This is a guest contribution by Harvi Sadhra, CEO and Founder of Hashtag Investing. Hashtag investing is an exclusive community for stock investors to get real-time feedback and discover compelling stocks and strategies any time.
Options trading can be a risky business depending on the options strategies that you employ. The danger is even greater for the buyers of options contracts due to a concept called time value.
An option’s time value is the excess premium paid above the contract’s intrinsic value. The intrinsic value of an in the money option is the difference between the strike price and the current price of the underlying stock.
When you buy calls or puts, you purchase the right to buy or sell an asset at a specified price called the strike price. An option’s strike price is the price at which the owner of the contract can buy the underlying stock at expiration from the seller.
Calls and Puts for Dummies
Before making your first options trade, you should understand how puts and calls work. There are four different transactions an investor can perform when trading options for income:
- Buy calls: Right to buy an underlying stock at a specified strike price.
- Sell calls: Obligation to sell the underlying stock at a specified strike price.
- Buy puts: Right to sell an underlying stock at a specified strike price.
- Sell puts: Obligation to buy the underlying stock at a specified strike price.
When the strike price is below the stock’s market price, calls are said to be in the money. When the strike price is above the underlying stock’s market price, puts are in the money.
Options as Insurance Contracts
Investors use options trading to obtain insurance against price volatility. Sellers of calls and puts are the insurance providers, and the buyers are the insured. Thus, you can think of the option’s cost as a risk-adjusted insurance premium.
This premium erodes at a rate represented by the option’s theta. Theta measures the rate at which the market value of an option decreases with time. Thus, options tend to lose value as the expiration date approaches.
Many market participants today might be concerned about buying stocks before understanding the timeline for economic recovery post-Coronavirus pandemic. To protect against market uncertainty, stock market investors may want to turn to options trading to buy the right to acquire the underlying assets at a future date at a fixed price via a call instead of purchasing the stock.
Options trading tutorial: American Airlines (NASDAQ: AAL)
Consider options trading in American Airlines stock. Travel restrictions due to Coronavirus has hit AAL hard. A bullish investor has two avenues to initiate a long position:
- Pay $1,431 for 100 shares of AAL at the closing price of $14.31 per share as of Friday,
March 13, 2020.
- Buy a call option with a $13 strike price and a maturity date of January 2021 for the last
sold price of $5.95 per share or $595.
The investor risks less cash by purchasing the call option than by buying the stock. Options trading allows the investor to obtain insurance in the event of a stock price rebound by contract expiration while safeguarding the total dollar amount of the stock purchase against downside risk.
The intrinsic value of the AAL call is $131 for the right to purchase 100 shares of AAL stock or $1.31 per share.
The remaining difference between the buyer’s cost for the call option and the intrinsic value is the time value.
The time value of this AAL call is $4.64, which is the last sold price minus the option’s intrinsic value. Sellers add the time value to the option price during options trading as an additional premium to account for the expected closing price at contract expiration.
The time value depends on the market participants’ dual perceptions of where the underlying stock price will be at maturity. Thus, the buyer of this option has a realistic expectation that the cost of AAL stock will be at least $18.95 per share on the expiration date, which is the breakeven price of the options trade.
Likewise, the option seller expects the price of AAL stock to cost no more than $18.95. If AAL’s stock price closes higher than $18.95 on the day of expiration, the buyer will exercise the option.
By selling an option that expired in the money, the seller will miss out on profit equal to the difference between the closing price and the breakeven price.
Be the Insurer, not the Insured
Trading options for a living tend to be more profitable for the insurance seller versus the buyer. When you are first learning to trade options, consider how you can minimize speculative risk by acting as the insurance broker in the transaction.
Buying a call on AAL is an example of speculative options trading. Market participants do not know how much time it will take for the price of AAL stock to rebound after the crisis. Options trading 101 warns against buying calls with a steep time value in a bear market.
On the other hand, the option seller knows the original purchase price of the underlying shares. The seller can choose to only sell call options with a strike price above the initial cost. If this isn’t possible, the seller can price the contract at an additional premium to neutralize expected losses from the transaction.
If the seller of the $13 AAL call purchased the covered shares at $18.95, the options trader
expects to at least break even on the transaction. If the market value of AAL stock is less than $18.95 by the time of expiration, the seller keeps the $595 from the options trade and maintains ownership over the underlying asset.
If you are looking for information on how to invest in options for beginners, start by hedging your long stock market positions by selling covered calls to minimize your losses from options trading.