What is an Option?

A financial option is a contractual agreement between two parties, whereby the buyer of the option is granted the right, but not the obligation, to purchase or sell an asset at a pre-determined price (referred to as the strike price), during a specified period of time. The underlying asset can be a stock, bond, commodity, currency, or any other financial instrument. The contract typically represent 100 shares of the asset. Every option contract has a price that frequently changes based on three things:

1. The price of the underlying asset (referred to as Delta)
2. The time left on the contract until expiration (referred to as Theta)
3. The volatility that exists in the market. (referred to as Vega)

When the buyer purchases the contract from the seller, the seller receives this amount from the buyer (referred to as the premium).

While the purchaser of the option technically has the ability to exercise the option at any point in time, most are not exercised until the final date the contract is good for (also referred to as the expiration date). Many brokerages will automatically exercise the contract if it finishes “in-the-money” at the end of the expiration date, because in this situation, it would be more beneficial for the option holder than doing the same transaction through the open market. Conversely, it will not be exercised if it finishes “out-of-the-money”, because in this situation the option holder could get a better deal by going through the open market. Sometimes options are exercised early when it is relatively close to the expiration date and a dividend payment is upcoming.

Financial options can be categorized into two main types:

1. Call Options
2. Put Options

What is a Call Option?

A call option is one of two types of options. It gives the purchaser the right to purchase, if they so choose, the underlying asset at the pre-determined strike price. Conversely, the seller must provide the 100 shares to the buyer if the option is exercised. On the exercise date, the seller may already own the shares, in which case he would sell them to the buyer for the pre-determined strike price (referred to as a covered call). If the seller does not own the shares, he will have to purchase them in the open market and sell them to the buyer at the pre-determined strike price (referred to as a naked call).

As previously mentioned, the call option is typically exercised only if the option finishes “in-the-money”. If it finishes “out-of-the-money”, then the contract is not exercised, which means no shares change hands. This is typically referred to as “expiring worthless” because the value of the option contract is zero. In this situation, the only change is that the seller has become enriched when they received the premium from the buyer at the initial purchase date.

What is a Put Option?

A put option can be thought of as the counter opposite to a call option. It gives the purchaser the right to sell, if they so choose, 100 shares at the pre-determined strike price. Should the buyer exercise the put option, the seller must buy the shares from the owner of the put option at the pre-determined strike price. A common use of put options is for an investor to have protection against an anticipated downturn. Should the market price fall below the strike price, the purchaser of the put option is able to sell those shares at a price that is better than the going market rate. This is referred to as the put option finishing “in-the-money”. Conversely, should the market price finish above the strike price, the option is said to have finished “out-of-the-money” and expires worthless. Puts can be thought of as a type of insurance contract for your investments.

What does “In-The-Money” vs. “Out-of-the-Money” mean?

“In-the-money” and “out-of-the-money” are terms used to describe the status of an options contract with respect to its strike price and the current market price of the underlying asset.

For a call option, if the current market price of the underlying asset is above the strike price, then the option is considered to be “in-the-money”. This means that if the option holder were to exercise their option, they would be able to purchase the underlying asset at a price lower than its current market value, and could then sell it for a profit, if they so choose. Conversely, if the market price of the underlying asset is below the strike price, the option is “out-of-the-money”, and exercising it would not be profitable, as the holder would have to pay more for the asset than its current market value.

For a put option, the situation is reversed. If the market price of the underlying asset is below the strike price, the option is “in-the-money”, as exercising it would allow the holder to sell the asset at a higher price than its current market value. If the market price of the underlying asset is above the strike price, the option would be “out-of-the-money”, as exercising it would result in a loss, since the holder could sell their shares for a higher price in the open market.

What does the Underlying Asset mean?

Underlying asset refers to the asset that the option contract centers around. For example, if you were to buy a call option in Tesla stock, it would give you the right to purchase 100 shares of Tesla stock, making Tesla stock the underlying asset.

What does the Premium mean?

Premium is the term used to refer to the current price of the option. It is the same concept as the stock price of a stock.

What does the Strike Price mean?

The strike price in an option represents the pre-determined agreed-upon price at which the shares will be bought (for a call option) or sold (for a put option) if the option is exercised by the holder. The strike price is stated on every option contract and is used to determine whether an option is considered “in-the-money” or “out-of-the-money”, depending on the option type. Should the option finish “in-the-money”, it will be exercised and the underlying shares will be exchanged from the seller to the buyer. If the seller does not have the shares, he will have to purchase them or borrow them. If the option finishes “out-of-the-money”, it will expire worthless and the shares will not be exchanged.

What does the Expiration Date mean?

The expiration date in an option contract is the last day that the option can be exercised. Most options are either exercised or not exercised on this date, and most are decided automatically by the brokerage based on the closing price of the underlying asset at the close of the expiration date.

What does it mean when someone says a “covered option” or a “naked option”?

A covered option means that the seller of the option contract has a position in the underlying asset that, if the option were to be exercised, would close his position in the underlying asset. This is most frequently done on call options, where the seller of the call option purchases 100 shares of the underlying. Should the contract be exercised by the holder at any point, the seller would be able to sell those 100 shares to the buyer.

A seller of a put option can also have a covered position, although done less frequently. This would involve borrowing 100 shares from someone else and then selling them in the open market ahead of time (referred to as “selling short” or short-selling). The seller would then have a negative position in the underlying. During the interim period, the seller would be paying interest to the entity in which it borrowed the shares from, which is typically their brokerage. If the buyer of the put option exercises it, he would sell the shares to the seller, who would then turn around and forward them back to the brokerage.

Conversely, a naked option does not involve any pre-purchased position in the underlying. The option seller simply sells the contract. If the contract is exercised at some point in the future, the option seller would have to take action at that later point in time. For call options, he would have to purchase 100 shares to sell to the option holder. For put options, he would have to sell the shares after receiving them from the option holder. Naked options are viewed by some as more risky than covered options because covering options is a form of hedging that results in less of a fluctuation in the seller’s market value, whereas a naked option can have more sharp fluctuations because it does not have the hedge and moves at a factor of 100. Naked options move most severely when they are “in-the-money”, and move least severely when they are “out-of-the-money”.

Additionally, for call options only, it is more difficult to mathematically define the risk taken with naked call options as opposed to covered call options. For covered call options, a seller is able to mathematically define both their maximum amount of gain and loss before they execute the option trade. Conversely, for naked call options, since there is no limit to how high a stock can go, there is no way to mathematically define the risk being taken. This is often referred to as “undefinable risk”. This means that there is no limit to the amount you could lose, and it could exceed 100% of the contract’s notional value. This is a concept used most notably by “Wall Street Bets”, which was responsible for the GameStop rally in January 2021. Their strategy involved identifying stocks that had an already high demand due to excessive short selling, and then rallying people through social media to buy up call options and stock. This caused a simultaneous shrinkage of supply and an increase in demand, which caused the price to spike. As the price rose, demand continued to increase through a number of different avenues, which caused some to realize massive profits from the undefinable profit potential of purchasing a naked call option. Although possible, these situations are generally rare.

For naked put options, since the underlying asset cannot go below zero, the maximum potential loss is 100% of the contract’s notional value. Compared with a naked call option, where the loss can exceed 100% of the notional value.

Notional value means the transaction price of the underlying shares. It is represented by the underlying stock price times 100 shares per contract. For example, if an investor had 1 option contract where the underlying stock was $100, the notional value would be $10,000 ($100 underlying * 100 shares * 1 contract).

The benefit of naked options is that because you are not taking out the hedge position, you are able to realize more profit at strike prices that are further away. This can reduce your potential risk to a very small amount, as the stock price would have to move in an extremely unexpected manner to reach these strike prices.

What is a “single-leg” versus a “multi-leg” option strategy?

A single leg option strategy simply means buying a naked option. Conversely, a multi-leg option strategy involves two or more different asset or derivative purchases simultaneously. For example, a covered option is a multi-leg strategy, because it involves two transactions: a option transaction, and a stock transaction. Another type is where, instead of having a stock transaction, there are two or more option transactions. Some common multi-leg strategies are:

• Vertical Spread: Selling an option contract and then purchasing another option contract that is further out-of-the-money. The only difference between the two options is the selected strike price. The underlying asset, the expiration date, and the option type are the same for both. It receives the term “vertical” in reference to the option chain, where choosing a different strike price involves going up or down in the option chain.

• Calendar Spread: Similar to the vertical spread, except instead of a different strike price, the difference is in the expiration date. The underlying asset, the strike price, and the option type are the same for both. The term “calendar” comes from the fact that the expiration date is different. This can also be thought of as a “horizontal” spread.

• Diagonal Spread: This is a combination of a vertical spread and a calendar spread. You sell an option contract and then purchase another option contract that is both (1) further outside-of-the-money, and (2) further away from expiration. The underlying asset and the option type are the same, but the strike price and expiration date are different. It get’s it’s “diagonal” name from the option chain, where the selection of the second option involves selecting a different expiration date (horizontal) and strike price (vertical).

• Straddle: A straddle involves making 2 transactions: one involving a call, and one involving a put. You can either buy both or sell both, but the transaction type must be the same for both. The underlying asset, the strike price, and the expiration date are also the same. The only difference is the type of option. The straddle forms a V shape profitability graph. If a trader buys a straddle, then the more the underlying asset price moves away from the strike price, the more profit he will make. The move can be in either direction. Conversely, the seller desires for the underlying asset price to stay close to the strike price.

• Strangle: The strangle is very similar to a straddle. The only difference is that the strike prices are different in a strangle. Instead of a V shaped profitability graph, the strangle makes a tabletop shape. The underlying asset and expiration date are the same for both options. However, the strike price and the option type are different.

• Iron Condor: This is a 4-legged option strategy that involves two vertical spreads: one on the call side, and one on the put side. The underlying asset and expiration date are the same, but the strike prices are different. There are 4 transactions: selling a call, selling a put, buying a call, and buying a put. If the asset price finishes between the strike price of the sold call and the sold put, the trader will recognize their maximum profit. If it goes past either of those strike prices, it will begin to lose profitability, eventually turning to a loss, until it reaches the strike price of the option that was bought. The strike price of the call or put represents the point in which the trader will recognize their maximum loss possible on the position.

What does the Option Greeks mean?

Option Greeks is a term used to refer to the various things that are affecting the price of the option. They are represented by the following 5 Greek letters: Delta, Gamma, Theta, Vega, and Rho.

• Delta: Delta measures the degree to which the price of an option moves in relation to the movement of the underlying asset. It ranges from 0 to 1 for calls and -1 to 0 for puts. A delta of 0.5 means that the option price will increase by 0.5 for every $1 increase in the underlying asset price for a call option, and decrease by 0.5 for every $1 decrease in the underlying asset price for a put option.

• Gamma: Gamma measures the rate of change of the delta. It shows how much the delta will change in response to a $1 movement in the underlying asset price. The higher the gamma, the more sensitive the option price is to changes in the underlying asset price.

• Theta: Theta measures the rate of time decay of an option. It indicates how much the option price will decrease as time passes, all else being equal. A negative theta means that the option value will decrease as time passes.

• Vega: Vega measures the sensitivity of an option’s price to changes in implied volatility. It shows how much the option price will increase or decrease for every 1% change in the implied volatility of the underlying asset.

• Rho: Rho measures the sensitivity of an option’s price to changes in the risk-free interest rate. It indicates how much the option price will increase or decrease for every 1% change in the risk-free interest rate.

The usage of Greek letters rather than regular letters does not have any significance. Greek letters are used because the concepts come from the Black-Scholes option pricing equation, which uses Greek letters.

As previously mentioned, the three concepts that have the largest impact on the price of the option are the change in the price of the underlying asset (Delta), the time remaining until the option contract expires (Theta), and the expected volatility in the underlying price over the life of the contract (Vega).

Ready to get started?

When trying to find the right investment strategy, it’s important to first understand what the end goal looks like and what you want the road to look like. Before you begin, you should answer the following:

• How much account value volatility do you desire?
• When do you need to arrive at your investment goal?
• What kind of risk/reward profile do you desire?

Having the guidance of someone well-versed in these areas can help translate the answers into the right investment strategy for you. If you think that could be of use to you, I invite you to please reach out here and we can get started.

You can find us at our home website at MageeTax.com

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