I wanted to chat a bit about options here. I realize that there are already plenty of articles about options that you can find online, but many are either overly complex, oversimplified, trying to sell you some products, etc. I figured I would explain some of it here, in order to reduce the learning barrier. After all, knowledge is power. And given the recent event with Robinhood, I figured it is worth repeating how options work so you understand what is happening under the hood, and don’t end up taking too many risks and making mistakes that you could regret later. If you are interested in trading options, I invite you to look for more details online.

I have been trading options for quite a long time. I made some mistakes, so many, especially in the beginning. Over the years, I kinda reduced my option trading activities, but these past few months, I have been doing it much more as there are so many opportunities and the market is so volatile, which helps with my trading style.

This first post is to explain how options work in general, the second post will go into some more details, the third posts 3a and 3b will explain some standard strategies, and the fourth posts (4a and 4b) will give some examples for my recent trades with gains and losses and how I approach option investing. If you are looking at r/wsb style of investment, please skip these posts, they are not for you. I am a relatively conservative investor and will avoid pure gambles, but I will still take some calculated risks. So I say. :) It is fair to say that most of my money is invested in standard ETFs / mutual funds / Real Estate. So, my option play represents only a percentage of my overall wealth.

It is often perceived that options are extremely risky, and one of the best ways to get ruined. For some trades, this can be true. To dispel a myth, in reality, options can also be used to be extremely conservative. Even to a point where you barely make any money at all in any market. Unlike for shares, where you can only control the diversification, with options you have a much bigger control on the risk / profit profile. Time and volatility is also a factor that you can profit (or lose) from.

One thing to note is that not all companies or ETFs provide options for their shares.

The basics: CALL and PUT contracts, strike, and exercise

Options are split into two groups: CALLs and PUTs. Both have a strike, an expiration date, and a number of shares attached to it. We’ll talk about the exercise and expiration date a bit later. When you buy a call or put option, you buy a contract with a 3rd party through your broker and the stock market. Usually, one contract represents 100 shares.

The strike corresponds to a share price for the underlying instrument. So for SPY that is worth $308 today, you will have options with strike $308, but also $300, $301, $310, etc… From $5 to $525. Options strikes are created as the underlying instrument SPY goes up and down. For SPY, strikes have a granularity of $1 around the share price, but can also be $5 or even $10 farther from the current price. Some other instruments have a $2.5, $5 or even $10 granularity. It can even have a $0.50 granularity. (Hello Hertz! It dropped so much that the lowest strike is $0.50 right now).

A CALL is a contract that allows the buyer to buy a number of shares at a given strike price before an expiration date. If you buy a call with a $150 strike, and the share price went up to reach $200, this allows you to buy some shares at $150 that are now worth $200. The action of exchanging your call against some shares that you bought at the strike price is called exercising the call. When you exercise your call contract, you are buying shares into your account.

Remember that, in most cases, 1 contract will buy 100 shares in your account. When exercising each call contract, you will need $15k of cash in your account in this example ($150 for the strike, multiplied by 100 shares). And the same 100 shares are now worth $20k (at $200 for each share). Not accounting for the price you paid for the call option (more on this later), this means you will make a profit of $5k if you sell the shares.

Conversely, a PUT is a contract that allows the buyer to sell a number of shares at a given strike price before an expiration date. If you bought a put with a $200 strike, and the share price went down to $150, this allows you to sell some shares at $200 that are now worth $150 each. Similarly to a call, the action of exchanging your put against some shares that you sold is called exercising the put.

When exercising each put contract, you are selling 100 shares from your account. When exercising each contract, your 100 shares will be sold for $20k ($200 for the strike multiplied by 100 shares). And the same 100 shares are now worth $15k (at $150 for each share). Not accounting for the price you paid for the put option, this means you made a profit of $5k. If you did not have the 100 shares per contract in your account, you would be actually short selling the shares, and you could make the $5k profit by buying these shares back.

In summary, a call buys shares when exercising. A put sells shares when exercising. Most importantly, in the vast majority of the cases, you should actually not exercise your contracts, but instead, you should sell your call or put at the market price, as you will increase your profit (see extrinsic value later).

Brokers do not allow you to exercise the contract if the difference between the strike and the current value is going to make you lose money. In other words, you can’t exercise when the current value is below the strike for a call (you want to buy low when the value is high), or current value is above the strike for a put (you want to sell high when the value is low).

Most brokers do auto-exercise your call and put contracts at the expiration date if they can be exercised. If the contracts cannot be exercised at the expiration date, and you did not sell your contracts before, they will be worthless, and the money you spent buying the contracts will be completely lost.

Although I am mostly talking about American style options that can be exercised at any time, there are also European style options that can only be exercised at expiration. In the US markets, pretty much all stocks and ETFs are American style, But the cash-settled indexes, like SPX and RUT, are European style.

The basics: Intrinsic and extrinsic value

A call or a put contract costs money to buy, called a premium, so a 3rd party can give you the right to exercise the call or the put. After all, they won’t take the other side of this contract for free, and they have to be remunerated. The minimum for a contract is $0.01 per share for some very liquid ETFs, but for most instruments, it is $0.05, thus $5 per contract for 100 shares. When you buy a call or put, this premium is the most you can lose by expiration date. The 3rd party that sold the contract to you is open to many more risks and potential losses (see below).

The value of the call and put contracts will depend on the strike, on the share price going up and down, the share’s volatility (how fast / far it goes up or down), and the time passing.

When you buy a contract, the strike and the expiration date is known. However, the share price and volatility will constantly change. All the call and put options are constantly repriced as time is also passing (closer to the expiration date).

The intrinsic value is the portion of the contract value that only depends on the strike and the current share price. It is above $0 only when you can exercise the contract. The extrinsic value is the portion of the contract value that depends on the volatility and time. For pretty much all options, this extrinsic value is above $0, and will slowly drop to $0 as we get closer to the expiration.

Let’s take an example with a share price of $150.

Say, you buy a call with a strike of $145 expiring in a month for $7. The intrinsic value is $5 ($150 — $145), the extrinsic value is $2 ($7 — $5). Said differently, if the share price did not move at all until the expiration date, your call contract would bring you $5 per share. You would have lost $2 due to the time passing.

Similarly, you buy a put with a strike of $155 expiring in a month for $7. The intrinsic value is $5 ($155 — $150), the extrinsic value is $2 ($7 — $5).

It is worth noting that any call with a strike price at $150 or above has $0 of intrinsic value. If you pay $4 for a $155 call, all the $4 is extrinsic value. If the stock price does not go over $155, you will lose the full $4 per share (so a $400 loss per contract). Similarly, a put with a strike price at $150 or below has $0 of intrinsic value. If you pay $4 for a $145 call, all the $4 is extrinsic value. Your contract will be worthless by expiration if the stock price did not drop under $145.

Note that, in these examples, I use the same price for the call and put options that are $5 away from the strike price, but it’s not always the case. The call and price options are priced differently depending on the volatility, market expectations, potential dividends, cost of money, etc.

The basics: ATM, ITM, and OTM

There are few definitions related to the relationship between the strike and the current share value for puts and calls.

An option is ‘At The Money’ (ATM) when the current share value is matching the strike. The share price is $150, and the strike of $150 for both the call and put contracts will be considered ‘at the money’.

An option is ‘In The Money’ (ITM) when the contract has some intrinsic value. The share price is $150, so a call at $140 is ‘in the money’, with $10 of intrinsic value. A put at $160 is ‘in the money’, with $10 of intrinsic value too.

An option is ‘deep in the money’ when the option is ITM and the strike is far from the current share price (for example more than 20%). For example, with a share price of $150, a $100 call will be considered ‘deep in the money’. Same for a $200 put.

Conversely, an option is ‘out of the money’ if there is no intrinsic value. With a $150 share price, a $160 call is ‘out of the money’. A $140 put is ‘out of the money’. The money you paid for the call and put is purely extrinsic value, there is no intrinsic value. An option is ‘deep out of the money’ when the option is OTM and the strike is far from the current share price. For example, with a share price of $150, a $200 call will be considered ‘deep out of the money’. Same for a $100 put.

As the share price goes up and down, depending on the option strikes, it can switch between ITM, to ATM, to OTM. The option price will always reflect that and will be based on the time at expiration and the current share volatility.

Few key things to note:

• The deeper ITM an option is, the more expensive it is. As it gets deeper ITM, the intrinsic value increases, the extrinsic value decreases. You have a higher chance for the option to be worth something, and you will lose less money on the extrinsic value. The price of Deep ITM options will move very closely to the underlying shares (a positive correlation for calls, a negative correlation for puts).

• The deeper OTM an option is, the less expensive it is. Again, OTM option price is pure extrinsic value. You have a very small chance for the option to be worth something by expiration.

• The maximum extrinsic value is when the option is ATM. It is purely extrinsic value, with barely any intrinsic value. These option strikes are the most sensitive to time, volatility and share price.

Here is an example, with the same share price of $150. For a call, you could get something like this:

Strike = $100 / Premium = $53 / Intrinsic = $50 / Extrinsic = $3 ← Deep ITM

Strike = $125 / Premium = $30 / Intrinsic = $25 / Extrinsic = $5 ← ITM

Strike = $150 / Premium = $9 / Intrinsic = $0 / Extrinsic = $9 ← ATM

Strike = $175 / Premium = $5 / Intrinsic = $0 / Extrinsic = $5 ← OTM

Strike = $200 / Premium = $3 / Intrinsic = $0 / Extrinsic = $3 ← Deep OTM

You can imagine the same table for a put but in the other direction.

It is worth noting that if you have a $100 call and you decide to exercise it, you would directly get $50 of proceeds per share, but you would also destroy the extrinsic value to $0, losing $3 of proceeds. Instead of exercising your call, you are much better off selling your call for $53. In general, there are not many reasons to exercise your options. Selling them is more advantageous.

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