could sell it for $225 or a loss of 43.75%. I’ve kept the math simple for illustration. In fact the delta would change with each dollar drop in price. Anyway, this is exact scenario is unlikely for a number of reasons.

Firstly that situation would only arise if the price of XYZ shares dropped from $100 to $95 within a few days of purchasing the option. And secondly, as we said the delta itself changes dynamically for each point of movement in the underlying. So the math is much more complicated than this simple example.

It is more likely that the price drop happens later by which time the value of the option has decayed anyway. Remember that if the XYZ share price doesn’t reach $110 by August then the option expires with no value. So the way options pricing works, the buyer would see the market value of the option decay to $0 as the August expiry date approaches as long as XYZ stays below $110.

In the money, out the money, and at the money

To understand a little better what is going on here, we need to consider what is called the moneyness of options. Again some simple examples illustrate.

A call option with a strike price of $110 is out-the-money or OTM if the stock price is below $110. Specifically, if the price is at $95 then the call option is $15 OTM, etc.

A call option with a strike price of $110 is at-the-money or ATM if the stock price is at $110.

A call option with a strike price of $110 is in-the-money or ITM if the stock price is above $110. So if the current price is $130 the call option would be $20 ITM.

In practice, we still refer to a call option as at-the-money if the price is close to the strike price within a few percentage points. At-the-money options are the most actively traded options.

We also refer to options as being deep-in-the-money for far out-the-money. A deep-in-the-money option typically has a high proportion of intrinsic to extrinsic value. A far out-of-the-money option is one whose strike price is not close to the current market price by a substantial margin.

This leads us to the components of an option’s price.

Intrinsic and extrinsic value

An option that is in-the-money has both intrinsic value and extrinsic value. An option that is out-the-money has only extrinsic value. An option that is at-the-money is on the borderline.

Extrinsic value is what you pay for the right to exercise the option. In other words, the extrinsic value represents the time value and riskiness or volatility of the option.

The intrinsic value is the difference between the strike price and the market price when an option is in-the-money.

As we said extrinsic value decays over time as we get closer to expiry. But actually, the price decay is not very noticeable until you get to about 90 days before expiry, then the decay starts to accelerate. We can represent this graphically here.

The graph below shows how the value of a deep-in-the-money option value decays over time.

The graph below shows how the value of an out-the-money option decays over time.

There are other charts that show how options prices move in comparison to the underlying. I include them here for the sake of completeness. I wouldn’t get hung up on these though. I saw graphs like this many years ago many times and they didn’t really mean anything to me until I started actively trading options.

The graph below shows how the return on a call option varies according to the price of the underlying at expiry.

The graph below shows how the return on a put option varies according to the price of the underlying at expiry,

It is important to remember that these charts show the value of an option to the holder on expiry in relation to the underlying share price at expiry. These charts don’t show how options prices decay over time, or really how options prices respond to changes in volatility.

One thing these kinds of charts are useful for is when you combine more than one option, effectively you can add the charts on top of each other to get the combined effect. If you open those options as part of a combined strategy then the combined graph shows the expected payoff of the strategy at expiration for different prices of the underlying.

And that is a useful thing to know.

Volatility

Volatility plays a big role in options pricing. The volatility of the underlying stock is reflected in the extrinsic value of the option. The stock price is volatile if we look back historically and has expected volatility looking forward in time towards expiry.

The historic volatility can be calculated statistically from the price movement of the underlying. The expected volatility is called implied volatility in options. Because options traders are thinking about what can happen between now and expiry the implied volatility is reflected in the price the market demands for an option.

An option is a contract between two parties. One party sells the option and receives payment for giving up rights to the other party. If the underlying stock is jumping about all over the place in value, then out-the-money options will have a greater chance of becoming at-the-money or in-the-money before expiry. This will mean that the seller will demand a higher price to sell or write the option.

The inverse is also true.

If the underlying is very stable in price, then there is less chance of out-the-money options becoming at-the-money or in-the-money before expiry so sellers will be willing to sell, or write the option at a lower price.

How delta varies

Delta is just one mathematical tool used to analyze options. There are a number of these all named after letters of the Greek alphabet and they are referred to as The Greeks. Just for the sake of completeness, in addition to delta the other main ones are, gamma, theta, and vega there are also others.

I will just quickly note that gamma measures the rate of change of delta, theta measures the time decay and vega relates to the risk of a change in the implied volatility. But a regular investor is unlikely to need to use these at least, to begin with anyway.

We have said that delta varies. It varies as an option moves into or out-the-money we also noted that delta changes as we approach expiry. So why is it important to talk about delta?

The reason we focus so much on delta is that when you buy an option, through the delta you are buying control of an equivalent number of shares of the underlying. An example explains this.

Let’s say you bought two XYZ August 110 call options. At the time you bought, it was 6 months to expiry and you paid $4 per call so a total of $800. We noted that at that time, the market price was $100 and the delta was 0.35. So in effect your $800 bought you the benefit of 2 x 100 x 0.35 i.e. 70 XYZ shares. Whereas buying the 70 shares outright would have cost you $7,000.

So delta is a bit like how many of the shares you own. That is when you buy a call option. If you sell a call option you have given away the equivalent in delta, but of course under the circumstances when an option is in-the-money and exercised.

Delta is also important because for example there are investment strategies used by hedge funds that create portfolios where the deltas of the underlying cancel each other out to zero. This article explains a hedge fund strategy that uses a zero delta approach.

A put option

It is always easier to understand options by starting with a call option. Somehow purchasing the right to buy something else that you don’t yet have sounds kind of logical if you think you know how the price of that thing might vary over time.

The other kind of option is a put option. With a put option, the buyer has acquired the right to sell the underlying at the strike price during the time between now and expiry. This means that the seller of a put option takes on the obligation to purchase the underlying at the strike price if the option is exercised.

The big advantage with put options is that it gives you a controlled way to benefit from price declines in the underlying stock. The other way to benefit from declining prices is to sell short.

Short-selling has been in the news a great deal recently as communities of small investors have piled into distressed stocks, like the video game retail outlet, GameStop, where financial institutions have sold large quantities of the stock short.

This is what is known as a short squeeze. Because the price has risen instead of declined as short-sellers had hoped, the short-sellers stand to lose more money if the price rises further. To avoid further losses, short-sellers close out their positions by buying back the stock. This just pushes the market price even higher.

Buy low then sell high vs sell high then buy low

We all know the classic advice on how to make money in the markets is to buy low and sell high. That works on a timeline when prices are rising. Short selling just reverses the order, so you sell high and then at a later time buy low, assuming that the price has declined.

Buying put options allows you to do the same. Let’s consider an example.

Put option example

Let’s say you have been watching the share price of company WXY. You note that the price is currently $100 and you expect that within 6 months the price will drop by 20% to $80. You also note that you can buy a WXY put option with a strike price of $90 and 6 months to expiry at a cost of $4.

In effect, this looks very similar to the earlier call option but just upside down as it were. Let’s consider what your choices are and what can happen.

Short-sell the stock

Assuming you have an account with a broker that allows you to sell short, you sell 100 shares of WXY at $100. Within a few months, the market price drops to $80. You close out your short position by buying back the stock for $8,000.

Some of the technicalities will depend on your broker and on what you have in your account. Essentially the broker borrows the 100 WXY shares from somewhere else to sell them on your behalf. You will be charged interest on the value of the short-position depending on the prevailing interest rates at the time,

In this case, your profit would be $2000 on a margin of $10,000, less commission and fees, and interest. So effectively something less than 20%.

Buy the put option

This time let’s say you buy the put option. It costs you $400. The put option will have a delta of minus 0.35 because the price of the option moves inversely with the price of the underlying and let’s assume that within a short time the WXY share price has dropped to $80. Your put option will be $10 in-the-money and you can expect it will be worth roughly $1000.

So again for an investment of $400, we gained a profit of $600 so we made a 150% gain.

Buying calls and puts

The examples we have so far considered are fairly simple textbook cases of call and put options. The advantages of buying call and put options are manifold.

Options provide leverage. When things go the way you want them, you can multiply your gains. As we saw with these two cases, where a 20% move in the underlying stock price resulted in a 150% gain from trading the options.

Options limit downside risk. Options are also a good way to manage and effectively cap your downside risk. This is most noticeably the case with the put option because buying a put option to replace short-selling the underlying limits your downside risk to the price of the option. In other words, the most you can lose with a put option is the cost of the option. Whereas, if you short-sell stock, the price can go up infinitely and your downside risk is technically infinite.

Options can generate income. This is an advantage of writing or selling options so we will get to that in a bit.

There are also disadvantages to buying options. You are paying for the time value and that time value diminishes as you approach expiry steadily eating away at the value of your option.

The value of an option diminishes over time if the price of the underlying stays static.

The market value of options can fluctuate substantially. Option prices can fluctuate much more than the underlying stock. This can be disconcerting to see the value of options positions increase and decrease often 20% in a normal day’s worth of trading when the underlying stock price has moved only by a couple of percents.

Selling or writing options

The other way to use options is to be the seller or writer of options. One advantage is that when you write an option you get paid. Of course, you are getting paid because of the rights you have given up and the obligations you have taken on.

We should also note that one of the obligations that a broker who trades options takes on is the obligation to take the other side of the trades that their customers open with them. So when you buy a call or a put, your broker has taken the other side of that trade.

Assignment risk

It is important to understand that with American-style options if you sell or write a call or put and it is either in-the-money or becomes in-the-money before expiry, you run the risk that you will be assigned. Being assigned is when the buyer of the option decides to exercise the option before expiry.

If you have written an option that is in-the-money at expiry you will be assigned anyway at that time. But there is also the risk that you will be assigned beforehand. There is a greater risk this will happen the closer you get to the expiry date because the extrinsic value is dropping.

As an option writer, you have no control over when an option could be assigned to you. It will just happen and you will have to deal with it.

There are a few common applications of writing calls and puts

Covered calls

A covered call is when you sell a call option for stock that you own. So let’s say you have 100 shares in XYZ. The shares are currently trading between $95 on the low side and $110 on the higher side. You judge that there is price support at $95 and resistance at $110. You see that you could sell a call option with a strike price of $115 with three months to expiry at a price of $3.50.

You think there is little chance that the price of XYZ will rise to $115 so you could earn $350 just for selling the $115 call three months out.

In fact only if the price rises above $118.50 would you be foregoing gains on the stock that you would otherwise have enjoyed.

Writing covered calls is a common way to create an income stream from stocks.

Writing uncovered or naked calls

If your account is approved by your broker, you can also write uncovered calls, also referred to as naked calls. Clearly, this is much riskier than writing covered calls.

If you write naked calls and the options move into-the-money those calls could be exercised and you will find you have to buy the stock at a higher market price to deliver them at the lower strike price.

If you get it right you can do this and draw an income. It’s when the markets move unexpectedly upwards that traders who have written naked calls start to lose money. It is actually quite common for ambitious and aggressive accounts to get wiped out in such circumstances.

Writing puts

There is no such thing as writing an uncovered put option. As the seller or writer of a put option, you are taking on the obligation to purchase a number of shares at the strike price before expiry. That is only going to happen if the market price drops below the strike price.

A side note on exercising options

If you are trading options you will most likely want to close out your positions before expiry. Most traders do not hold in-the-money options through expiry but would close out before. As noted before, with American-style options you can exercise them before expiry if you choose to do so. But if you do, you will lose any remaining extrinsic value.

So if you sell or write American-style options you take on the risk that the option will be exercised and you will have to either buy them or sell them at the strike price which you can guarantee will be at your disadvantage with respect to the current market price.

Back to writing puts

Other than being paid for it, there is a sensible reason to sell put options. If there are stocks or ETFs that you would like to own for the long-term but the current market price is too high for you and if you think a short-term market correction is likely, you can write put options for a strike price you wouldn’t mind paying for the stock.

If the market does correct and the stock price drops below your strike price then at expiry your broker will deliver you the shares and deduct their price from the cash on your account.

You can see why there can be market conditions where writing puts for stocks you would like to own on a pullback is a good idea. You will have to be realistic though. Pick a strike price that has at least some chance of being reached.

When to go deep in the money

Holding options that are deep in the money is like being long on the stock if you hold call options, or short on the stock if you hold put options.

It is always easier to talk about the call option case. A simple way to add leverage to your account is to hold deep-in-the-money call options that are many months from expiry on stocks or funds that you would want to own.

You will be paying for the time value of the options but you can trade out of options that get near to expiry and into options that have longer to expiry. If the underlying stock is on a gradual price uptrend, and the options aren’t expensive then the leverage you gain can more than compensate for the cost of the time value of options that you incur.

The best way to do this is to be systematic about it. You identify a stock or fund that has strong fundamental and technical attributes indicating it is on a long-term price uptrend and has options available that are liquid and not expensive.

You buy call options that are 7 months to expiry and are deep-in-the-money targeting a specific delta or say 0.8. Because extrinsic value doesn’t start to decay rapidly until 3 months out, just before you get to 3 months to expiry you close out that option and buy another that is 7 months out and has a delta of 0.8 adjusting the strike price as necessary.

The process of closing out an option position and opening another position in an option of the same underlying stock but with either a different expiry and/or a different strike price is called rolling.

If the price of the underlying has moved up by a modest amount, that should be enough to cover the cost of the additional time value on the new option.

If the price of the underlying has increased by a large percentage then the value of your option will have increased by a much larger percentage. As you roll your current option for a new one, you will probably be pulling a substantial profit out of the position. You will, however, still be maintaining your long exposure to the stock or ETF.

If the price of the underlying has declined, then your option will also have lost value. However, as the underlying drops in price, the delta of the call option decreases so the price of the option drops by proportionally less.

When to be OTM but near the money

There are circumstances when you want to hedge your account against a market decline. Let’s say you have a portfolio of stocks and funds that amount to $100,000 in value and you are in a variety of sectors and you notice that your portfolio tends to move more or less with the main market indexes.

One approach to hedging against a say 10% market decline would be to buy a put option on a major market index that would give you a profit of 10% of your portfolio value if the market and that index do drop 10%. It will only make sense to do this if the option costs you substantially less than the profit you will make.

In these circumstances, you will likely be buying put options that are out-the-money but not by a great deal so still near the money.

Married put

A married put is when you buy a put option as protection against a price decline in stock you own. It is a hedging strategy because if the price of the stock drops, your put option starts to gain in value in direct proportion. The disadvantage is that it costs money to buy the put option.

The additional cost of the married put is the cost of the option which will depend on how far it is either in-the-money or out-the-money and the time to expiry.

Combining options

You may have heard of options, spreads, collars, straddles, strangles, iron condors, and iron butterflies. All of these involve combinations of buying and selling either call and put options in the same underlying stock usually but not always with the same expiry date and either at the same or different strike prices.

These options strategies are either used to reduce the cost while capping the potential gain and the potential loss. Each one is suited to different market conditions, either high volatility, low volatility, the likelihood of either a price increase or the likelihood of a price decrease, alternatively the likelihood of a large price move either up or down, you may not know which.

Each of these options strategies takes time to study and understand and you will only really understand these if you decide to pursue and use them. Real understanding will only come with practice.

A word about emotions

If you do take the plunge and add a few options to your portfolio then you will probably start to notice that while the headline indexes may move up or down a half percent on a typical day, your option positions can easily move 5%, 10% even 20% in a single day. If you fill your portfolio with options then your whole portfolio can be moving that dramatically in either direction.

Remember most stocks move most of the time between levels of resistance and support within trading ranges. That is the natural price action of most stocks most of the time. Taking positions in options will amplify that movement. Investing in options is a bit like investing in stocks on steroids.

If you have trouble controlling your emotions with stock positions, you will likely have more trouble controlling those same emotions if you have a large proportion of option positions.

To invest and trade successfully you have to know what kind of investor you are and what strategies you are comfortable with so you stick with them.

This article gives more detail on options strategies.

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Questions and answers

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Q. Can you make more money with options?

A. Yes, and many people do. You can also lose more money with options and many people do that too. If you use options carefully, responsibly and in an educated way you can manage your risk, add leverage and provide yourself with an additional source of income.

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Q. Which options strategy is the safest and which is the riskiest?

A. I would say that the options strategy that has the least downside risk is to buy deep-in-the-money call options with at least 6 to 9 months to expiry on strong outperforming stocks in strong outperforming sectors or strong ETFs that are leading a long-term general bull market  However, no strategy including that one is without risk.

There are plenty of risky options strategies too numerous to mention. The riskiest way to use options is not to know what you are doing.

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Q. Which options strategy is the most profitable?

A. I don’t think there is a simple answer to this because it depends on what sort of investor you are. If anyone does give an answer then I would take that with some caution. They are probably trying to sell you something. The doesn’t necessarily mean it won’t work for you though. Any options strategy can be profitable as long as you manage risk, understand what the market is doing and invest in a way you are comfortable with.

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Single-page summary

Here is a single-page PDF summary of working with stock options.

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I hope you found this article interesting and useful. Do leave me a comment, a question, an opinion, or a suggestion and I will reply soonest. And if you are inclined to do me a favor, scroll down a bit and click on one of the social media buttons, and share it with your friends. They may just thank you for it.

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Disclaimer: I am not a financial professional. All the information on this website and in this article is for information purposes only and should not be taken as personalized investment advice, good or bad. You should check with your financial advisor before making any investment decisions to ensure they are suitable for you.

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