The Optional Tourist: How to Worry Less about the Derivatives Market
Lesson B: Learning about Calls and Puts
Options are financial instruments which allow investors to speculate (bet) and/or hedge against risk. Options are called derivatives since their value derives from the performance of an underlying asset’s future performance.
They’re a bit daunting to try and figure out since they can take many forms and have complex condition-specific triggers depending on your aims. But hopefully by the end of this article, you’ll feel comfortable with the basic workings of an option as they are used in “calls” and “puts”.
To get things started, let’s distinguish options from the wider futures market.
The Futures Market
In a general sense, the entire financial market is based on future expectations. Take, for example, the rent charged for leasing a property to run a business. The rent you decide to pay is based on what you expect to earn in the future while using that property (usually up to 1/3 of your income!). Obviously, if you can’t make enough to pay the rent, you’ll realize that your future will be absent that particular plot of land.
Likewise, the landlord will base the rent on the general idea that future wages will be high enough and widespread enough so that there will be several prospective leasees interested in the property. (Or in some cases, the landlord may hold out with a high rent and an unleased property because they expect that in the future, the rent will be competitive.) In other words, the competitive market for rents is based on a loose notion of future wages in the area.
The so-called “futures market” basically injects a bit of steroids into this notion of the expectation of future earnings and losses. It does so by designating explicitly what future expectations for an asset might be.
Hence, in financial parlance the term “future” refers to a type of financial contract where something is purchased by a specific future date. This practice appears to date back to the Babylonian empire around 7500 BCE.
Today, things remain more or less the same. Futures contracts can vary, but the important point is that the contract obligates the buyer to purchase the asset at the specified price and date.
Futures contracts have historically included rice, corn, and other commodities whose price can fluctuate. In such contracts, all relevant information is declared, and the buyer must purchase the commodity at the agreed price regardless of the market price.
In contrast, options work like a futures contract except that the buyer has a right but not an obligation to buy or sell the underlying asset.
There are two sides to options — a buyer and a seller.
- The buyer is the one who has the right but not the obligation to exercise option. Note therefore that in order to have the right, the buyer has to in fact buy the option, which amounts to paying the premium to the seller.
- The seller is the one who offers or writes the option contracts and gets paid the premium if the buyer decides to buy the option. The seller is obligated to sell the option per the contract if the buyer exercises his/her right.
There are three key components to options (these will make more sense as we go through examples):
- Market price — price of the underlying asset in the market.
- Strike price — price at which the option contract can be exercised (buy or sell) and is basically the break-even point; so depending on the type of option, the strike price needs to be either more than or less than the market price to make a profit for the buyer.
- Premium — the fee paid to the writer of the option, regardless of whether or not you exercise the option.
What Is a Call Option?
A call option is a contract to buy the underlying asset before an expiration date and is usually a bet that the market price of the asset will rise in the future.
An easy way to remember this is that expectations of a rise in price are often called “long positions”. So just think of a call option in terms of a long distance call.
Ok, more terminology . . .
This is specific to call options: When the market price is above the strike price, a call option is considered “in the money”, or profitable. When the option is at breakeven value, the strike price (including the premium paid) is the same as the market price, it is considered “at the money”; and when the market price is lower than the strike price, the option is considered a loss, or “out of the money”.
Here’s what a call option can look like:
5 ABC Feb 225 @1
The template is essentially:
number of contracts/shares | name of the asset or stock | expiration month | the strike price | the premium.
Ok, let’s apply those three key components to parse what’s going on. Essentially, the option above translates into a right to buy:
- 500 shares of ABC stock
- with a strike price of $225
- for a premium of $1
- and an expiration date in Feb.
Some important things to note:
- The number of shares is always based on 100. So although the call refers to “5 ABC”, this is really 5 contracts, or 500 shares (and not 5 shares).
- The expiration date of options is usually the 3rd Friday of the month specified (i.e. Feb) at 3pm US Eastern. The option can be exercised at any point up to the expiration date (this is different with European style options, where the option has to be exercised on the expiration date).
- The premium is $1 per contract. You have to remember that the premium is multiplied by the number of shares. In the example above, the premium paid for the option would be $1 x 500 = $500. This cost needs to be figured in when determining whether one exercises the option.
- Premiums are paid upon sale of the contract and are not refundable. So even if you don’t exercise the option, you can’t get your premium back.
- Given the preceding points, calculating the breakeven point involves adding the premium to the strike price. So to break even, the market price of the asset would need to be $225 + $1, or $226.
So given the above information, here’s how the calculation would work out if we decided to exercise the option at a market price of $226:
(Marketbeat’s options calculator is a great cheat!)
And well, given we wouldn’t make a profit, we’d be better off seeing if the market price of the underlying asset bumps up a little.
Hey, it’s your call (sorry for the pun!).
What Is a Put Option?
If a call option involves the right (but not the obligation) to buy an asset, a put option is the opposite. It is the right (but not the obligation) to sell an asset without actually having to own the asset. This last bit about ownership sounds odd, but all you have to remember is that the options market is a derivatives market — meaning, speculation on value falls on betting the way stocks and indexes will go without having to own anything in those markets.
Put options, nonetheless, can be used by investors to hedge their position on assets they own. If the asset they own goes down, they may lose on their initial investment, but they can exercise the put option to make some money back.
A put option is profitable, or “in the money”, when the market price is below the strike price. It is “at the money” when (taking into account the premium), the strike price and market price are equal. It is “out of the money” when the strike price is higher than the market price.
Let’s take a look at an example.
Sondheim decides to take out a put option on a stock which he believes will drop in the near future. Here’s what his put looks like:
10 GHI Apr 32 @1
The market price drops to 20.
Things to note:
- 10 GHI = 100 shares x 10 = 1000.
- The cost of the contract (premium) is 1000 x $1. So he will be paying $1000.
With the market price at $20, the option is currently “in the money”, but by how much?
- Multiply the number of shares by the strike price.
- Subtract the number of shares multiplied by the market price.
- Subtract the number of shares multiplied by premium.
Sondheim decides to exercise the option since it’s in the money for $11,000!
The world of options gets truly complex, especially when the person selling or writing the option owns the underlying asset. These are called “covered” options. So let’s delve into that next.
Covered Calls and Covered Puts
A covered call refers to a further investment strategy with options. While investors do not have to own the underlying asset to use call or put options, in a covered option the investor does in fact own the underlying asset and sells the option to another person. Hence, the use of an option is to further speculate on how the underlying asset might perform.
Covered Call Options (CCOs)
CCOs are typically used in neutral bull markets, where the asset owner does not expect the asset to rise dramatically within the near future. So when writing a CCO, the asset owner is essentially willing to sell a portion of the underlying asset if the price should rise. CCOs are used to make short-term gains from premiums.
There are a lot of factors one has to take into account when writing a CCO. Asset owners usually write COOs out-of-the-money or at-the-money, in which case the strike price is below or equivalent to the market price. The idea here is that they are hoping the contracts they sell expire worthless, and they can walk away with the premium.
If the market price rises above the strike price, the option is in-the-money and the owner/buyer of the contract will most likely exercise the option. If this is the case, there are two points to consider:
- If the market price is moderately above the strike price, the writer of the CCO will profit because s/he will have made more in the premiums of the CCO than the gain in the price of the underlying asset.
- If the market price is above the strike price by a significant amount, the writer of the CCO would have likely been better off not writing the CCO.
Covered Put Option (CPO)
The easiest way to understand the use of CPOs is to remember that they function like CCOs. They act as hedges. With CPOs the investor has a short position with respect to an underlying asset. To recall, a short position is when an investor has borrowed an asset, sold it at one price in order to buy it back at a lower price. So a short investor wants the price of the asset to drop.
In short, CPOs are used in slightly bearish markets. By selling a CPO, the short investor who writes the CPO gets the premium. Ideally, the CPO expires worthless — in this case, the market price is above the strike price (the opposite from a CCO).
When the market price is below the strike price, the CPO is in-the-money for the person who has bought the option. Should the put be exercised by the buyer, then the profit of the short investor (the seller/writer of the option) would have to be measured against how much s/he makes when buying the asset back at a lower price.
What Is a Perpetual Option?
Unlike standard options, perpetual options do not have an expiration date and can therefore be traded at any time. Their non-standard format means that they are not traded on exchanges. Investors interested in perpetual options have to trade them on OTC (Over-The-Counter) markets. As one can imagine, with no expiry date, a perpetual option will most likely have a very high premium. For example, theoretically there is no upper limit to the seller’s/writer’s exposure on perpetual call options where the price of an asset could rise like a moonshot.
How This Can Be Applied
I hesistate to say that with this lesson you’re a seasoned veteran as opposed to a tourist. But if I did, I would be lying. If you grasp the theory behind options and futures markets, there is still a lot of practical complexity. It’s easy to make a lot money, and as you guessed it, it’s easy to lose a lot of money. Here are two ways to remember how options can be used:
Speculating
Options can be used to speculate on the future direction of assets without having to own the asset itself.
Hedging
Options can be used to hedge one’s investment position. This is particularly the case with put options, but can also be so with call options.
Imagine an someone who is invested in oil, which is competing with green energy stocks. The investor does not want to buy green energy stocks but instead wants to hedge his position with a call option on a green energy stock in case it goes up.
Hedging can also involve options on indexes based on how indices like the S&P and Dow Jones will perform. So someone heavily invested in tech stocks might decide to sell his shares as their price drops. But s/he can also hedge by taking out a call index option on NASDAQ in case the index goes up. If it does, s/he can exercise the option. If it doesn’t, then s/he loses the premium paid.
Before jumping into options trading, it might be a better transition to start with something like inverse stocks or inverse cryptocurrency investments to get a sense of hedging. You can certainly learn more at our own The Art of the Bubble (see below).
And if you find the entire idea of options a bit unpalatable, well then you might like to hear the story of a venture capitalist who left trading derivatives because he realized (after witnessing a colleague die on the exchange floor from a heart attack, with no one really batting an eye):
- derivatives trading does not add real value to anything
- life is too short to be trading derivatives
Until you decide on your options (sorry for yet another pun!), may you enjoy the journey!
This article is a part of the Crypto Industry Essentials educational program presented by The Art of the Bubble.
Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his The Art of the Bubble education series on cryptocurrencies.
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