In the world of DIY trading, options trading has become very popular.
Traders can buy or sell the right, but not the obligation, to buy or sell an underlying asset, like a stock or ETF, at a specific price (called the strike price) before or on a certain date (called the expiration date).
Option Trading Explained
Option trading essentially provides exposure to the potential returns of the shares without directly owning the underlying asset.
There are two types of options:
- Call option: Gives the holder the right to buy options for the underlying asset at the strike price.
- Put option: Gives the holder the right to sell options for the underlying asset at the strike price.
Options trading offers the potential for bigger returns because using leverage allows traders to control more shares with less money. It is also a way for investors to generate income by earning premiums by selling options.
The Option Premium
The option premium is the price that the buyer pays to the seller for the right (but not the obligation) to buy or sell an underlying asset at a specified strike price, on or before the expiration date.
Due to dynamic pricing in the derivatives market, the option premium fluctuates continuously based on numerous factors. This makes the premium a real-time reflection of market sentiment and risk.
- For the buyer, the premium is the upfront cost to acquire the option. It represents the maximum potential loss if the option expires worthless.
- For the seller (or writer), the premium is the income they receive in exchange for taking on the obligation to fulfil the contract if the option is exercised to sell (in a call option) or buy (in a put option) the underlying asset at the strike price.
The premium represents the seller’s maximum potential profit, but their downside risk can be substantial or even unlimited (especially in uncovered call writing), depending on the strategy and market movement.
However, sellers also benefit from using option premiums to hedge positions, as the money received from selling options can help reduce the impact of a negative market event, such as a decline in stock prices in their portfolios. The fees can also help improve returns from the stocks they own.
The Premium Effect
The option premium plays a crucial role in determining the profitability of an options trade. Buyers will always look to minimise premium costs to lower their initial investment, while sellers aim to collect higher premiums to enhance their profit potential.
For the buyer to generate a profit, the option must increase in value enough to offset the premium paid, plus any commissions. For the seller, the premium represents the potential profit if the option expires worthless.
Calculating the option premium involves adding the intrinsic value and extrinsic value of the option (Intrinsic Value + Extrinsic Value = Option Premium)
- Intrinsic value: Reflects the value of the option if it is exercised immediately.
- Extrinsic value (or time value): Accounts for additional factors like time until expiration, implied volatility, and interest rates.
Paying The Premium
To understand how the option premium affects an options trade, consider this example. If a call option with a strike price of R500 is trading at a premium of R50, the buyer pays R5000 to purchase the option contract (calculated as a R50 premium per share x 100 shares per contract).
If the stock price rises above the R550 breakeven point, the trade is in the money, and the buyer can profit from exercising the option. A R100 rise in the share price to R600 would generate a profit of R5000 (R600 [new share price] – R550 [breakeven point] = R50 profit per share x 100).
If the stock price stays below R500, the option expires worthless and is out of the money, meaning the buyer loses the R5000 contract value.
Factors to consider
The option contract is influenced by several factors, including:
- Intrinsic value: The inherent value of the option based on the difference between the current market price of the underlying asset and the strike price.
- Time value: The value of the option due to the time remaining until expiration. As expiration approaches, time value decreases, especially for at-the-money options (the strike price is equal to the current market price).
- Implied volatility: The degree of price fluctuation of the underlying asset. Higher volatility generally leads to higher option premiums.
- Interest rates: Changes in interest rates can also affect premiums, particularly for options with longer expirations.
- Stock price: The price of the underlying asset – in this case, a stock – directly affects the premium, as it determines the intrinsic value of the option, particularly when it is near the strike price. This relationship is often referred to as “moneyness”, which indicates the option’s value in relation to its strike price and the underlying asset’s price.
- Dividends: Dividends on the underlying stock can impact option premiums, especially around the ex-dividend date.
- Option status: The relationship of the option to the underlying asset also influences the premium. In-the-money options generally have higher premiums due to the higher demand in the market. Out-of-the-money options have lower premiums.
- Supply and demand: Increased demand for options (either calls or puts) generally drives up implied volatility, which directly leads to higher option premiums. If there are many sellers and few buyers for a certain option, its premium will tend to decrease.
Know your options
Options trading has gone mainstream for DIY traders, driven by easy access, low costs, social media hype, and a desire for outsized returns.
However, while it’s a powerful tool, it’s a double-edged sword, requiring skill, risk management strategies, and ongoing education on critical concepts like the option premium to successfully navigate markets and trade your way.
*Clarity, by Investec does not currently provide option trading.
