Derivative Markets: Options

The basics assets of the economy, traded in spot markets, are Equity, Fixed Income, Commodities, Currencies, and Cryptocurrencies.

Derivatives are financial instruments that derive their value from the performance of the basic financial assets listed above.

A Forward Commitment, which we will cover in another article, is one type of derivative. In a nutshell a forward commitment forces the parties that entered into the agreement to transact at a predetermined price and time in the future. Futures contracts, Forward contracts, and swaps belong to this category.

Another type of derivative that provides the right (but not the obligation like in forward commitments) to buy or sell the underlying asset at a pre determined price at some point in the future is a Contingent Claim. The main type of contingent claim is an Option.

This topic is actually very complex, however I will try to simplify it as much as possible. My objective is to provide financial education and a concrete way to apply it to our day to day investing activities. Options are an instrument that I use frequently in my trading strategies, however it is very easy to blow up an account by misusing them therefore it is crucial to understand how they work and which strategies to use.

To recap:

An option is a contract that gives the buyer the right but not the obligation to buy or sell the underlying asset at a specific price (Option Strike) on or before a predetermined expiration date. The buyer pays a sum of money to the seller for this right.

What does it mean in real life. Let's use an example and understand how to read an option:

AAPL currently trading at $135 per share on February 3rd 2021

Option: AAPL March 19 2021 $145 Call --- Cost $4.50 (assuming buying at the ASK).

The above is a Call Option on Apple stock (ticker AAPL). The contract expires on March 19 2021. The strike price is $145. The cost is $4.50 per share. An option contract is for 100 shares, therefore its cost will be $450.

Buying that call option means hoping that Apple shares on March 19 2021 (the expiration date) are at a minimum at $145+$4.50= $149.50. This is our breakeven point.

Why buy an option:

An option gives control over a large number of shares with a fraction of the capital needed to buy them in the spot market. In this example we could profit from the appreciation of Apple shares by only paying $450 instead of buying 100 shares at $135 for $13,500 in the cash market.

The option seller thinks somewhat the opposite regarding the direction of Apple shares price. He or she believes that at expiration Apple shares will be at or below the $145 strike price. In that event he or she will keep the premium received and earn upwards of a 3% return in a little over a month. If you compound a 3% return on a yearly basis, it generates incredible gains.

This simplified example allows me to introduce two new aspects that define the price of an option contract:

- Intrinsic value

- Time value

In the above AAPL example, being an out of the money option, the full cost was based on Time Value. Out of the money: option strike price above current spot price.

If instead we were buying an in the money option, say a $125 strike price, the contract would have had $10 of Intrinsic value: $135 (spot price ) minus $125 (strike price). All things equal the cost of the option would have been say $12: Intrinsic value ($10) plus Time Value (let's say arbitrarily $2).

It's beyond the scope of this article to introduce and educate on valuation models for derivative contracts, therefore I will use assumptions (like the above $2 Time Value figure). We will take for granted that the option price at the brokerage firm where we decide to trade represents all information available at that time.

I mentioned above that it is very easy to blow up brokerage accounts by misusing options. I feel it is important to repeat it once again as we conclude this brief introduction on the subject.

In upcoming articles we shall explore some basic option strategies and provide a view into how I trade on a regular basis. We will start by discussing when is a good idea to buy a Call contract, when to buy a Put contract, when to write a Covered Call. Also we will look at Leaps and why in my opinion they represent one of the best way to use leverage with the lowest amount of risk.