What Is a Stock Option?
An option is a hold on a particular asset, in this case, a stock, to buy it at an agreed price if purchased within a specific timeframe. The purchaser does not have to purchase the stock, but if they do, they will buy it at the agreed-upon price rather than the current market price.
There are two different types of stock options:
- A call option is for buying a stock at an agreed-upon price
- A put option is for selling a stock at an agreed-upon price
At a Glance
- An option allows a buyer to put a hold upon a stock at a certain price, without obligating them to buy it.
- Options can be extremely profitable, but the risk is the market price for the asset could be lower than the strike price (agreed-upon price) when the investor decides to buy it.
Stock Options
The parties involved in an option contract are the buyer and the seller. In a call option, the buyer believes the market price for the share will be higher during the term. The seller in a put option believes that the market price for the share will be higher during the term.
A buyer will pay a premium fee per share for an option contract. The premium fee price is calculated based on the strike price and the term of the contract. For stock options, the contract expiry date is usually the third Friday of the month.
Why Option a Stock?
An option allows investors to do three different things:
- Speculate – An investor can say they think the price of the stock will rise, without having to bear the cost of buying the stock until it does.
- Hedge – The investor reduces their risk by not purchasing the stock unless it performs as expected.
- Generate income – The seller generates extra income on the option premium. The buyer will generate income if the stock performs better than its strike price.
American stock options can be claimed any time during the term of the option. European options, on the other hand, may be claimed only on the expiration date or predetermined exercise date.
What Are the Risk Metrics of Options?
The risk metrics of options are referred to as “the Greeks” because they are labelled with Greek symbols. Here we will explore the different risk metrics and what they mean.
Delta (Δ)
Delta is a ratio that calculates how the option price will change in relation to the underlying asset value. A call option will have a delta value between zero and one. A put option will have a delta value between zero and negative one. For example, a call option with a delta of 0.25 will rise 0.25 cents for every dollar the asset value increases.
Theta (Θ)
Theta calculates the depreciation of the asset in relation to the expiration date of the option agreement. A stock, as an asset that does not depreciate, would have a theta of zero. A long option will have negative theta, and a short option will have a positive theta.
If an investor has an option with theta -0.50, the price of the option will decrease by 50 cents every day. This is based on all other factors remaining the same.
Gamma (Γ)
The gamma measures how the option’s delta will change in relation to changes to the asset price. This measurement calculates the stability of the delta and therefore, indirectly measures the stability of the option price. For example, if a call option has a gamma of 0.1, it means that when the price of the asset changes by $1, the option’s delta will change by 0.1.
An option’s gamma value will often increase closer to the option agreement expiration date as any price changes will affect the option’s price.
Vega (V)
Vega predicts the sensitivity of the option to volatility of 1%. A change of volatility will often affect the price of the option. For example, if the volatility increases, the price of the option will go up.
If an option has a vega of 0.1, then if the volatility changes by 1%, the option’s value should theoretically change by 10 cents.
Rho (p)
Rho measures the sensitivity of the option’s value to the interest rate. If the interest rate rises by 1% on a call option, the option value will increase by the Rho. If the interest rate rises by 1% on a put option, then the option value will decrease by the Rho.
Minor Greeks
There are some minor Greeks which measure second or third derivatives, which means they calculate the Greeks in relation to another aspect rather than the option vs the underlying asset. Some of these are epsilon, vera, lambda, ultima, zomma, speed, color, etc.
What Are the Advantages and Disadvantages of Buying Call Options?
The advantages of buying a call option are that the buyer can secure an agreement to purchase an asset at a particular price as long as they purchase it within the agreed term. There is no obligation to purchase the asset if they change their mind.
To calculate the profit of an option, calculate the market price minus the option strike price and any expenses. Investors will generally buy a call option because they believe the market price of the share will rise.
If the market price of the share goes down, then the call option will expire and the buyer will lose the amount they paid in premium for the option.
What Are the Advantages and Disadvantages of Selling Call Options?
A call option seller believes that the market price of the share will decline or remain similar to the strike price for the duration of the option agreement term. They will make profit in the form of the premium fee. Regardless of whether the buyer exercises the option or lets it expire, the seller will make money in the form of the premium fee.
If the market price of the asset is more than the strike price when the option agreement expires, then the buyer will exercise their option and purchase the shares at the strike price. The seller will lose because they will have to sell their shares at market price to give to the buyer who purchased them at a lower price.
What Are the Advantages and Disadvantages of Buying Put Options?
In a put option, the buyer believes that the market price of the asset will be lower than the strike price upon expiry. The seller in this case has no obligation to sell the shares if they do fall below the strike price.
The buyer’s profits is calculated as the strike price minus (the current market price + expenses.) If the option expires without the seller exercising their put, then the buyer will only lose their premium fee.
What Are the Advantages and Disadvantages of Selling Put Options?
The put option seller believes that the market value of the asset will increase above the option strike price. If they are correct and the market value of the asset is higher than the strike price, then the seller can choose not to sell the put option and will still profit via the premium fee.
If they are incorrect and the option strike price is higher than the asset’s market value, then they have to purchase shares at the strike price and may lose due to the asset’s appreciation. The loss will be offset a little by the premium fee.
Examples of Options
Let’s say for the example that shares of Apple are trading for $110 per share and you believe that the share price will rise. You buy a call option so you can profit from the share rise without the risk of buying shares now.
A call option contract is usually for 100 shares. You agree to a contract with a strike price of $120 per share with a premium fee of 39 cents per share. Therefore, your total cost for 100 shares is $39.
If the stock’s market price rises to $121, then your option will now be worth $1 because that is the profit per share that you will make if you exercise your option. When you exercise your option, you will immediately resell the share for the market value of $121 per share, thus pocketing the $1 per share or $100 for the full 100 shares.
If the stock’s market price falls to $100 per share, then you would just not exercise the option. Instead of buying the stocks outright and being out $100, you have only lost the $39 premium. The main benefit of an option for a buyer is that they limit the risk.
Frequently Asked Questions
What Are Options?
Options allow an investor to speculate on stock or hedge against market volatility. A call option allows the buyer to profit if the stock price rises and a put option allows the buyer to profit if the stock price falls. The seller of a call option profits if the stock price falls and the seller of a put option profits if the price rises.
What Are the Advantages of Options?
An option allows an investor to speculate on the market fluctuations while minimizing their potential risks. The investor only has to pay the small premium up front rather than the cost of the whole share, meaning the investor can option more shares than they would be able to afford outright.
What Are the Disadvantages of Options?
The disadvantage of options is that they are difficult to price and often very complex. They are considered by most investors to be advanced investments and only suitable for those with experience. Recently, they have gained more popularity, but investors should ensure they understand them properly before purchasing or selling options.