The best article on options and option trading that I have encountered is this one on Investopedia. Do not judge a book by its cover. Although the article is plainly entitled “Essential Options Trading Guide,” it cuts deeper than others with more promising titles.
I agree with the author, Lucas Downey, that options may seem overwhelming but once you have a few “anchoring points,” things get better.
A few such “anchoring points” from Mr. Downey are worth repeating and/or commenting. I will start by quoting his “Key Takeaways” list and will put my own words in italics and in curly braces because Downey himself used parentheses, rendering them unavailable for me.
- An option is a contract giving the buyer the right—but not the obligation—to buy (in the case of a call) or sell (in the case of a put) the underlying asset at a specific price on or before a certain date. {This definition gives the contract nature of options, plus two critical features of strike price and maturity or expiration date. These elements should all be included in formal definition of options. The only thing missing from Downey is the seller. Behind every buyer stands a seller. It takes at least two parties to have a contract. One way to fix is to say, “An option is a legally binding contract where the seller guarantees the buyer the right — but not the obligation — to buy or sell the underlying asset …”, followed by the strike price and expiration date.}
- People use options for income, to speculate, and to hedge risk. {The three reasons are a good summary. I want to add that not all three goals are created or treated equal. Premium Income may be a big thing for small investors, while hedging as an insurance of value in the underlying asset matters a great deal for investors with a large amounts of investment, who expose themselves to greater risks of losing value. Of course, large investors can also make handsome premium income, simply because the sheer number of shares they own. A premium of $0.5 per share will become half a million dollars if one owns and sells one million shares of Google, for example.}
- Options are known as derivatives because they derive their value from an underlying asset. {Notice Downey says “asset” and not “securities.” This is because, as he said in another article, “almost any asset is optionable,” including commodities, futures, currencies and real estate. Most people only link options to “underlying securities” but options are more ubiquitous and flexible than that.}
- A stock option contract typically represents 100 shares of the underlying stock, but options may be written on any sort of underlying asset from bonds to currencies to commodities. {Downey pays attention to small things like 100 shares represent one option for stock only. Not all authors do that.}
To make the discussion more interesting, I will cite this as a bad example, which unfortunately has been used by more than one article. In this particular case it is about the long put option, but the general idea applies to all others. It has a seemingly concise way of defining along putoption that simply “gives you the right to sell the underlying stock at strike price A.”
Not that it is wrong because the minute you see the word “right,” you know it refers to an option buyer because in option trading, only buyers get right while sellers get obligation for completing the transactions. Therefore, “the right to sell” means a put option (to put is to sell), otherwise it would be “the right to buy” for a call option. When there is a buyer who is selling or is entitled to sell, it has to be a “long put” contract.
As a formal definition it has room for improvement. Like Downey, it gives the impression of one side (just “you” the buyer) action (“to sell”) when all options are binding contracts involving at least two parties, buyer and seller. A bigger problem is to omit a key element of the story that all options have a limited time frame — not being perpetual like equities or stocks do. A limited time frame matters because without it we say things wrong.
For example, all option articles I have encountered claim that short selling strategies have unlimited downward exposure to loss because the underlying securities have unlimited potential to gain. The truth: Within a limited period of time all gains are limited, not unlimited, unless we have a long term option contract that matures in more than one year. But even there the volatility is typically limited rather than unlimited.
Are All Options Securities: Potential Challenges
Another thing I am wondering is whether all options are securities. There is little doubt that all security based options satisfy the legal tests of Howey and Forman, meaning they are indeed full-fledged securities. As I discussed last time on what exactly qualify securities, we must consider the issues of risk, ownership liquidity, common enterprise, third party efforts, intrinsic value and passive income.
But what about options that are based on non-securities asset, like commodities and futures? Are we able to claim that even though some options are derivatives of non-security asset, they are still always securities?
Downey seems to suggest they are when he says “Options are a type of derivative security” with no condition or modifier attached. As a mental exercise, I can imagine that some may argue there is not a “common enterprise” involved for the non-security options, as an individual investor can enter a contract with another investor for transaction in an over the counter (OTC) market. But how an option transacts should have little bearing on its nature, because the value of options, more generally the value of all derivatives, is not generated by themselves but by the underlying asset or securities.
One may also argue that the income from option trading is not entirely passive, because option seller and buyer will decide a “strike price,” which directly impacts whether the option contract is “in the money,” meaning having positive intrinsic value, “at the money” meaning zero intrinsic value, or “out of money” meaning negative intrinsic value.
The Problem with “Common Enterprise”
In my opinion, the “passive income” issue presents less a problem than the “common enterprise” issue does. Consider passive income first and take commodity futures for an example. The commodity market price is typically independent of the strike price. Just because two investors agreed on a strike price of $100 for their option contract on oil futures does not mean the market price of oil will be $100. In other words, investors’ efforts in reaching a strike price are unlikely to impact market price, while the prevailing market price will likely impact the strike price.
More generally, the value of all options, security based or not, always depends on the value of underlying asset — not the other way around. In that sense, income from an option of oil futures is still passively determined — merely having a strike price does not change that.
The issue of common enterprise is another story. For the most part we do not expect to see commodity market price to be controlled by third party efforts in a common enterprise, but rather by decentralized supplies and demands of the (potentially global) market. Therefore, those options would fail at least one element of the legal tests.
Options Should Be Securities for Regulation Purpose Alone
Of course, I do not mean to make the issue bigger than it actually is. For all practical reasons, we can safely regard all options, securities based or otherwise, as securities, holding them to the same rigorous regulation standard as other securities. As Downey correctly points out, in option trading investors are likely receiving warnings like “Options involve risks and are not suitable for everyone. Options trading can be speculative in nature and carry a substantial risk of loss.” For the purpose of protecting investors, especially private, non-institutional and unsophisticated investors, it makes full sense to treat all options as securities.
Options as Down Payment & Insurance
I now come to the core points of this blog. Downey made two interesting analogies: A call option is like a down payment, while a put option is like insurance. Downey uses real estate example to illustrate the point, where one puts down a payment for a house that is still being built. The scenario Downey described is atypical I must say, as he says the down payment will protect one from future rising price, and also secure a position of guaranteed transaction no matter how many people are in the line waiting for the same house. If the market price for the house is going to be $400,000 in 2022, and one puts down $40,000 (10%) in 2021, one has effectively locked up a guaranteed deal on the house — even when the new price is $450,000, unless one cannot come up with the rest of the payment or one changes his or her mind for buying the house. Either way the real estate developer gets to keep the down payment.
In the far more typical scenarios, house buyers are willing to pay an upfront lump-sum to the seller because it guarantees a lower transaction cost, typically through lower monthly mortgage payments, avoiding private mortgage insurance and obtaining more home equity fast. In a real estate sellers’ market like we are in now, buyers may compete among themselves by putting down a larger down payment to ensure the ownership of hot selling properties.
Still, Downey’s hypothetical scenario described a good way to link option trading with real estate buying. The $40,000 (10%) down payment is similar to the premium that option buyers (aka option holders) must pay option writers (aka sellers) in exchange for getting the right to buy the underlying asset.
Similar things can be said about put option as insurance, like a homeowner purchasing insurance policy for his or her home. In this case, because to put is to sell, if the underlying asset is going down in value, the option buyer always retains the right to sell it at a guaranteed strike price, regardless of where the market price is.
An I-S-O Framework for Reading Options & Option Trading
While the down payment and insurance metaphors are interesting, they inspired me to come up with a new model for understanding options: The I-S-O (or ISO) model, in which “I” stands for investors, such as the sunken investment and opinions about the underlying asset, “S” for scenarios like all the terms on the option contract, and “O” for options features like the smaller amount of money required in options than in securities and the limited time frame. My main argument is that we cannot have a solid grip on option trading unless we simultaneously consider investors (I), scenarios (S) and features of options (O).
Everything starts from asking a simple question: Are we missing anything in comparing a call option to down payment and a put option to insurance? I believe we do. To be sure, there is a real link between a call option and a down payment, which is buying asset at a low price. Remember the two fundamental motives in all financial transactions: buying low and selling high? A call option contract can guarantee buyers the right to buy low in the underlying asset — lower than the prevailing market price — just like a down payment can in real estate. It is just that the call option strategy has other uses that is not like down payment.
What is in the name of option strategy?
Before getting to the details, let me say a few words how option contracts are named. Like all simple option strategies, the first term in the name indicates the move or action taken by the investor, like long (buy) or short (sell or write). The second term shows the content of the contract, like to buy or to sell the underlying asset.
There will be exceptions, especially with complicated strategies combining two or more strategies or positions together, like “covered calls,” “married puts,” “bull call spread,” “bear put spread,” “protective collar,” “long strangle,” and “long straddle.” See this article for more details. But even there the naming convention still helps. Take “long straddle” and “long strangle” for example, “long” still means to buy there. Also note the term “covered” typically means existing ownership of the underlying asset, while “naked” indicate no current ownership. “Covered” is always the opposite of “naked” transactions.
The tricky difference between a buying and selling contract is that all selling or shorting contracts are written for someone else to buy or to sell, while all buying or longing contracts are for the investor him- or herself to buy or to sell. Thus long put = the investor buys the contract to sell the underlying asset, while short call = the investor writes up a contract for someone else to buy or to call the underlying asset.
When call option is like down payment
Downey talks about four basic ways to trade options: (1) buy calls; (2) sell calls; (3) buy puts and (4) sell puts. Again in securities and options trading, to buy is to long, and to sell is to short. So the above can be called “long calls,” “short calls,” “long puts” and “short puts.”
The way it works is simple: Say Morgan decides to buy (or long) a call option for Google stock from Finley (I picked two gender neutral names from a Google search that lists top 25 names shared by both genders). Finley writes up the contract with a strike price of $100 per Google share (a quick note: A strike price is just a legally binding and predetermined transaction price). Finley asks for a premium of $5 per share and specifies an expiration date in three months.
In real estate a down payment lowers transaction cost typically through cutting down mortgage cost, not through lowering the house sales price. But in an option contract paying the premium always guarantees the strike price for both parties. Finley essentially tells Morgan “If you pay me $5 a share, I will guarantee you to buy 100 Google shares at $100 a share — regardless of what the market price for Google shares will be in three months.”
Of course, while the strike price is guaranteed and legally binding, market price is not. The “moneyness” of all options depends on the difference between market price and strike price.
Say in three months Google shares jump to $120 a share, suddenly the strike price of $100 per share to buy Google is very attractive — it is “in the money” because the $20 difference ($120 – $100) means a real saving of $20 per share for Morgan ($15 net gain after deducting the $5 premium Morgan paid to Finley). We always want to buy low and sell high and in this case, Morgan did buy Google shares $20 lower (again with a net gain of $15) and in that case, paying $5 premium is like paying the down payment in real estate.
But even in this scenario, there is no guarantee of saving or buying low as in real estate purchasing. If Google share tanks to $90 in the market, the $100 strike price is worthless and is “out of money” — again because we all want to buy low and sell high. Morgan will be better off letting the contract expire without executing it. What if the market price is exactly $100? It is called “at the money” and Morgan will be indifferent toward buying from Finley or from the market.
When A Call Option Is Not Like Down Payment
We must keep in mind that the same call option can be used in other ways that bear little resemblance to down payment. Investors can use call option to get premium income, which is one of the reasons why people enter option contract as discussed by Downey. In all option trading, only the writer /seller/shorter receives premium, while buyer/holder/longer pays premium. A related asymmetry is that only writers have obligation to complete transactions, while buyers only have right, not obligation to exercise the contract.
To see call option can be used not as down payment to “buy low”, let’s consider selling (or shorting) a call. This time we will make Morgan the seller and Finley the buyer — the opposite of the scenario discussed above. Simply switching from a buyer to seller for Morgan can cause big differences.
Morgan the seller or writer will say the same thing to Finley the buyer, just like Finley said to Morgan last time: “If you pay me $5 a share, I will guarantee you to buy 100 share of Google stock for $100 a share, regardless of what the market price for Google is in three months.” Notice a call option is always about the right to buy an underlying asset, the only difference is that last time Morgan was buying the right to buy Google and this time is selling the right to buy Google. In other words, Morgan was long the call last time but short the call this time. Different positions in the contract (buyer or seller) make up an “I” factor for the investors dimension in the ISO model.
Investors’ Opinions Matter
Is Morgan selling the call option to Finley as down payment to buying low of more Google shares? No, Morgan as the seller has a different mindset than Morgan as the buyer, even for the same call option. This is why I say we must consider both the investors and the scenarios they face jointly to understand options and option trading.
In addition to different positions in the contract, the investors dimension also mean different opinions investors hold about a particular asset or security. Often investors enter option contracts because they have certain opinions about the underlying securities and want to make money out of the opinions.
Not all opinions are strong, as investors can have neutral opinions, which tend to make them more cautious and end up taking two opposite positions. But if we only consider strong opinions, then they fall into two types: bearish or bullish. It’s easier to illustrate them through examples.
A simple question: Why Morgan wants to sell the call to Finley. It is highly likely that Morgan has an opinion that Google shares are overvalued, and the price will go down next. With such an opinion, even though Finley bought the call, Morgan is betting Finley has no incentive to really exercise the contract (i.e., to buy 100 Google shares from Morgan), because Google shares will stay lower than the strike price. Morgan is said to be “bearish” rather than “bullish” for Google stock, at least during the time frame covered by the option contract.
Taking scenarios into consideration
But positions in the contract and subjective opinions of investors are not the only thing that matters in option trading. Many scenario variables play a role often jointly with investors. Let’s see how they work in our example.
Morgan holds an opinion that favors Google share to stay low. Such an opinion drives Morgan into a seller position and to write a call contract that allows Finley to buy Google shares. From the moment when Finley enters the contract, terms like the strike price, the premium, past transactions, market price and expiration date, become the scenario for both Morgan and Finley. It is no longer just personal opinions but all the contract terms that matter.
Of all the scenario variables, market price and strike prices are easy to understand because gain or loss in an option deal is directly determined by the difference between market and strike prices. An individual investor like Morgan may hold a bearish opinion about Google stock, but that means little more than a personal opinion — until Morgan quantifies the opinion into a predicted share price in the market and accordingly comes up with a strike price to be included in the contract. This is how investors and scenarios are related.
Expiration date: an underappreciated scenario variable
Unlike strike price, expiration dates have not received much attention. People tend to implicitly believe opinions are stable but when it comes to options and securities, opinions can be short lived and time contingent.
Consider Morgan again, who may genuinely believe Google is one of the best companies in the world, yet it won’t stop Morgan from believing its stock is overvalued last month or last year. This is another way investors (i.e., opinions) and scenarios (time before the expiration date) are interconnected.
But that is not all. A long expiration date is also associated with high volatility of securities. During a longer period of time, market prices fluctuate more — other things equal. This is known as higher time value of the option, which translates into higher premium (i.e., the price of option) as investors are willing to pay more for the higher potential to realize gains.
Finally, I believe a longer time to expiration has a (little discussed, hidden) effect on the likelihood for investors to use the hedge strategies, those complicated and combining two or more strategies or positions such as long straddle and long strangle. In the longer term option trading, risk reduction or hedging becomes more prominent than shorter term goals like income from premium.
Taking option features into account
We have discussed the I (investors) dimension and the S (scenarios) dimension. We must now consider the O (option) dimension. This is relatively simple because liquidity and phased operations are the only two factors in this dimension.
First is liquidity. Options or all derivatives are not like the underlying asset because the former is more flexible and cost less than the latter. Small investors may not have the capital for buying or owning a large number of shares for a Fortune 500 firm, but they can afford to buy an option whose value is tied up to that stock.
A lower cost means lower transaction cost, which in turn increases trade frequency but accompanied by low rate of contract execution. Downey shared interesting numbers with us, “Only about 10% of options are exercised, 60% are traded (closed) out, and 30% expire worthlessly.” We may call option trading some kind of “side dish” rather than a “main dish” in the dinner of investment. In a way, investors enter an option contract not necessarily to execute it but only to test water for the bigger game of trading the underlying asset. This explains why 30% of option buyers do not mind losing the premium they paid to the seller by letting the options expire worthlessly. The majority (60%) of option buyers “sell their options in the market, and writers buy their positions back to close.”
The second feature of option is the phased transaction. Option contracts conceptually have two steps. Step One is for parties to enter the option contract. The transaction at this step is all about right and obligation, strike price, premium and maturity date. Only Step Two may actually see the underlying asset involved in transaction. This is because this second step has two possible end results: Either the contract expires, or the buyer exercises the contract. Only the latter would involve transaction of the underlying stock. Considering that option buyers have the right but not the obligation to exercise the contract, the underlying securities may not be involved in the transaction at all. Looking at the statistics provided by Downey, apparently this is the case in the majority of option trading (60% + 30% =90%).