How to not get ruined with options - Part 2 of 4

The basics: Volatility and Time

Now that you understand the basics of intrinsic and extrinsic values and how together gives a price to the premium, it is important to understand how the extrinsic value is actually calculated. The intrinsic value is easy:

The intrinsic value of a call = share price - strike (if positive, $0 otherwise)

The intrinsic value of a put = strike - share price (if positive, $0 otherwise)

The extrinsic value is mostly based on two variables: volatility of the share price and time.

Given the historic volatility, and the predicted volatility, how far can the share price go by the expiration date? The longer the date, and the higher the share volatility, the higher the chance of the share to change significantly.

A share that jumped from $25 to $50 in the past few weeks (hello NKLA!) will have much higher volatility than a share that stayed at $50 for several months in a row. Similarly, an option expiring in two months will have a higher extrinsic value than an option expiring in one month, just because the share has more chances to move more in two months than a single month.

The extrinsic value is calculated as a combination of both the expiration date (how many days to expiration, hours even when you are close to expiration), and the implied volatility of the share.

Each strike, call or put, will have their own implied volatility. It is quite noticeable when you look at all the strikes for the same expiration. Sometimes, you can even arbitrage this between strikes and expiration dates.

The basics: Buying and Selling contracts

Until now, we have only talked about buying call and put contracts. You pay a premium to get a contract that allows you to buy (call) or sell (put) shares of a specific instrument.

As your risk is the cost of your premium, you can notice that buying options is a risky proposition.

To make a profit on the buying side:

1. You have to be directionally correct. The price must go up for calls, down for puts.

2. AND the share price move must be bigger than the premium you paid.

3. AND the share price move must happen before the option expiration.

You will notice that it is pretty unforgiving. Sure, when you are right, you can make a 100% to 1000% profit in a few months, weeks, or even days. But there is a big chance that you will suffer death by thousands of cuts with your long call or put contracts losing value every day and become worthless.

We were discussing earlier how volatile stocks can have a high extrinsic value. What happens to your option price if the share is changing a lot and suddenly calms down? The extrinsic portion of the option price will crater quickly because volatility dropped, and time is still passing every day.

The same way you can buy options, you can also sell call and put options. Instead of buying the right to exercise your ITM calls and puts, you sell that right to a 3rd party (usually market makers).

To make a profit on the selling side:

1. You have to be directionally correct.

2. OR the share price does not move as much as the premium.

3. OR the share price does not move before the option expiration.

Buying calls and puts mean that you need to have strong convictions on the share’s direction. I know that I am not good at predicting the future. However, I do believe in reversion to the mean (especially in this market :)), and I like to be paid as time is passing. In case you didn't guess yet, yes, I mostly sell options, I don’t buy them. This is a different risk, instead of death by a thousand cuts, a single trade can have a big loss, so proper contract sizing is really important.

It is worth noting that because you sold the right of exercise to a 3rd party, they can exercise at any time the option is ITM. When one party exercises, the broker randomly picks one of the option sellers and exercises the contract there. When you are on the receiving end of the exercise, it is called an assignment. As indicated earlier, for most parts, you will not be getting assigned on your short options as long as there is some extrinsic value left (because it is more profitable to sell the option than exercising it). Deep ITM options are more at risk, due to the sometimes inexistent extrinsic value. Also, the options just before the ex-dividend date when the dividend is as bigger than the extrinsic value are at risk, as it is a good way to get the dividend for a smaller cash outlay with little risk.

In summary:

• Buying a call, you hope the price to go up significantly.

  • Max loss is the premium. You lose money with time.

  • Max profit is infinity, minus the premium.

• Buying a put, you hope the price to go down significantly.

  • Max loss is the premium. You lose money with time.

  • Max profit is the strike price, minus the premium.

• Selling a call, you hope the price to not change much, or to go down.

  • Max loss is infinity (just don’t sell straight calls, at most do verticals - see next post).

  • Max profit is the premium. You profit from time.

• Selling a put, you hope the price to not change much, or to go up.

  • Max loss is the strike price.

  • Max profit is the premium. You profit from time.

The Greeks

Each option contract has a complex formula to calculate its premium (Black-Scholes is usually a good initial option pricing model to calculate the premiums).

Things that will determine the option premium are:

• Current share price

• Strike price

• Call or Put

• American or European style options

• Cost of money (or risk-free rate)

• Volatility

• And the time to expiration

There are four key values calculated from the current option price: delta, gamma, theta, and vega. In the options world, we call them ‘the Greeks’.

Delta is how correlated your option price is compared to the underlying share price. By definition 100 shares have a delta of 100. If an option has a delta of 50, it means that if the share price increases by $1, the new price of your option means that you earned $50. Conversely, a drop of $1 means you will lose $50.

Each call contract bought will have a delta from 0 to 100. A deep ITM call will have a delta close to 100. An ATM call will have a delta around 50. Note that on expiration day, as the intrinsic value disappears, an ATM call behaves like the share price, with a delta close to 100. Buying a put will have a negative delta. A deep ITM put will have a delta close to -100. Selling a call will have a negative delta, selling a put will have a positive delta.

Gamma is the rate of change of delta as the underlying share price changes. Unless you are a market maker or doing gamma scalping (profiting from small changes in the share price), you should not worry too much about gamma.

Theta is how much money you lose or profit per day (week-end included!) on your option contracts. If you bought a call/put, your theta will be negative (you lose money every day due to the time passing closer to the contract expiration, and your option price slowly eroding). If you sold a call/put, your theta will be positive (you earn money every day from the premium). It is important to note that the theta accelerates as you get closer to the expiration. For the same strike and volatility, a theta for an option that has one month left will be smaller than the theta for an option that has one week left, and bigger than an option that has 6 months left. In the third post, I will explain how you can take advantage of this.

FWIW, with the current volatility, I get 0.1% to 0.2% of Return On Risk per day, so roughly 35% to 70% of return annualized. I don’t expect these numbers to keep like this for a long time, but I will profit as long as we are in this sideways market. I also have an overall positive delta, so I will benefit as the market goes up, and theta gain will soften the blow when the market goes down.

Vega is how much your option price will increase or decrease when the implied volatility of the share price increase by 1%. If you bought some puts or calls, your vega will be positive, as your extrinsic value will increase when volatility increases. Conversely, if you sold some puts or calls, your vega will be negative. On the sell side, you want the actual volatility to be lower than the implied volatility to make money.

This is why we often say that you sell options to sell the volatility. When volatility is high, sell options. When volatility is low, buy options. Not the opposite. This also explains why some people lose money when playing stock earnings despite being directionally correct. Before earnings, the option price takes into account the expected stock price change, so the volatility is significantly higher than usual. They bought an expensive call or put, numbers are out, share price moves in the correct direction, but because suddenly the volatility dropped (no uncertainty about the earnings anymore), the extrinsic value of the option got crushed, and offset the increase in intrinsic value. The result is not as much profit as expected or even a loss.

Bid/Ask spread

Options are less liquid than the corresponding shares, especially given the sheer quantity of strikes and expiration dates. The gap between the bid and the ask can be pretty big. If you are not careful about how you enter and exit the trade, you will transform a profitable trade into a losing one. Due to the small contract costs, the bid/ask spread adds up quickly, and with the trading fees, they can represent 10% or more of your profit. Beware!

Never ever buy or sell an option at the market price. Always use a limit order, start with the mid-price, or be even more aggressive. See if someone bites, it happens. If not, give up $0.05 or less, wait a bit longer, and do it again. Be patient. If you are at mid-price between the bid and the ask, and you think this is a fair price, and the market or time is on your side, again just be patient. It is better to not enter a trade that is not in your own terms than overpaying/underselling and reducing your profit/risk ratio too much.

LEAPs

Leap options have a very long expiration date. Usually one year or more. ETF indexes, like SPY, can have leaps of 1, 2, or 3 years away. They offer some advantages as they have a low theta. A deep ITM Leap can behave like the stock with 30% of the cost. Just remember that if the share drops by 30% long term, you will lose everything. Watch out! This is a personal experience of mine in 2008, where I diversified away from a few companies to many more companies by buying multiple leaps. It was akin to changing 100 shares into options with a delta of 250. However, when the market tanked, all these deep ITM leaps lost significantly (more than if I only had 100 shares). Good lesson learned. You win some, you lose some.

Number of shares

The vast majority of options trades at 100 shares per contract. But during share splits, or reverse splits, company reorganizations, or special dividend distributions, the numbers of shares can change. The options are automatically updated.

The 1:N splits are easily converted as you just get more contracts, and your strike is getting adjusted. For example, let’s say you own 1 contract of ABC with a strike of $200 controlling 100 shares (so exposure to $20k). Then the company splits 1:4, you are going to get 4 contracts with a strike of $50, with each contract controlling 100 shares (so still the same exposure of $20k).

The N:1 reverse splits are a tad more complex. Say you have 1 contract of ABC with a strike of $1, controlling 100 shares (so exposure to $100). Then the company reverse splits 5:1, you are going to still get 1 contract, but with a strike of $5, with each contract controlling 20 shares (so still the same exposure of $100). You will still be able to trade these 20 shares contracts but they will slowly trade less and less and disappear over time, as new 100 shares contracts will be created alongside.

Brokers and fees

In my experience, ThinkOrSwim (TOS owned by TD Ameritrade, being bought by Schwab) is one of the very best brokers to trade options. The software on PC, Mac, iPad, or iPhone is top-notch. Very easy to use, very intuitive, very responsive. Pricing on contracts dropped recently, it’s now $0.65 per contract, with $0 for exercise or assignment. You may actually be able to negotiate an even better price.

I also have Interactive Brokers (IB), and that’s the other side of the spectrum. The software is very buggy, unstable, unintuitive, and slow to update. I tried few options trades and got too frustrated to continue. Too bad, it has very good margin rates (although if you are an option seller it is not really needed, as you receive cash when you open your trades). However, it’s perfectly acceptable to trade plain ETFs and shares.

Market Markers

Most of the options you buy or sell from will be provided by the Markets Makers. Do not expect that you will get good deals from them.

You will see in the third post how you selling a put and buying a call is equivalent to buy a share. When you buy/sell a call / put from the market makers, you are guaranteed that they will hedge their corresponding positions by buying/selling a share and the opposite options (put/call).

The next post will introduce you to simple option strategies.

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