After discussions with my friends, I thought it would be a good idea to write a couple of articles about options – what they are, what they do, and how one could (or should?) use them. I’ll be focusing on U.S. exchanges and options trading there. But the same principles should apply to other exchanges as well.
Right now, I’m planning a series of three articles about options:
- An introduction
- Some options-specific mathematics
- Beginner-friendly options strategies
Disclaimer: Options trading is not for everyone and may not be suitable for your specific situation. They are a riskier type of investment than stocks, as option prices fluctuate significantly, and you might lose more than your initial investment. Therefore, think twice before investing in them.
What Is an Option?
An option is the right (but not the obligation) to sell (a put option) or to buy (a call option) a specific asset (such as a stock, index, commodity, etc.) at a specified price (the strike price) before or on a specific date. In the case of stock options, 1 option contract represents 100 shares of the underlying stock.
Option Premiums
Since you, as the option holder, have a privileged position compared to the option seller (you have the right, but not the obligation, to act), you must compensate the seller for taking on the risk. This compensation is called the option premium – the cost of the option – which you pay upfront. It is an immediate profit for the option seller.
An option premium consists of two parts:
- Intrinsic value: The difference between the current stock price and the strike price.
- Extrinsic value (also called time value): The difference between the option price and the intrinsic value.
The further away the expiry date, the higher the extrinsic value. As a result, such options are more expensive.
An Example
It might sound a bit cryptic at first, right? Let’s take an example from Yahoo Finance for KO (Coca-Cola) call options (right to purchase) expiring on August 1, 2025.
Suppose we look at a strike price of $67. If you had this option, you would have the right (this is called exercising the option) to purchase 100 shares of KO stock until August 1. This right would cost you a premium of $3.70 × 100 shares = $370, plus commissions.
What does this mean? It means you could purchase 100 shares at $67 per share, totaling $6,700.
So why would you exercise this option? Imagine KO stock is trading at $100 on the market. You could buy it for $67 and immediately sell it at $100, locking in a profit. Or, you could sell the option itself for a premium. Either way, profit.
Expiry and Execution
But not so fast. After the expiry date (August 1 in our example), the option becomes worthless—its value becomes zero. So you lose the premium you paid. In practice, if you see the option’s price decreasing (spoiler: it does that every day), you can sell it on the market and recover part of your premium.
Also, there’s the matter of execution. In our KO example, if the stock trades at $60, you wouldn’t exercise your right to buy at $67, because you could simply buy the stock on the open market at a lower price. The option becomes useless.
American vs. European Options
There are two types of options: European and American. Despite their names, they don’t necessarily reflect where the options are traded. American options can be traded in Europe, European options can be traded in the US.
- European options can only be exercised on the expiry date.
- American options can be exercised any time before the expiry date.
Because American options offer more flexibility, their premiums tend to be slightly higher.
Typically:
- Stock and ETF options = American
- Index options = European
ITM, ATM, OTM
There are three key terms in options trading:
- ITM (In The Money)
- ATM (At The Money)
- OTM (Out of The Money)
Let’s use our KO example. Suppose KO is trading at $69.55.
- ITM Option: A strike price below the current stock price.
Example: Strike = $67, Premium = $3.70
- Intrinsic Value = $69.55 – $67 = $2.55
- Extrinsic Value = $3.70 – $2.55 = $1.15
- Intrinsic Value = $69.55 – $67 = $2.55
- ATM Option: A strike price closest to the current stock price.
Example: Strike = $69, Premium = $2.30
- Intrinsic Value = $69.55 – $69 = $0.55
- Extrinsic Value = $2.30 – $0.55 = $1.75
- Intrinsic Value = $69.55 – $69 = $0.55
- OTM Option: A strike price above the current stock price.
Example: Strike = $73, Premium = $0.55
- Intrinsic Value = $0 (no value because it’s not profitable to exercise)
- Extrinsic Value = $0.55
- Intrinsic Value = $0 (no value because it’s not profitable to exercise)
Interesting patterns to note:
- ITM options have high intrinsic and some extrinsic value.
- ATM options have some intrinsic and high extrinsic value.
- OTM options have only extrinsic value.
Spoiler alert: That’s not a coincidence.
We’ll discuss which types are best to buy – OTM, ATM, or ITM – in a future article.
Why Trade Options?
- Speculation: Option prices fluctuate far more than the underlying stock. You can make – or lose – money faster.
- Leverage: Buying 100 KO shares at $69.55 would cost $6,955. But buying an ATM option might cost just $230 (2.3 × 100). For a fraction of the cost, you get exposure to the same 100 shares. Just remember: the option can expire worthless.
- Protection: Options can be used as insurance. Buying a put gives you the right to sell at a specific price. If the market crashes, you’re covered.
- Income generation: Selling options allows you to earn premium income. This can reduce portfolio sensitivity to market fluctuations.
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