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Options

What are they - How they work

Page Summary:
What are Traded Options and how can they be used to make profits and hedge stockmarket risk? This pages offers an introduction and a look at the basics
An Option is a derivatives contract on an underlying instrument. Options on London stocks are often referred to as 'Traded Options', but there is no difference between a Traded Option and an Option.

Options do not always have a good reputation because people view them as incredibly risky. This is true, they are extremely high-risk high reward tools for trading and speculating on the markets.

Conversely they can be used to limit and hedge risk. Some people therefore use the analogy of dynamite. Dynamite is the wrong hands can wreak havoc but in the right hands, for example when used it in the Alps to control avalanches, it greatly reduces risk.
The basics of an Option

All Option contracts work the same way; when you understand what a stock option is you will also understand how an option on a commodity works.

Options come in two primary forms, Calls and Puts, and as most readers of this site are interested in the stockmarket we will mainly be focusing on equity options.

  • A call option gives the holder the right, but not the obligation, to buy a fixed number of shares of the underlying stock at a fixed price within a fixed period of time
  • For example: Tesco June £3.00 call option - The buyer of this call option has the right, but not the obligation, to buy 1,000 Tesco shares at £3.00 on or before the expiry in June (normally always the 3rd Friday of the month)
  • A put option gives the holder the right, but not the obligation, to sell a fixed number of shares of the underlying stock at a fixed price within a fixed period of time
  • For example: BP May £4.50 Put option - The buyer of this Put option has the right, but not the obligation, to sell 1,000 BP shares at £4.50 on or before the expiry in May (3rd Friday).
Note, most UK equity options deal in 1,000 shares whereas options on American equities are usually in 100 shares. But information such as this should always be confirmed with your broker or online before any trading is done.
How Options work
When you're starting to learn about Options it is important to understand that they are somewhat like icebergs.

10% - 15% of an iceberg is visible above the surface, the rest is hidden from view. A ship can therefore get easily damaged if it sails too close to the berg even if the visible part of the ice is some distance away.

Understanding the basics of options is not hard - this is the 10% - 15% that's visible above the surface. But to have a proper grasp of how they really work you also have to delve below the surface.

This means that you should not contemplate using options until you have a proper understanding of exactly how they work and their subtle nuances. Please don't forget this because a lot of money continues to be lost by new option traders who dive into the deep end without the proper knowledge and experience. And knowledge in the markets always carries two advantages -

  1. it can help you make decent returns, and more importantly
  2. it can help you avoid unnecessary losses
Call Options

Call options generally rise when the underlying asset rises in price. For example, Call options on Vodafone will generally increase when Vodafone rises in price.

Note the word 'generally' above because it's important.

Without it the statement would say 'Call options in Vodafone increase when Vodafone rises in price' but that would be wrong.

There are times when the underlying share rises in price and the Call options decrease in price. Conversely there are times when Vodafone might decrease in price but the Call options increase in value.

This can be due to many factors but the main one relates to what is called option volatility. We've written a dedicated page as to what option volatility is, how it works, and why it is so important when trading options.

But if you're starting out in Options or thinking about using them here's some golden advice -

Don't even think about trading them until you understand how volatility works and influences the price of all options.

Put Options

Put options generally rise in value when the underlying asset falls in price. For example, Put options on Sainsbury's will generally rise in value as Sainsbury's share price falls

And as with Call options the word 'generally' is important and it's related to how volatility is used in the pricing of all option contracts.

Options Are Wasting Assets

All options expire at some stage in the future, so they can only have value for a set period of time. They are therefore known as 'wasting assets' because the price can decrease or waste away the closer it gets to its expiration date.

This makes sense if you think about it. As indicated above an option only lasts for a set time period. So if you believe that a share has the potential to rise by 25% over six months, that's very possible isn't it?

But if the stock doesn't start climbing as the days tick by the chances of it rising by more than a certain percent start to diminish and hence the value of the option will decrease. For example -

  • What is the chance of Tesco's stock price rising 25% in 180 days? - Very possible
  • What is the chance of it rising 25% in 90 days? - Possible
  • What is the chance of it rising 25% in 30 days? - Not that possible
  • What is the chance of it rising 25% in 5 days? - Virtually impossible unless it's a takeover candidate or there is some other extremely price sensitive actively happening

So in the above example a call options price to buy Tesco's stock at 25% higher than today's price would be of a relatively high value if it had six months till it expired. But as the days drift by the chance of the stock rising significantly also diminish and therefore the price of the option declines over time.

This is why options are wasting assets.

Basic Option Terminology
  • Premium - The value of an option and what the buyer pays or the seller receives
  • Strike Price - The price at which the underlying product will be exchanged
  • Expiry - The date when the option will expire

The same terminology applies to both call and put options.

Vodafone March £1.30 Call priced at £0.15

  • The premium of the option is £0.15
  • The strike price is £1.30
  • The expiry will be the 3rd week of March (most options will expire on the 3rd Friday of the month)

Tesco June £3.50 Put priced at £0.45

  • The premium of the option is £0.45
  • The strike price is £3.50
  • The expiry will be the 3rd week of June
An example of Option prices
Option prices are usually quoted in what they call an option chain. An Options change is where all the prices are quoted on the one screen. This is because they will always be many different options available and so traders often want to see the whole range.

An Options Chain on BT - The month is currently April and BT are trading at £1.62

Call Option Prices
Strike Price
Put Option Prices
Jun
Sep
Dec
Jun
Jun
Dec
£0.635
£0.68
n/a
£1.00
£0.01
£0.047
n/a
£0.545
£0.602
n/a
£1.10
£0.017
£0.07
n/a
£0.457
£0.525
£0.582
£1.20
£0.03
£0.092
£0.145
£0.38
£0.455
£0.517
£1.30
£0.052
£0.122
£0.177
£0.272
£0.392
£0.452
£1.40
£0.077
£0.157
£0.212
£0.24
£0.33
£0.392
£1.50
£0.112
£0.195
£0.25
£0.187
£0.282
£0.342
£1.60
£0.16
£0.247
£0.30
£0.137
£0.268
£0.295
£1.70
£0.21
£0.30
£0.35
£0.102
£0.197
£0.250
£1.80
£0.275
£0.362
£0.405
£0.07
£0.167
n/a
£1.90
£0.342
£0.430
n/a
£0.05
£0.14
£0.195
£2.00
£0.422
£0.502
£0.547

  • As you can see, this lists the different months and option strikes
  • To the left and right of 'Strike Price' are the prices for the individual options
  • So the September £1.50 call is priced at £0.33 (highlighted blue)
  • The December £1.30 put is priced at £0.177 (highlighted in red)
  • Note, that each option is on 1,000 shares so the call option would cost £330 (£0.33 x 1,000) and the put option £170
How much is an Option worth - The Premium

An option is always priced in points or as many refer to them, ticks. The point value is then multiplied by how many shares the option is on.

Most London shares, unless they're of a very high value, are on 1,000 shares. A call option on BP trading at £0.21 is worth £210.

But remember, equity options for shares traded in different countries will be different. For example, in the US most options are on 100 shares.

Option Intrinsic & Time Value
There are always two parts to the pricing of an option: intrinsic value and time value.
Intrinsic Value
Intrinsic value is the amount of money an option is worth if it were exercised and turned into shares today. It is therefore the difference between the underlying security and the option's strike price. This means that options can have intrinsic values of zero (explained below).
  • For example, using the BT Jun £1.50 call. If BT stock is at any price above £1.50 the call option has to be worth at least that difference - this is the so-called intrinsic value

  • Therefore if the stock is trading at £1.76 the option will be priced at a minimum of £0.26

  • This should be easy to understand because if the option gives the holder the right to buy shares at £1.50 he can then immediately sell the shares in the cash market for a profit of £0.26

  • But using the same options (the BT June £1.50 call) what would be the intrinsic value if BT shares were trading at £1.25? None, because why would anyone buy the option, which gives the right to buy shares at £1.50, when the shares can be bought in the cash market for £1.26.
But the June £1.50 call would not be worth zero? Why, because of what's known as Time value and this is discussed below.
Time Value

Time value is the amount by which the premium (price) of an option exceeds its intrinsic value (that is if it has any intrinsic value)

If the BT June £1.50 call is trading at £0.45 with the stock at £1.75 then the option will have time value of £0.20 and intrinsic value of £0.25.

  • If the BT June £1.80 call is valued at £0.10 with the stock price at £1.70 then there would obviously be no intrinsic value in the options and the £0.10 premium would all be time value

  • The longer the option has till expiry the more time value it will have and therefore the higher its price will be

  • If BT stock is trading at £2.00, the £2.25 call option with 1 month to expiry may well be trading at £0.05, but the £2.25 call with nine months till expiry is priced at £0.25

  • This is because within one month it's a lot harder for BT to rally over £0.25 than it is over a nine month period

To summarise

  • All options have time value
  • But some options have both time value + intrinsic value

There are specific names to describe this, as mentioned below.

At-The-Money : In-The-Money : Out-Of-The-Money

There are three different sub terms used to describe both call and put options.

  • At-the-money
  • In-the-money, and
  • Out-of-the money

We will use the BT June £1.50 call as an example.

In-the-money

  • If the BT share price is greater than £1.50 the option will be referred to as in-the-money because it has an intrinsic value.
  • The intrinsic value will the share price - the option strike price
  • If the share price is £1.70 the intrinsic value = £0.20 (£1.70 - £1.50)

Out-of-the-money

  • If the BT share price is less than £1.50 the option will be referred to as out-of-the-money because its premium will consist of only time value
  • It will therefore have zero intrinsic value

At-the-money

  • If the BT share price is at £1.50 the option is at-the-money and again it will have no intrinsic value
This is obviously reversed with Put options. Using the BT June £2.00 put as an example -

In-the-money

  • If the BT share price is less than £2.00 then the Jun £2.00 put will be in-the-money and will have an intrinsic value
  • For example, if the shares are trading at £1.50 the intrinsic value will be £0.50 (£2.00 - £1.50)

Out-of-the-money

  • If the BT share price is greater than £2.00 then the put option will be out-of-the-money and its premium will consist of just time value

At-the-money

  • If the price of BT stock is at £2.00 then the option will be at-the-money and it will also have no intrinsic value

There are also other phrases that are used to describe in-the-money and out-of-the-money options which are self-explanatory.

  • Just in the money - A call or put option that has a tiny amount of intrinsic value. For example, if a share price is currently £2.10 the £2.00 call can be described as just-in-the-money
  • Deep-in-the-money - If the share is currently at £3.00 the £2.00 call could be described as Deep-in-the-money, ie it has a lot of value
What Does 'The Right But Not The Obligation' Mean

A dictionary description of an option might read something like this -

An option gives the holder the right but not obligation to buy a set number of shares at a set price on or before a set period of time.

So why is the phrase 'right but not obligation' used to define an option?

Options are tradable financial products. Most of them are not used to actually convert into the underlying shares. For example -

  • You buy a £1.50 call on XYZ Industries when the share is trading at £1.40
  • A few weeks later the shares rise to £1.75 and you want to take your profit
  • This can be done in one of two ways -
  1. Exercise the option - this would give you the right to buy 1,000 BT shares at £1.50. You could either keep them or immediately sell them to bank a profit, or
  2. Sell the option and make the same profit as above

Commissions aside, it doesn't matter which of the above you do, both will result in the same profit. This is why the phrase 'right but not obligation' is important when defining options. Just because you might have a profitable option position you don't have the obligation to exercise the option into shares and hence generate the profit.

Most options therefore are not exercised. Market participants, unless they really want to own or deal in the underlying shares, will just trade the option to realise their profits/losses. Options are therefore flexible financial tools.

What Are European and US Style Options

When dealing in options there are two styles, European and US. Confusingly the terms have nothing to do with the different continents or shares and financial products listed on the two continents.

  • European style options can only be exercised on the day of the option expiry

For example if you owned the IBM June $65 call with the shares at $75, you can't exercise this option and receive the shares until the expiry day. Of course the option can still be freely traded in the market place enabling a profit or loss to be taken.

  • US style options can be exercised at any time on or before expiry

If you owned the BT Dec £1.50 call when the shares are trading at £1.75 you could exercise the option and take delivery of 1,000 shares at any time before the December expiry date.

All options on UK equities are US style and are therefore more flexible. Although they trade both the US and European style options on the FTSE 100 index, most if not all of the business is done European style.

Personally I wouldn't worry too much which style of options to use because for most retail clients it is immaterial. But if you have the choice it's simple to work out which style to use - always trade where the majority of trading is being done.

For example, if you want to trade options on the FTSE 100 index, both US and European style are offered. Look at the daily volumes and you'll see the vast majority are traded European style - that is therefore where you should trade.

This is because the busier a market the tighter the bid offer spreads. You might find for example the spread on a FTSE (Euro style) option is 91-92 whereas the same spread for the US style option is 89-94. Never forget that the cost of doing business in the financial markets is so important to overall profitability. The more you pay in costs the less overall profit or more overall loss you will make.

Some traders think of costs as a tax. And it's hard to find people who want to pay a higher tax percentage of their income!

Buying or Shorting Options

Shorting means profiting from declining prices, and it's a universal phrase in trading. Shorting RBS shares, shorting the dollar, shorting Gold is the same as shorting a BP call or put option. All of these trades will make money if the shorted product declines in price but will lose money if it rises.

Note, that shorting shares in the UK is normally always done by using Contracts for Difference (CFDs).

Shorting options, for those that are not used to shorting in general, can be somewhat tricky to understand. But work at it because it's easy once you get to grips with it.

Understanding Shorting (being able to make money via falling prices)

I often say that correctly understanding the concept of shorting is like learning to ride a bike.

It takes time, but once you know how you'll never forget. You also can't kid yourself that you can ride a bike - you know if you can or can't. Likewise, when you understand shorting you'll know you understand it.

  • If you buy a Call option for £0.20 and sell it at £0.30 that's a profit of £0.10 per option
  • If this was an option on a UK share that would equate to a profit of £100 (£0.10 x 1,000 shares)

Shorting the option would result in the opposite

  • You short the option at £0.20, realise that you've got it wrong when the option moves to £0.30 and so buy it back
  • The loss of £0.10 per option equates to a total loss of £100 (-£0.20 x 1,000 shares)
  • But what if you shorted an option at £0.60 and bought it back at £0.25?
  • This would be a profit of £0.35 per option or £350 (£0.35 x 1,000 shares)

Understanding how shorting works in options is important because many option strategies involve what are called spreads. A spread is where 1 or more option is bought and 1 or more option is simultaneously sold short. Spreads are discussed in more detail on the Options Strategy page

Options trading is often multi-dimensional
I hope you can now see that buying calls or buying puts is not the only way to make money out of the direction of the underlying security. For example -
  • If you're bearish - You can buy puts OR you can sell short calls
  • If you're bullish - You can buy calls OR short puts.

But with options you can also make money out of sideways movement. For example, if Tesco's shares are currently trading at £3.50 and trade in a narrow band for the next 4 weeks between £3.40 and £3.60 it's hard to make money trading the shares unless you're a nimble day-trader.

But remember - options are wasting assets.

The shorter time they have to expiry the cheaper they become. Some traders therefore use options to take advantage of expected lacklustre trading. They do this by selling short Calls or Puts or a combination of the two.

For example -

  • Tesco is trading at £3.50 at the beginning of January
  • The £3.50 March calls and Puts might be both quoted at £0.20
  • If the shares hardly move in January (range of £3.40 - £3.60) towards the end of the month both the calls and puts might have lost 50% of their value
  • The trader who sold either the call or put short at £0.20 would be able to buy them back at £0.10 making a £0.10 profit

Important - Shorting is an excellent way to make money with options but it should never be done without -

  1. Having a very solid grasp of options, and
  2. Really understanding the risks involved, alongside having a plan to deal with them (ie, not being like a deer caught in a car's headlights)

This is because options are leveraged assets and therefore even small movements in the price of the underlying stock can move the option prices by 25%, 50% or even 100%+.

If you were therefore to short a call at £0.10 and there was a surprise takeover for the stock in question the call option might suddenly explode to £1.25 in value. That equates to a £1.15 loss per option (£1,150).

But not many people trade 1 option, normally they'll trade at least 5 and possibly up to 50 contracts. Do that sort of size, get the trade disastrously wrong, and options can easily blow your entire trading account - it's happened many times in the past, even to very experienced option traders.

So I repeat - do not even consider shorting options when you are just starting out as you might open yourself up to the risk of potentially horrendous losses.

LearnMoney comment:
Options are flexible tools for both making money and reducing risk in most financial markets, especially the stockmarket.

Many people new to options believe they've found an almost perfect tool because the financial markets can be and are often extremely volatile. And highly volatile movements can if you get them wrong lead to nasty losses. But with options you theoretically have the best of both worlds.

  1. Limited risk - can't lose more than you paid for the option, alongside
  2. Unlimited reward - an option can be bought for pennies and sold, if the market makes a large move for considerably more

But at the same time they forget the Achilles heel of an option (if bought) - it's a wasting asset so will always expire at some date in the future. Therefore it can lose all its value as the days tick down to expiry.

so it's not enough to get the future direction of the market correct, your timing has to be excellent as well. And even a 1 day or even 1 week can be the difference between spectacular profits and zero gains.

To have a good chance of making money in options, or correctly using them to reduce risk, I'm going to be brutally honest. I mentioned above that understanding an option is like understanding an iceberg - what you can see above the surface is only 10% - 15% of the story. And if you don't attempt to delve below the surface to explore option theory in more detail it's going to be extremely tough to show a profit over time.

My advice is simple, use one of these two strategies to have a good chance of making money with options -

1. Trade options occasionally

For this you only need a solid understanding of their basics and fundamentals. Do this and you can add options to your financial toolbox. A handyman carries a bag of tools all designed for certain jobs. He'll use a chisel for wood and a wrench for plumbing etc.

A good stockmarket operator should also have many tools at his disposal. He can use shares, CFDs, spread bets and options. Given any type of trading situation one tool might be better than the other. For example, if he wants to use leverage and short (profit from falling prices) an individual share, CFDs or Spread Bets would work well.

For another trade idea options might be the best tool to use. But you've got to know how to correctly use them and which options to use.

For example if it is the beginning of April and you're extremely bullish should the April, May, June or July calls be bought. Should a selection of them be bought, or perhaps it makes a better risk/reward trade to use an option spread strategy? You don't need to be an options boffin to carry out that sort of analysis but you need to have an excellent grasp of the basics.

To summarise - If you plan to use options occasionally just learn the basics and don't worry too much about the really technical and mathematical side to their nature.

2. If trading options regularly you must become an expert - that takes time

It is as simple as that and there are no short cuts.

You have to dive deep below the surface using the iceberg example to explore and understand the subtler and finer points of option theory. You also have to rely heavily on computer power but it is unnecessary to have an expensive PC or software.

How do you get this education? You can teach yourself, which will be difficult unless you're already mathematically gifted, or you can get somebody to teach you.

And in my experience there's no better guy than the Ri$k Doctor. Take his course(s), put in the real effort needed and there's no reason why you can't be pulling decent profits from the options market over the coming years.

To Summarise - don't get heavily involved in options or option trading unless you're correctly trained and also are willing to devote a major part of your time to this issue.

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  • For my personal trading I like to use Core Spread
  • Got to love their ultra low bid-offer spreads





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