Buying Options

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The Basics Of Option Prices

Options are contracts that give option buyers the right to buy or sell a security at a predetermined price on or before a specified day. The price of an option, called the premium, is composed of a number of variables. Options traders need to be aware of these variables so they can make an informed decision about when to trade an option.

When purchasing an options contract, the biggest driver of outcomes is the underlying stock’s price movement. A call buyer needs the stock to rise, whereas a put buyer needs it to fall. But there is more to an options price than that! Let’s dig deeper into why an option costs what it does, and why the value of the option changes.

Key Takeaways

  • Options prices, known as premiums, are composed of the sum of its intrinsic and extrinsic value.
  • Intrinsic value is the amount of money received immediately if an option were exercised and the underlying disposed of at market prices—it is calculated as the current underlying price less the strike price.
  • Extrinsic value of an option is that which exceeds the option’s premium above its intrinsic value – it is composed of a probabilistic element influenced mainly by time to expiration and volatility.
  • In-the-money options have both intrinsic and extrinsic value elements, while out-of-the-money options only have extrinsic value.

Intrinsic Value

The option’s premium is made up of two parts: intrinsic value and extrinsic value (sometimes known as the option’s time value).

Intrinsic value is how much of the premium is made up of the price difference between the current stock price and the strike price. For instance, assume you own a call option on a stock that is currently trading at $49 per share. The strike price of the option is $45, and the option premium is $5. Because the stock is currently $4 more than the strike’s price, then $4 of the $5 premium is comprised of intrinsic value, which means that the remaining dollar has to be made up of extrinsic value.

We can also figure out how much we need the stock to move in order to profit by adding the price of the premium to the strike price: $5 + $45 = $50. Our break-even point is $50, which means the stock must move above $50 before we can profit (not including commissions).

Options with intrinsic value are said to be in the money (ITM), and options with only extrinsic value are said to be out of the money (OTM).

Options with more extrinsic value are less sensitive to the stock’s price movement while options with a lot of intrinsic value are more in sync with the stock price. An option’s sensitivity to the underlying stock’s movement is called delta. A delta of 1.0 tells investors that the option will likely move dollar for dollar with the stock, whereas a delta of 0.6 means the option will move approximately 60 cents for every dollar the stock moves.

The delta for puts is represented as a negative number, which demonstrates the inverse relationship of the put compared to the stock movement. A put with a delta of -0.4 should raise 40 cents in value if the stock drops $1.

Extrinsic Value

Extrinsic value is often referred to as time value, but that is only partially correct. It is also composed of implied volatility that fluctuates as demand for options fluctuates. There are also influences from interest rates and stock dividends.

Time value is the portion of the premium above the intrinsic value that an option buyer pays for the privilege of owning the contract for a certain period. Over time, the time value gets smaller as the option expiration date gets closer—the further out the expiry date, the more time premium an option buyer will pay for. The closer to expiration a contract becomes, the faster the time value melts.

Time value is measured by the Greek letter theta. Option buyers need to have particularly efficient market timing because theta eats away at the premium. A common mistake option investors make is allowing a profitable trade to sit long enough that theta reduces the profits substantially.

For example, a trader may buy an option at $1, and see it increase to $5. Of the $5 premium, only $4 is intrinsic value. If the stock price doesn’t move any further, the premium of the option will slowly degrade to $4 at expiry. A clear exit strategy should be set before buying an option.

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Implied volatility, also known as vega, can inflate the option premium if traders expect volatility. High volatility increases the chance of a stock moving past the strike price, so option traders will demand a higher price for the options they are selling.

This is why well-known events like earnings are often less profitable for option buyers than originally anticipated. While a big move in the stock may occur, option prices are usually quite high before such events which offsets the potential gains.

On the flip side, when a stock is very calm, option prices tend to fall, making them relatively cheap to buy. Although, unless volatility expands again, the option will stay cheap, leaving little room for profit.

The Bottom Line

Options can be useful to hedge your risk or speculate, since they give you the right, not obligation, to buy/sell a security at a predetermined price. The option premium is determined by intrinsic and extrinsic value. Intrinsic value is the moneyness of the option, while extrinsic value has more components. Before taking an options trade, consider the variables in play, have a plan for entry and have a plan for exiting. (For related reading, see “Understanding How Dividends Affect Option Prices”)

Three Ways to Buy Options

When you buy equity options you really have made no commitment to buy the underlying equity.

W hen you buy equity options you really have made no commitment to buy the underlying equity. Your options are open. Here are three ways to buy options with examples that demonstrate when each method might be appropriate:

Hold until maturity.

. then trade: This means that you hold onto your options contracts until the end of the contract period, prior to expiration, and then exercise the option at the strike price.

When would you want to do this? Suppose you were to buy a Call option at a strike price of $25, and the market price of the stock advances continuously, moving to $35 at the end of the option contract period. Since the underlying stock price has gone up to $35, you can now exercise your Call option at the strike price of $25 and benefit from a profit of $10 per share ($1,000) before subtracting the cost of the premium and commissions.

Trade before the expiration date

You exercise your option at some point before the expiration date.

For example: You buy the same Call option with a strike price of $25, and the price of the underlying stock is fluctuating above and below your strike price. After a few weeks the stock rises to $31 and you don’t think it will go much higher – in fact it just might drop again. You exercise your Call option immediately at the strike price of $25 and benefit from a profit of $6 a share ($600) before subtracting the cost of the premium and commissions.

Let the option expire

You don’t trade the option and the contract expires.

Another example: You buy the same Call option with a strike price of $25, and the underlying stock price just sits there or it keeps sinking. You do nothing. At expiration, you will have no profit and the option will expire worthless. Your loss is limited to the premium you paid for the option and commissions.

Again, in each of the above examples, you will have paid a premium for the option itself. The cost of the premium and any brokerage fees you paid will reduce your profit. The good news is that, as a buyer of options, the premium and commissions are your only risk. So in the third example, although you did not earn a profit, your loss was limited no matter how far the stock price fell.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Buying a Call Option

Dan Kenyon/Getty Images

Traders buy a call option in the commodities or futures markets if they expect the underlying futures price to move higher.

Buying a call option entitles the buyer of the option the right to purchase the underlying futures contract at the strike price any time before the contract expires. This rarely happens, and there is not much benefit to doing this, so don’t get caught up in the formal definition of buying a call option.

Most traders buy call options because they believe a commodity market is going to move higher and they want to profit from that move. You can also exit the option before it expires—during market hours, of course.

All options have a limited life. They are defined by a specific expiration date by the futures exchange where it trades. You can visit each futures exchange’s website for specific expiration dates of each commodities market.

Finding the Proper Call Options to Buy

You must first decide on your objectives and then find the best option to buy. Things to consider when buying call options include:

  • Duration of time you plan on being in the trade
  • The amount you can allocate to buying a call option
  • The length of a move you expect from the market

Most commodities and futures have a wide range of options in different expiration months and different strike prices that allow you to pick an option that meets your objectives.

Duration of Time You Plan on Being in the Call Option Trade

This will help you determine how much time you need for a call option. If you are expecting a commodity to complete its move higher within two weeks, you will want to buy a commodity with at least two weeks of time remaining on it. Typically, you don’t want to buy an option with six to nine months remaining if you only plan on being in the trade for a couple of weeks, since the options will be more expensive and you will lose some leverage.

One thing to be aware of is that the time premium of options decays more rapidly in the last 30 days.   Therefore, you could be correct in your assumptions about a trade, but the option loses too much time value and you end up with a loss. We suggest that you always buy an option with 30 more days than you expect to be in the trade.

Amount You Can Allocate to Buying a Call Option

Depending on your account size and risk tolerances, some options may be too expensive for you to buy, or they might not be the right options altogether. In the money call, options will be more expensive than out of the money options. Also, the more time remaining on the call options there is, the more they will cost.

Unlike futures contracts, there is a margin when you buy most options. You have to pay the whole option premium up front. Therefore, options in volatile markets like crude oil can cost several thousand dollars. That may not be suitable for all options traders, and you don’t want to make the mistake of buying deep out of the money options just because they are in your price range. Most deep out of the money options will expire worthlessly, and they are considered long shots.

Length of a Move You Expect From the Market

To maximize your leverage and control your risk, you should have an idea of what type of move you expect from the commodity or futures market. The more conservative approach is usually to buy in the money options.

A more aggressive approach is to buy multiple contracts of out of the money options. Your returns will increase with multiple contracts of out-of-the-money options if the market makes a large move higher. It is also riskier as you have a greater chance of losing the entire option premium if the market doesn’t move.

Call Options vs. a Futures Contract

Your losses on buying a call option are limited to the premium you paid for the option plus commissions and any fees. With a futures contract, you have virtually unlimited loss potential.

Call options also do not move as quickly as futures contracts unless they are deep in the money. This allows a commodity trader to ride out many of the ups and downs in the markets that might force a trader to close a futures contract in order to limit risk.

One of the major drawbacks to buying options is the fact that options lose time value every day. Options are a wasting asset. You not only have to be correct regarding the direction of the market but also on the timing of the move.

Break Even Point on Buying Call Options

Strike Price + Option Premium Paid

This formula is used at option expiration considering there is no time value left on the call options. You can obviously sell the options anytime before expiration and there will be time premium remaining unless the options are deep in the money or far out of the money. 

A Stop-Loss Instrument

A call option can also serve as a limited-risk stop-loss instrument for a short position. In volatile markets, it is advisable for traders and investors to use stops against risk positions. A stop is a function of risk-reward, and as the most successful market participants know, you should never risk more than you are looking to make on any investment.

The problem with stops is that sometimes the market can trade to a level that triggers a stop and then reverse. For those with short positions, a long call option serves as stop-loss protection, but it can give you more time than a stop that closes the position when it trades to the risk level. That is because if the option has time left if the market becomes volatile, the call option serves two purposes.

  1. First, the call option will act as price insurance, protecting the short position from additional losses above the strike price.
  2. Second, and perhaps more importantly, the call option allows the opportunity to stay short even if the price moves above the insured level or the strike price.

Markets often rise only to turn around and fall dramatically after the price triggers stop orders. As long as the option still has time until expiration, the call option will keep a market participant in a short position and allow them to survive a volatile period that eventually returns to a downtrend. A short position together with a long call is essentially the same as a long put position, which has limited risk.

Call options are instruments that can be employed to position directly in a market to bet that the price will appreciate or to protect an existing short position from an adverse price move.

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