A Call Option is the right but not the obligation to buy a fixed number of shares in a specified equity at a set price (the strike price) on a certain future date (the expiry). If you buy this option you are said to be ‘long’ and if you sell this option you are said to be ‘short’. [Note this describes a ‘European Option’ as opposed to an ‘American Option’ which can be exercised at any time].
Let’s take the following basic example. You buy a (European) call option on Stock A which expires in 3 months’ time and gives you the right, but not the obligation to purchase Stock A shares for $100 at expiry. For this option you pay a premium of $5.
The Payout profile of that call option at expiry is as follows:
The X axis shows the Stock A price and the Y axis shows the profit or loss on expiry. If the Stock A price on expiry is $90 then it doesn’t make sense for you to exercise the option. Why would you choose to buy the stock at $100 when you go could go straight into the market and buy at $90?
With the Stock A price below $100 then you lose money on the position, being the premium you paid to buy the option. The option is said to be Out of the Money [OTM].
Notice when the underlying stock reaches the strike price (referred to as At the Money [ATM]) you still show a loss on the position as you’ve paid the premium. However as the underlying price moves up from this point your loss becomes less and once Stock A passes $105 then your position becomes profitable. Our option is then said to be In The Money [ITM].
A Put Option is the right but not the obligation to sell a fixed number of shares in a specified equity at a set price (the strike price) on a certain future date (the expiry). If you buy this option you are said to be ‘long’ and if you sell this option you are said to be ’short’.
Lets take the same example except this time you’ve bought a put option on Stock Awith a strike price of $100 (the premium is still $5):
The payoff profile here is the mirror of the call option profile. With the Stock A price above $100 then exercising the option to sell at $100 doesn’t make sense and you lose your premium. As the stock falls then the option becomes more in the money.
Combinations of long and short puts and calls can be used for specific option trading strategies. These will be covered in a later article.
Basic Option Valuation
Simplistically, an option’s value is a combination of two things.
- Intrinsic value
- Risk Premium (also known as extrinsic value or time value)
Intrinsic value is solely related to how far ITM the option is. So if you are long a call on a stock with a strike price of $50 and the stock is trading at $55 then your intrinsic value is $5 (ie. You could exercise the option to buy the stock at $50 and then sell it in the market at $55).
If the stock is trading at $60 then your intrinsic value is $10. Note by definition only options which are ITM have intrinsic value.
Risk Premium is the difference between the option price and the intrinsic value. So if our $50 strike call is valued at $8 and the stock is trading at $57 then we know the market has priced the risk pemium of the option at $1.
Intrinsic Value + Risk Premium = Option Valuation
The risk premium is influenced by a number of different factors and is effectively a measurement of how likely the option is to finish in the money.
As you can see, there is more to an option valuation than just the price of the underlying asset. This is where the greeks come in and in the next article OPTION GREEKS IN PLAIN ENGLISH we’ll take you through each of them in turn and explain how they impact an option’s price.
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