What is a Call Option?
A call option is a derivative contract that gives the holder the right, but not the obligation, to buy an underlying security at a specified price on or before a specified date.
There are a wide variety of uses for the purchase and sale of call options in contemporary trading. However, at its simplest a call option is merely a bet on an increase in the price of a stock that does not require the actual purchase of that stock.
They are considered a riskier form of speculating on an increase in the price of a stock, as the entire value of the premium can be lost if the price of the underlying stock fails to exceed a certain point.
However, the potential returns from an increase in the price of the underlying stock are similarly out-sized compared to traditional stock buying due to the leverage involved with options.
When you are a buyer of a call you are speculating that the price of the underlying will increase in value before the expiration date on the contract. While if you are a seller of a call option then you want the price of the underlying to at or below your strike price, which is a neutral to bearish position.
Call Option Breakdown
Imagine that an investor wants to sell a call contract for 1 share of company A for $2 per share that expires in one week.
• The seller of the call is known as the ‘underwriter‘ for that contract, while the buyer of the call is known as the ‘holder’ of that contract.
• The price that the seller of the call option receives and the buyer of the call pays is known as the contract’s ‘premium’.
• The one week duration of the call is known as the ‘expiry date‘ of the contract.
• American style call options allow the contract holder to exercise the contract on or before the expiry date, while European style call options can only be exercised on the expiry date.
• Call options can be resold on the open market by the holder, though the underwriter remains the same.
• Call options for sale are displayed in an ‘options chain’, which is a table detailing the various call options available according to their expiry date and strike price, and displays the current bid/ask spread for the premium or sale price of the contract.
What is a Put Option?
A put option is a derivative contract that gives the holder the right, but not the obligation, to sell an underlying security at a specified price on or before a specified date.
There are a wide variety of uses for the purchase and sale of puts in contemporary trading. However, at its simplest a put is merely a bet on a decrease in the price of a stock that does not require the actual short selling of that stock.
Put options are considered a riskier form of speculating on a decrease in the price of a stock, as the entire value of the premium can be lost if the price of the underlying stock fails to fall below a certain point. However, the potential returns from a decrease in the price of the underlying stock are similarly out-sized compared to traditional short selling.
When you are a buyer of a put option, you are speculating that the underlying asset will decrease in value within the expiration date you selected. However, if you are a seller of a put then you want the price of the underlying to stay out of the money, or above the strike price, which is a neutral to bullish position.
Put Option Breakdown
Imagine that an investor wants to sell a put option contract for 1 share of company A for $2 per share that expires in one week.
• The seller of a put is known as the ‘underwriter‘ for that contract, while the buyer of the put option is known as the ‘holder’ of that contract.
• The price that the seller of a put receives and the buyer of the put option pays is known as the contract’s ‘premium’.
• The one week duration of the put option is known as the ‘expiry date‘ of the contract.
• American style put options allow the contract holder to exercise the contract on or before the expiry date, while European style put options can only be exercised on the expiry date.
• Put s can be resold on the open market by the holder, though the underwriter remains the same.
• Puts for sale are displayed in an ‘options chain‘, which is a table detailing the various put options available according to their expiry date and strike price, and displays the current bid/ask spread for the premium or sale price of the contract.
Option Expiration
This is the day an option or futures contract expires. In option trading, investors have the ability of purchasing options. When the purchase is complete, the option or futures contract gives investors the right to purchase or sell assets at a pre-determined price within a particular time.
This value is called the strike price. When it comes to call options, the strike price refers to the purchase of a security up to the expiration date. On the other hand, the strike price at which shares can be sold refers to put options.
Option Expiration or Expiration Date is set on the third Friday of the contract month when a futures contract expired. There is a probability that the third Friday may fall on a holiday.
As a result, the Option Expiration will be moved to the Thursday before the third Friday. It is important to note that once the options contract expires, the contract becomes invalid.
There are options that have automatic exercise provision. This type of option is automatically exercised in the money at the time of expiration.
What is IV Rank?
IV rank or implied volatility rank is a metric used to identify a security’s implied volatility compared to its IV history and is an important metric for active traders. If I were to tell you that a stock’s implied volatility is 50%, you might think that is high, until I told you it was a biotech penny stock that regularly makes 100% moves in a week.
Conversely, you might think that 20% is a low implied volatility level until I tell you that the stock is a low-volatility utility company that hardly moves 5% throughout a year.
IV rank takes the highest and lowest levels of implied volatility over the trailing 52 weeks and ranks the current IV level relative to those highs and lows. Here’s the formula, taken from TastyTrade:
100 x (the current IV level – the 52 week IV low) / (the 52 week IV high – 52 week IV low) = IV Rank
For example, if a stock’s 52 week IV high is 100%, and the 52 week IV low is 50%, that would mean a current IV level of 75% would give the stock an IV rank of 50 because it’s implied volatility is directly in the middle of its 52-week range.
The Implied Volatility rank is kind of like a P/E ratio for a stock. If I tell you a stock is $100 per share, that tells you virtually nothing. You don’t know how many shares the company has outstanding or how much earnings per share the company is producing.
However, if I told you that the P/E ratio is 10, you get much information from that. It says that the earnings yield is 10%, and you can compare it to the P/E ratio of comparable companies as well as the general market.
In the Money (ITM)
In the money is a term from options trading used to describe an option that would create value, but not necessarily profit, if exercised. It is not necessarily profitable because a trader needs to account for the premium spent to purchase the option, which being in the money has no bearing on.
It just means that you can exercise your option and receive shares for a better price than where it is currently trading.
A call option is in the money when the strike price is below the current market price of the security and a put option is in the money when the strike price is above the current market price of the security.
In the Money Example
Take a call option with a strike price of $40. Whenever the market price exceeds $40, the option is considered to be in the money. This is because the call option can be exercised, the security can be purchased from the counterparty to the option for $40 and then the security can be sold for more than $40 in the market, thereby creating value for the option holder.
Similarly in the case of a put option with the same strike price, it is considered to be in the money whenever the market price for the underlying security is below $40. When the option is exercised, the holder can buy a unit of the security for less than $40 from the market and then sell that security for $40 to the counterparty to the put option who is obligated to purchase it for $40.
Out of the Money (OTM)
The term out of the money refers to a strike price on a vanilla equity option that is above the current market price for the underlying stock in the case of a call option and below in the case of a put option.
Out of the money options have no intrinsic value, as they are currently worthless to exercise, while they do retain extrinsic value as a result of their time value, where the market price still has time to change in favor of making the option profitable to exercise.
The opposite of an out of the money option is an in the money option.
Option Basics
A standard vanilla equity option gives the holder the right, but not the obligation, to buy (call option) or sell (put option) a set amount of shares at a given price (the strike price).
The holder of the options turns a profit on the exercising (the execution of the contracted transaction) of the options when the strike price is below the market price in the case of a call and above in the case of a put.
Out of the Money Example
Take an underlying stock with a current market price of $40 per share. Any call options with a strike price of more than $40 or put options with a strike price of the less than $40 are out of the money.
For example, if the holder of a call option with a $45 strike price were to exercise the option, the option writer would be obligated to sell the holder shares of the underlying security at $45 per share.
However, the holder of the options could just buy the same shares from the market at $40 per share, leading to a loss of $5 per share by exercising the options.
Strike Price
Strike Price is the option price set on a derivative contract. It is often used in index and stock options, where the strike is listed precisely in the contract. Strike price is where security can be purchased during call options. Conversely, it is also the amount at which security can be sold during put options.
The value of a financial product may depend on the value of other financial commodities. This is simply referred to as a derivative. Derivative products can be classified into 2 types- a put and a call.
The “Put” gives the financial product holder a way to sell stock at a specific price to interested individuals. The “Call” gives the holder a way to purchase stock at a specific price. Keep in mind that Puts and Calls are entirely optional and the holder is not forced in any way to buy or sell financial product stocks in the future.
They are often referred to as Exercise Prices. It is the single most important element in option pricing. Other factors to think about include prevailing interest rates, underlying security and option volatility.
Understandably, strike prices are agreed upon even before a contract drawing. They are commonly traded in increments of $2.5 and $5. The investor has to agree with the strike price before the option is passed.
The option’s strike price and current market price are different. The difference between them is representative of the amount of profit per share gained when the option is bought or sold.
Valuable options are sometimes referred to as in-the-money, while worthless options are sometimes referred to as out-of-the-money at expiration.
An Example of Strike Price
Let’s say there are 2 option contracts available. One is a call option that has a $100 strike. The other is a call option that has a $150 price strike. The underlying stock price is standing at $145. Now, let’s say all that strike is the only difference between these two option contracts.
The first contract has a gain of $45, which can also be called an in-the-money valued at $45. This means the stock is currently standing at $45 higher than the first contract’s strike price.
The second contract has a $5 loss, which can also be called an out-of-the-money valued at $5. When the asset doesn’t reach the strike price, then that option is considered worthless.
Buy to Open (BTO)
"Buy to open" refers to an options trader opening (buying) a long call or put position in options. If a new options investor wants to buy a call or put, that investor should buy to open. A buy-to-open order indicates to market participants that the trader is establishing a new position rather than closing out an existing position
Sell to Open (STO)
"Sell to open" refers to instances in which an options trader initiates, or opens, an option trade by selling or establishing a short position with an option call or put. This enables the option seller to receive the premium paid by the buyer on the opposite side of the transaction.