Let’s begin by covering some of the basics and defining the fundamental aspects of trading options so that we can build a solid foundation to base our future learning off of.
We’ll start by looking at calls and puts and the relationship between the two.
A call is the right (but not the obligation) to buy a financial instrument -the underlying security – at a specified price on or before the specified time. That purchase price is known as the strike price, while the exact time is called the expiration date of the option. It’s important to note that we are talking about the American style of options, whereas the European style is exercised on, but not before, the expiration date. A long call allows for participation in an upside move with downside risk being limited to the amount originally paid for the call.
A put is the right (again not the obligation) to sell the underlying vehicle at a specified strike price on or before the listed expiration date. A long put allows for participation in a downside move of the underlying security with upside risk again being limited to the amount initially paid for the put.
While the option buyer owns the right to exercise the contract, the option seller has the obligation to provide the underlying vehicle at the agreed price upon demand. The matching of the exercising buyer and the assigned seller is handled in a basically random manner by the exchanges and clearing firms. In general, with exercising calls for dividends being the primary exception, there is no reason to exercise before the expiration date (also known as an “early exercise”). If interest rates become meaningful again, puts become potential early exercise candidates.
The basic equation for the relationship between the underlying security (in this case we’ll assume it’s a stock) and the same strike call and put is:
Stock = Call – Put (where a long call, short put is a “synthetic stock”).
Using basic algebra, this can be re-expressed for some of the common options positions:
- Call = Stock + Put (a “married put” is a synthetic call).
- -Put = Stock – Call (a “covered write” is a synthetic short put).
- Put = Call – Stock (before puts were introduced, synthetic puts were used for the same effect).
The value of a call can be stated as:
Call = the greater of (Stock price – strike price) or 0 (“intrinsic value”) + volatility premium + interest – dividend.
Everything but the intrinsic value is sometimes referred to as the extrinsic value, or sometimes as the amount over parity. A quick way to get the extrinsic value for an in-the-money (“ITM”) call is to look at the corresponding out-of-the-money (“OTM”) put, so for example with XYZ trading at 26, the extrinsic value of the 25 call will be roughly equal to the 25 put (this works because for the most part interest is not a significant consideration).
Likewise, the value of a put can be stated as:
Put = the greater of (Strike price – stock price) or 0 (“intrinsic value”) + volatility premium – interest + dividend.
Now that we’ve covered the basics of calls and puts we can move forward with defining and exploring some of the more detailed facets of options trading. For my upcoming installments in this series we’ll be looking at Greeks, some basic strategies including looking at the risks vs. the rewards, and finally we’ll dive into comparison strategies of both winning and losing trades.
The world of options trading can offer the potential for tremendous gains, but equally can hold tremendous risk as well. Join us as we analyze these topics throughout this series.