Basics of Options and Futures for Value Investors


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

  1. 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),
  2. Options are cheaper to buy when volatility is lower,
  3. Options bring more premium when volatility is higher,
  4. 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 –

  1. 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.
  2. Initial Margin – paid by both the buyer and the seller of a futures contract into the margin account.
  3. 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.


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