Introduction:
Options and Futures are both zero-sum in the sense that for every
winner there is a corresponding looser. They are both contracts between buyers
and sellers.
Options are contracts between buyers and sellers whereby the
buyer (long) gets the right to buy (call) or sell (put) a particular security
at the strike price from the seller (short). The buyer pays the seller a
premium for this privilege upfront which is the price of the contract. 100
shares of a security is equivalent to one contract.
Futures are contracts between buyers and sellers whereby the
buyer (long) is obligated to buy a particular commodity at the pre-determined
price from the seller (short) on a particular date. To enter a contract, you
need to deposit an initial amount into the margin account (usually 5% to 10% of
the contract value), called the initial margin – the contract does not have a
premium as such. The account is credited or debited from/to every day based on
contract price changes. In addition to the initial margin, there is also a
maintenance margin requirement, which is the lowest amount an account can reach
before needing to be replenished. One contract stands for an amount of
commodity that is different for each commodity. For example, for the E-Mini
S&P futures contract is valued at 50-times the value of the S&P 500
stock index. So, based on the current S&P 500 index value of 1370, one
E-Mini S&P futures contract has a value of 1370*50=$68,500.
What do the terms “long put”, “short put”, “long call”, and “short call” mean w.r.t. Options?
The put buyer is short on the underlying asset of the put,
but long on the put option itself. That is, the buyer wants the value of the
put option to increase by a decline in the price of the underlying asset below
the strike price. The writer (seller) of a put is long on the underlying asset
and short on the put option itself. That is, the seller wants the option to
become worthless by an increase in the price of the underlying asset above the
strike price. Generally, a put option that is purchased is referred to as a long
put and a put option that is sold is referred to as a short put.
Similarly, a call option that is purchased is referred to as a long call and a call option that is sold
is referred to as a short call.
Who can be assigned and when?
Assignation is a trade that happens between the buyer and the seller of an option at the request of the
option buyer to exercise his option position. As such, only the option seller
can be assigned – ie, the seller is made to either buy (call option) or sell
(put option) the security at the strike price as a result of the buyer
exercising the option any time before expiration date. The logic is
straight-forward: The option seller sold the right to buy (call option) or sell
(put option) the security at the strike price to the option buyer. As such the
right to assign is with the option buyer.
How to close an option and what happens between the buyer and seller?
Closing an option position is a transaction that happens between the closer and the exchange,
not the counter-party when you opened the position. Basically, when doing a
“Buy to Close” or “Sell to Close” against an open option position in your
brokerage account, what happens is you are doing an offsetting transaction to
exit the trade.
Intrinsic Value and Extrinsic Value (“Time Value”) of Options:
Intrinsic value is the money that can be realized, if
exercised. Example: Assume stock ABC is trading at $30 and a call option with a
strike price of $25 is trading at $7. Then, if the option is exercised, the
amount realized is $500 per contract – so, $5 is the intrinsic value.
Extrinsic value or “Time Value” is the difference between
the option price and the intrinsic value, when it is trading more than the
intrinsic value. In the above example, $2 is the time value.
Out-the-money options have 0 intrinsic value and a positive
time value. So, if ABC stock is trading at $25 and call option with a strike
price of $30 is trading at $1, the intrinsic value is 0 and the time value is
1.
One strategy for
short-term traders involves capturing the time value. Time Value decays
faster as the expiry date approaches. For this reason, such traders prefer
at-the-money near-term (1-week to a max of 60 days or so) options. At-the-money
is preferred because time premium is highest with at-the-money options. On the
other hand, that strategy has minimal down-side protection. Some protection can
be achieved while sacrificing some time premium by choosing deep in-the-money
options with “decent” time premium.
Implied Volatility (IV), Statistical Volatility (SV), and Theoretical Value (TV) (“fair value”) of Options
SV is a measure of how rapid price changes have been. IV is
a measure of what the market expects the price to do. They are both numbers
between 0 and 100, higher numbers imply higher volatility.
The derived value of the option price when plugging in the
SV into an option pricing model is the theoretical or fair value of an option.
The difference between the theoretical value and the actual value of an option
is known as option mispricing.
Practical Use:
- It
is good to sell options when IV
> SV (market price is higher than theoretical price) and buy options when SV > IV (theoretical price is higher than market price), - Options are cheaper to buy when volatility is lower,
- Options bring more premium when volatility is higher,
- Implied volatility increases when the macro sentiment is bearish and vice-versa – this is because of the belief that bearish markets are more risky than bullish markets.
Delta, Gamma, Vega, and Theta – “The Greeks”
These are measurements of risk for an option position.
How do Options and Futures differ?
Margins in Futures vs Premiums in Options:
Margins are specific to Futures while premiums are specific
to Options –
- Margin – these are financial guarantees (5% to 10% of contract value) required of both buyers and sellers of futures. Since, the guaranty is only a small percentage of the total contract value, there is very large leverage allowing large gains or losses.
- Initial Margin – paid by both the buyer and the seller of a futures contract into the margin account.
- Maintenance Margin – the lowest amount an account can reach before needing replenishment.
Premiums are the payment that the buyer makes to the seller
when entering an Options contract.
Risk in Futures vs Options:
Options - the maximum risk for the buyer of an option is the
premium amount while the maximum risk for the seller is unlimited (call – there
is no limit to how much a stock can go up) or limited (put – the risk is
limited as the stock cannot go below zero).
Futures – the maximum risk for the buyer of a futures
contract is limited to the total contract value while there is unlimited risk
for the seller. Because of the leverage, the risk for both the buyer and the
seller is very large.
Obligation in Futures vs Right in Options:
Upon expiration, buyers of futures contracts are obligated
to buy the underlying commodity from the seller of the contract, independent of
the price of the commodity. For most contracts, settlement is in cash and so
there is no physical delivery of commodity. Also, price differences are settled
daily, which means margin calls can occur any day.
Upon expiration, buyers of options contracts have the right
to exercise their option contract, but they are not obligated to do so.
Versatility in Options vs Futures
Options are much more versatile as you can construct option
positions that profit in all directions while futures are uni-directional – you
can profit only in one direction.
Related Posts:
- Cash holdings in an investment portfolio - strategies to squeeze income for value investors
- Kelly Criterion based Strategies for Value Investing
- Covered Call Strategy for Stable Income Portfolio
- Basics of Options and Futures for Value Investors
- Basic Options Strategies for Value Investors
- Basic Futures Strategies for Value Investors
- Short Selling Strategy for Value Investors
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