Guide To Options (Part 1)

Options are probably the most misunderstood financial instruments among the retail investing community. It does not help that there are so many contrasting sources of information. Also, you’ll notice that trading options often come with an intimidating warning about how risky these instruments are.

Is It Worth Your Time?

Ironically, many willing to spend the time poring over financial statements for stocks, but don’t bother to research another instrument that could better serve their needs. The second irony is that options, when utilized correctly, are actually less risky than buying a stock.

If one is willing to put in the effort, a whole new world of investing opens up to him – effort here refers to more than just attending a trading course, but spending time learning the theory, and then gain experience trading it in the real world.

The Basics Of Options

Options are nothing more than contracts between parties that bet on 2 different outcomes. The same concept applies to Toto. When you buy your Toto ticket, there is an implicit contract between you and Singapore Pools, where one will win or lose depending on different outcomes.

If you buy a stock call option, you are betting that the stock price will be above the specified strike price by the specified time period on the option. The opposite is true for put options. Thus, buying call and put options represent bullish and bearish views respectively.

For example, if you buy an Apple call option with the strike price of $100 with expiry on 27 May 2016, you expect the stock price to trade above $100 by the end of that date. However, whether you will eventually make money depends on several other factors. But fear not – these will be explained in due time.

Read also: Active Investing or Passive Investing? Which Is Really Better For Retail Investors?

What Determines The Value Of An Option?

To many, option values seem like a mysterious concept that is out of reach. To understand what goes into the price of an option, one needs to understand the following concepts.

Option prices are based off the combination of 2 components – Time Value and Intrinsic Value.

Intrinsic value is simply the difference between the current stock price and the strike price. From the previous example, if AAPL was trading at $105, the intrinsic value would be $5. If AAPL were trading at $99, the intrinsic value would be $0.

Time value is slightly more complex. Basically, it is the remaining option value after you take away the intrinsic value. There are different variations of what this value is based on, but it becomes easier when one thinks about it this way: (Assuming AAPL is not trading above the strike price of $100 yet). More time till option expiry means there is a greater chance the price will go above the strike price, so the time value will be correspondingly higher. Given that logic, the option’s time value will also decay every day, since the chance of it going above the strike price becomes lower.

This is the reason why when some people buy call options, they might still see a loss, even though the price was trading above the strike price by expiry.  These people bought the option when the time value was still very high, and the resulting increase in intrinsic value was not enough to offset the complete loss of time value (since at expiry there is 0 time value).

Top Image Credit: DollarsAndSense.sg

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