Options – The Basics

What is an option? An option is a contract that gives the buyer the right, but not the obligation to either buy or sell an underlying asset.

The buy side

When you buy an option you can speculate on either a rise or a fall in the underlying asset price. An option buyer can buy a call option if he thinks the underlying’s price will rise. He can buy a put option if he thinks the underlying price will fall.

In both cases, the buyer has the right to either buy or sell the underling at a certain price and on a certain date. The strike price and the expiry date respectively and are two fundamental elements of any option contract.

When you buy an option, there usually isn’t any need for margin. This is because at no time can the option be worth less than zero – it always has some value.

When you buy and hold an option till expiry, one of two things can happen. Either it expires worthless or it expires in the money (ITM) in which case you profit from the difference between the strike price and the price of the underlying at expiry.

The sell side

On the other side to the buyer someone has to be willing to underwrite that commitment to deliver the underlying. This is the job of the option seller or “writer” of the option. The seller of an option contract is giving the buyer the right to either buy or sell from them, at a given price on a given date. The compensation for taking on this risk and commitment comes in the form of an option premium. The premium is paid by the buyer to the seller unconditionally.

Option cash flow example

It helps to look at the cash flows in a real example. Let’s take an Future Options call option on GBPUSD. The GBPUSD spot price is 1.44. The call option is as follows:

Strike: 1.4600

Expiry: 30-days

Size: 1 x 100,000 USD

On day zero the price of the call option is $1624.94 (see this spreadsheet for the pricing). The option buyer pays this amount to the option seller. The table below shows the profit & loss on both sides of the transaction from the day the option is bought until expiry.

Day

GBPUSD

Premium

Intrinsic

Time

Buyer P&L

Seller P&L

0

1.4400

1,624.94

0.00

1,624.94

0.00

0.00

10

1.4700

2,601.75

1,000.00

1,601.75

976.81

-976.81

25

1.4400

314.85

0.00

314.85

-1,310.09

1,310.09

30

1.4300

0.00

0.00

0.00

-1,624.94

1,624.94

Notice the two components of the option price which make up the premium; the intrinsic and the time value. The intrinsic is the amount by which the option is already in the money.

For a call option, when the spot price is below the strike price the option is out of the money. The time value or extrinsic value accounts for the fact that the option still has time to run. If it isn’t in the money now, there is still a probability that it could go into the money before expiry. If this happens the option seller would have to pay out.

Notice that the time value decreases during the life of the option. This amount “migrates” to the seller as time elapses. When you buy an option time is not on your side.

At day 30, the option expires worthless. The contract gave the holder the right to buy GBPUSD at 1.46 on day 30. But since the price is now less than this at 1.43, this contract is worthless. The seller therefore pockets the $1624.94 option premium because his obligation to deliver under the contract is annulled.

Let’s consider another example where GBPUSD rises to 1.48.

Day

GBPUSD

Premium

Intrinsic

Time

Buyer P&L

Seller P&L

0

1.4400

1,624.94

0.00

1,624.94

0.00

0.00

10

1.4700

2,601.75

1,000.00

1,601.75

976.81

-976.81

25

1.4750

1,950.77

1,500.00

450.77

325.83

-325.83

30

1.4800

2,000.00

2,000.00

0.00

375.06

-375.06

Copyright © 2019 forexop.com

On day 30, the option is in the money to the tune of $2,000. The seller however has by now made $1624.94 from the option premium. So his net loss is $375.06 ($1,624.94 – $2,000). This is the gain for the buyer.

“The Greeks”

There are a few ratios that traders use to understand options. These are referred to as “The Greeks”. The most important are:

Delta • Also called the hedge ratio. A measure of how sensitive the option price is to changes in the underlying. For example, when a call option has a delta of 0.8 this means that for every dollar rise in the underlying, the option rises by 80 cents. As a rule of thumb, traders use delta as the probability of the option expiring in the money. Thus an option with 0.8 delta, has an 80% probability of expiring in the money or becoming profitable.

Theta • A measure of time decay. Theta is the amount in dollars that the option loses each day. An option loses value quicker, the closer it gets to expiry. The option is also more sensitive to time the closer the spot price is to the strike price – when it’s at the money (ATM).

Vega • The sensitivity of the option price to implied volatility. The higher the volatility, the more expensive the option will be. This cost is reflected within the time value component. Vega peaks when the option is at the money. Longer dated options also have a higher vega than short dated options – all other things being equal.

If you are an option seller, delta and vega are especially important. This is because they are used in the determination of the amount of margin required. See the second part of this tutorial for an explanation of margin for option sellers.

Types of Options

If you’ve come from the equity trading side, trading options will be a different ballgame altogether. However if you’ve already traded futures, forex and CFD you will have an advantage. Because you should already be familiar with margin trading and leverage.

Options are available on virtually every type of asset, but the most popular options are on stocks, indices, bonds, commodity futures, interest and exchange rates. When selling options it’s wise to stick to highly liquid markets. If you need to get out, you want to be able to do so quickly and cheaply. This may not be the case with illiquid markets.

The beauty of options is that they are practically the same regardless of the underlying asset. For example futures options work virtually the same way as equity options, except the prices are derived from an underlying future, such as Light-Sweet Crude Oil, Soybeans, and E-mini S&P 500 contracts.

How and where to trade options

Most retail brokerages will require a risk appraisal before they’ll let you trade options. Extra checks may be required for short selling. Nonetheless, if you are aware of the risks and understand the concepts, options trading can open up a world of opportunity.

As always, it is important to find a reliable broker with low fees and good technology and trading platforms. Most retail brokerages that have futures trading also offer futures options trading.

You can trade options through a securities trading account available through major banks as well as online brokers such as TradeStation, and TD Ameritrade.

Risk and Rewards

The risks of selling options

When selling a call option there is an unlimited risk. This is because a stock or futures contract could technically trade to infinity. Similarly, when selling any put option the risk is the underlying instrument going to zero. Although this is extremely unlikely, it’s technically not impossible. Options traders need to be aware of the inherent risks when selling.

Selling options can be disastrous if risk factors aren’t properly understood and managed.

The reward: Time decay

The trade-off for this elevated amount of risk is a high probability of profit. All options are decaying instruments. Every day, there is money systematically being priced out of the option. This is regardless of the direction the underlying futures contract price. As the seller, this is money in your pocket.

This concept is known as “theta decay”. It is the main attraction to option sellers. Recall that theta is the time value in the option. Theta is a component of the overall premium. Taking advantage of this time decay aspect requires selling a sizeable amount contracts. Thankfully, because of SPAN margining, this is possible with futures options, and excellent theta decay can be achieved with relatively small amounts of capital.

Figure 4: Probability analysis chart. © forexop

For example as the above figure shows $105.13 in theta decay per day is achieved with selling a 10-lot of .04 delta Crude Oil puts, with a margin requirement of about $10,000. If the Crude Oil trades down by 10%, the options would still be out of the money and theta would increase, but so would the margin requirement.

Selling options can generate a much higher probability of profit than trading in the underlying. In order for the 10-lot of short Crude Oil contracts to lose money at expiration, the price of Crude Oil needs to be lower than the strike price minus the premium.

If a trader sells a .04 delta option there is theoretically only a 4% chance that option will expire in-the-money. In other words, the position has a 96% probability of profit, while the trader collects around $100 per day via theta decay. See Figure 4.

Specific Strategies

As I mentioned above one advantage of trading options is their common properties across asset classes. Many of the same option strategies can be used across the board without sacrificing any of the margin benefits. Short strangles, straddles, and iron condors can be used to create delta-neutral and theta-positive positions and capitalize during periods of increased implied volatility.

Moreover, a trader can also sell futures options for purposes beyond speculation. Traders can reduce their cost basis and hedge a long position in an underlying by selling futures calls. Or reduce their cost basis and hedge a short position by selling futures puts.

Due to the leverage and therefore inherent risk when using futures options, strategies such as iron condors and credit spreads might be more appealing for traders to limit risk or hedge existing short option positions.

For example if a short Soybean put position is losing money and a trader wants to hedge, he could leg into a credit spread by purchasing a further out-of-the-money put.

Although this would reduce the maximum profit, it would limit the loss of the entire position while still keeping a partially reduced margin requirement.

With options credit spreads, the margin requirement is often less than the width of the strikes. This results in less capital usage even for a risk-defined trade. Moreover, more time until expiration and a greater distance away from the money result in reduced margin requirements.

Of course if a short option position goes in your favor the margin requirement will be reduced.

Timing

Sell when volatility is high

If there’s one “golden rule” to selling options, it is that the best time to sell is when volatility is high. Option prices increase with volatility. When volatility is high, traders will pay more in option premium to hedge their positions and/or speculate.

One thing to keep in mind when selling options is that a rise in volatility can create a paper loss. This is true even if the underlying price remains the same. It can also increase margin requirements.

For example, think of Crude Oil futures before a scheduled OPEC meeting or before an output freeze discussion in Doha. Despite what the media or market pundits may tell you, no one really knows how the price of Crude Oil will be affected. Because the outcome of a binary event is expected to have a dramatic effect on the price of the underlying future, traders price in the potential for significant upside and downside.

Often there is a “skew” in one direction. This can see puts trading richer than calls or vice versa. This reflects the collective opinion of market participants. In fact put/call ratios are sometimes used as a signal of market sentiment.

This results in increased implied volatility and is reflected in the option prices. Therefore selling options before such turmoil could be a disastrous strategy.

When to close short option positions

When selling low delta options, there is by definition a high probability of making a profit. Theta decay as well as volatility contraction will reduce the extrinsic value of the option. Once most of this has gone, you the option seller have little more to gain. At this point it is wise to close out the position.

Keeping short options positions open that have returned most of their profit and are trading near or at a zero value is simply adding excess risk.

If a short futures option is worthless prior to expiration, it should be closed out for a small price, every time. Regardless of how far out of the money the options have become, if the option is worthless there is no profit left to make on the position. Yet there is an enormous potential loss waiting to happen.

All of this, of course, is assuming the position is profitable. On occasion, a short out of the money option can wind up in the money. The position will eventually need to be closed out for a loss prior to expiration. This however will depend on the delivery specifications of the future.

Some traders prefer to close out their short options when a profit target is reached. This can be around 75% of the maximum profit for the trade. Other traders like all the value of the option to be destroyed before they cover.

The moneygrubber will let his options expire worthless to save on commissions and extract every cent.

How you close the position depends on your individual trading style and appetite for risk.

The Endgame

Selling options is not an end-all strategy and route to early retirement on a tropical tax haven. However it can be an important part of a balanced investment plan. Going short options offers you a way to speculate and reduce your trading costs in commodities, index products and currencies. This can add a new and exciting dimension to your overall strategy.

Shorting options can generate profitable trades in markets where conventional methods fail. It also offers attractive use of capital and highly favorable outcomes. Despite this, option writing is best used in small doses. It wouldn’t be a good idea to have an entire portfolio full of short futures options – think Victor Niederhoffercirca 1997.