Risk & Leverage within Options Trading
When it comes to options, relatively small changes in the price of an underlying stock can result in large changes in the prices of the corresponding options. This property of options is known as leverage, and can work to the benefit or detriment of a trader, depending on which direction the underlying stock price is moving.
This leverage exists because a few cents can make the difference as to whether or not an option would be profitable to execute. If an option would be profitable to execute, then the option is called in the money. A call is in the money if the strike price is lower than the price of the underlying stock, and a put is in the money if the strike price is higher than that of the underlying stock. A call is out of the money if the strike price is higher than the price of the underlying stock, and a put is out of the money if the strike price is lower than the price of the stock. If an options strike price is equal to the value of the underlying stock, the option, whether it is a call or a put, is called at the money (more about ITM vs. OTM can be found here).
Intrinsic Value vs. Time Value
The total premium of an option is made up of two components: the intrinsic value and the time value.
The intrinsic value of an option is the amount by which the strike price of the option is profitable. The intrinsic value for a call is the difference between the underlying stock’s price, and the call’s strike price. The intrinsic value of a put is the difference between the put’s strike price and the underlying stock price. An option that is out of the money or at the money has no intrinsic value, but still has time value.
The time value of the option is the value associated with an option due to the amount of time left until the expiration day. As expiration day comes closer, an option’s time value will decrease, because there is less and less time for something favorable to happen to the price of the underlying stock. This is known as time decay. Even if all other factors stay the same, an option will lose value as time goes on due to time decay. The time value of an option is the difference between the option’s premium and its intrinsic value. Time decay is exponential, and therefore time value decreases faster and faster each day. This effect of time decay can be estimated via the Greeks. (more about the Greek values can be found here).
Long vs. Short
In terms of purchasing and selling contracts, you can either be long or short. If you purchase a stock or option, and then hold that contract in your brokerage account, you are said to be long. For example, if you hold a call option, you are said to be long a call contract. If you hold 100 shares of a stock, you are said to be long 100 shares of that stock. If you then sell that contract, you are not long anymore. When you are long an options contract, you have the right to execute that option at any time up until expiration day. Additionally, your potential losses are limited to the premium you paid for the contract.
If instead, you sell a contract that you do not already own you are now considered short. For example, if you have sold the right to buy 100 shares, without having already held that right yourself, then you are said to be short a call. When you do this, you are writing a contract, creating a contract where there was not one before. You receive the premium of the option from the buyer upon that contract’s initial sale and keep it. If you are short a call, you are under the obligation to sell the contract holder shares of the underlying stock at the strike price, if the contract holder executes the contract. If you are short a put, you are under the obligation to buy the underlying shares at the established strike price, should the holder execute the contract. Theoretically, someone who is short a call faces unlimited potential risk, but someone who is short a put only faces finite potential risk, because the price of the underlying stock cannot fall below $0.
Opening vs. Closing Transactions
Any option transaction can be considered an opening transaction or a closing transaction.
An opening transaction creates a new trading position, or adds to an existing one. A transaction is considered an opening sale if the seller intends to create or add to a short position. A transaction is considered an opening purchase if the purchaser intends to create or add to a long position.
On the other hand, a transaction is considered a closing purchase if the purchaser intends to decrease or end a short position. This is often known as covering a short position. A transaction is considered a closing sale if the seller intends to decrease or end a long position.
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