Table of contents:
- 1 Explanation of the terms
- 1.1 Presentation of the options to the broker
- 1.2 Further data define an option
- 1.3 The long call (purchase of a call option)
- 1.4 The calculation of the premium
- 1.5 Representation of the possible course
- 1.6 Option software helps with the analysis
- 1.7 Time value loss and price formation
- 1.8 The implied volatility (IV for short)
- 1.9 The Greeks (Delta, Gamma, Vega, Theta)
- 1.10 The Delta
- 1.11 The gamma
- 1.12 The Vega
- 1.13 The Theta
- 1.14 Advantages and disadvantages of the Long Call
- 1.15 The trade management
- 1.16 Conclusion on Long Call (purchase of options)
Long Call (buying a call option): This is the first of four articles in which I introduce the basic building blocks of options trading.
Further strategies are based on these building blocks. The methods I trade are based on these elements. Therefore, I will not include trading approaches with ownership of the underlying asset and options on futures in this series. For the examples, I will concentrate on US equities as underlyings.
Explanation of the terms
On the options market, there are two instruments which, by definition, guarantee certain rights and obligations. On the one hand, there is the call option. On the other hand, there is the put option, also called put. The buyer of an option is also called the option taker.
Based on the fact that a market participant can both buy and sell an option, four basic positions can be taken. These are the trading instruments I call building blocks.
As a rule, the purchase of an option is called “long” and the sale is called “short”.
The four resulting basic terms I will compare here:
- The purchase of an option to buy = long call
- The sale (or writing) of a call option = Short Call
- The purchase of a put option = long put
- The sale (or writing) of a put option = short put
Presentation of the options to the broker
The contract, which is an option, should be transparent for any market participant. For this reason, the name of the options contains additional data.
Options on shares have a limited life. The last trading day is called the expiration date, and the remaining days until expiration are called the maturity date.
The available options for an underlying asset (also known as the underlying) can usually be displayed by the broker in a table. I once set this for the First Solar stock using the example of the broker Captrader.
First, the different terms can be selected. Then, under a certain term, the prices for the respective options can be found.
Such a table is also called “option chain”. The stringing together of the prices forms a chain. You can also see that the price of options with the same term depends on the underlying strike price.
Further data define an option
The strike price (also known as the “strike”) is the market value of the underlying instrument to which the option relates. In the example, First Solar is currently trading at a price of $57.90.
The next strike prices are $57.50 and $60.00. From this value, the option chain goes up and down as far as prices are available or quoted on the stock market.
At this point, let’s begin with the purchase of a call option:
The long call (purchase of a call option)
The price of an option is determined, among other parameters, by the distance between the strike price and the market value of the underlying. If the strike price is below the market value of the stock when the call is made, the option is “in the money” and has an intrinsic value.
At this point it should be briefly explained that the buyer of a call option acquires the right to buy the underlying asset at the strike price. His only obligation is to pay the seller the price for the option. In the example, an option contract relates to 100 shares, so the price for an option must be multiplied by 100.
The intrinsic value results from the right of the option holder to exercise an American-style option at any time. When the option is exercised, 100 shares are entered in the account at the strike price, provided that the corresponding capital is available in the account. Since the price of the stock is higher than the strike price for an option in the money, this stock position would immediately be in profit. The profit in the event of exercise would be the difference between the strike price and the price minus the premium paid.
For example, I disregard this possibility and calculate exclusively with the price of the options, since my regular trades do not provide for an exercise.
The calculation of the premium
The intrinsic value of the call option can be calculated in this way:
Net Asset Value (Call) = Price – Strike. In the option chain, for example, the intrinsic value of the 50 Strike is $7.88 = $57.88 (mid price FSLR) – 50 (Strike).
The difference to the option price is the time value:
- Time value = option price – intrinsic value, in the example: mid price of the 50 option $8.48 – intrinsic value $7.88 = $0.60 time value
The price of options that are not quoted “in the money” consists solely of fair value. These options are “out of the money”.
The strikes closest to the price are called “out of the money”; in First Solar’s example, this would be the 57.5 call, as the stock is quoted at $57.88.
For the example, we continue to assume that the buyer is speculating that FSLR will increase in price by the expiration date. Therefore, he decides to call the call with a 60 Strike and the buy is executed at $2.035. The multiplier results in a purchase price of $203.50 plus the brokerage fee.
Representation of the possible course
From the price of the option and the price of the underlying, the course of the possible gain or loss can be shown in a diagram.
The so-called “profit and loss profile” (P&L profile) can usually be displayed very simply via the broker’s platform. Professional options software is also helpful in adjusting the positions to changes in the market environment.
Option software helps with the analysis
All relevant key figures can be displayed in the Excel-based P&L profile software from Optionsuniversum. A projection of the expected profit can also be read. I use the software to set up trades, document the course of my trades, and adjust the strikes for certain strategies.
The description of the software can be found under this link: https://www.optionsuniversum.de/produkt/guv-software/
The X-axis shows the price of the underlying, the Y-axis represents the price of the option.
The different colored lines show possible price movements of the option on the corresponding days, which are shown in the left area. Depending on uncertainty or calm in the market, the lines may change. The software recalculates this on the basis of current data.
The bottom line represents the expiration date. This line applies to the expiration of the option. If the option is out of the money on the expiration date, it has neither time value nor intrinsic value.
At a stock price of $62.04, the price of the option would be out of the money on the expiration date. If the price is then higher, the buyer of the option will make a profit by a factor of 100, equivalent to a position of 100 shares.
Using the example of a long call on FSLR, the chart clearly shows that the risk in falling prices is limited to the price paid for the option. The price of FSLR must rise by exactly this price for the trade to reach the threshold of potential profit on the expiration date.
Time value loss and price formation
The fair value is paid for the chance that the price of the underlying asset will move into profit until the expiration date. Since this chance decreases when the price moves sideways or falls, the value of the time factor also falls.
Similarly, the loss in value accelerates as the expiration date approaches.
The price formation is based on the expected performance of the underlying instrument. And the speed with which a price change occurs is also important.
This is where the so-called Greeks come into play in conjunction with the implied volatility.
The implied volatility (IV for short)
The implied volatility is a measure of expected uncertainty. For example, it increases for many stock options before the quarterly figures are announced.
At these dates, it is often not certain whether the company in question can build on past results. Analysts like to assess the development in advance, and if the figures turn out better, there is often a price jump upwards. The same can happen in the other direction.
Even in the event of major corrections or a falling market, participants want to hedge their equity holdings against losses. They then buy more options. If demand rises, prices rise as well.
The Greeks (Delta, Gamma, Vega, Theta)
The Greeks got their name from the use of Greek letters (except the Vega).
Each letter stands for a key figure that influences the pricing of options. Since whole books can be written on the subject of Greeks themselves, I would like to give here only a small view of the influences of these parameters.
The statements always apply to the fact that the other ratios do not change for the moment. The quite complex interplay of all the parameters for pricing was worked out in the Black-Scholes model. If you want, you can read about the history and derivation of the formula in this Wikipedia article.
The delta is the most common key figure and indicates the price change of the option depending on the price change. In the example of the 60 call on First Solar, the delta column of the option chain contains the value 0.418.
If First Solar increases by one dollar, the price of the option increases by approximately 42 cents. However, since a change in the price also changes the delta (as do the other key figures), the options can sometimes become very scientific.
For the basics, I like to remember that a delta of 0.5 is an option at the money. The higher the delta, the higher the option is in the money. A rule of thumb is that the delta is a measure of the probability that the option will be in the money on the expiration date.
For example, an option with a delta of 0.2 would be at least in the money with a 20% probability on the expiration date.
The gamma closes the gap to the delta change just mentioned when the price of the underlying asset changes.
To calculate the change in the delta, the gamma is added to the delta or subtracted from it if the price of the underlying asset falls. Again, referring to the example of the 60 call, you will find the value 0.0535 in the option software (the Greeks in the software are multiplied by 100).
Thus, the delta would increase to approximately 0.47 if the dollar price rose.
(Values from the software: Delta 0.4142 + Gamma 0.0535 = Delta 0.4677)
The gamma value is highest for options quoted at the money and decreases in both directions.
The vega indicates how a change in implied volatility affects the option price.
In the example, if the implied volatility (also abbreviated IV) increases by one percentage point, the option would become more expensive at $2.1129.
(Current price 2.0350 + Vega 0.0779 = New price 2.1129)
With the theta, the circle closes again to the time value. This key figure is useful for estimating the daily loss of value for the remaining term.
In the example, the value is negative. This makes it clear that the time value decreases daily for a purchased option. In the example, it is $3.48. Even if all other measures were the same, the theta increases daily.
Basically, for options with a longer term, the theta is smaller, and for options with a shorter term, it is larger.
Advantages and disadvantages of the Long Call
Now the advantages and disadvantages of a pure purchase strategy are also revealed.
The advantages lie in the maximum risk limited to the premium paid. The stop loss is, so to speak, integrated in a long call, and the risk for the portfolio can be adjusted with the number of options purchased.
The maximum risk of an individual position should be about one percent of the portfolio. For the example, a securities account size of 50,000 dollars is suitable.
According to the rule of thumb, the risk for the individual position would therefore be limited to 500 dollars. In the example, 2 options with strike 60 and a term of 21.06.2019 can now be purchased on FSLR. Even if the trade runs until the expiration date and the stock price falls to zero, the maximum loss on two contracts would be $407.
If prices rise, the holder of the long call participates in the profit by a factor of 100 without having to tie up capital to buy 100 shares.
A disadvantage is that rising prices are necessary for a profit in any case. If the price remains below the break-even of $62.04 (strike + premium) until the expiration date, the premium paid is lost in whole or in part.
The trade management
If the option runs into the profit, a set of rules for taking profits is a good idea. This can be determined by the chart of the underlying asset. In this case, it would make sense to use an indicator such as the Parabolic SAR as a trailing stoploss. Or, on the other hand, use a reset to a moving average for profit-taking.
In the event of a loss, the trade can be closed if certain price markers are broken. For a valuation, it is helpful to ask whether the trade would be re-entered in the current situation.
If the original idea is no longer valid, it is a good idea to close the position. The cause can be a broken trend line, for example. I would also recommend a revaluation of the position in the event of a massive change in the news situation or company valuation.
In this way, some of the current value can still be saved and no further losses need to be realized until the expiration date.
Conclusion on Long Call (purchase of options)
The long call as a single position is therefore more suitable for speculation on rising prices with a lower capital investment than a direct investment in the underlying.
In combination with other building blocks, however, good strategies can be formed with which a profit can be made even if prices move sideways.
In the next article I will discuss the long put. This is another step into the world of options and their potential to profit in certain market situations.
Read my other articles about options:
- Bear Call Spread Options Strategy
- Bull Put Spread – Earn Money With Puts And Limit Risk
- Butterfly Spread Options Strategy
- Definition Of Option Price/Option Premium
- Earn Money With A Covered Call Options Strategy
- How to exercise Options
- How to use the Standard Deviation for Options Trading
- Iron Condor – Profit From Low Price Fluctuations
- Options Trading Tutorial for beginners
- Options vs. Futures – Two Different Types Of Futures Contracts
- Options vs. Warrants – 4 Differences
- Protective Put – Hedging Of Equity Positions
- Simple Trading Strategies for Options
- Term structure options
- What are options? – Explained Simply And Quickly
- What is a Long Call in Options Trading?
- What is a Long Put in Options Trading?
- What is a Short Call in options Trading?
- What is a Short Put in Options Trading?
- What is delta in Options Trading? – The Most Important Key Figure
- What is Historical Volatility in Options Trading?
- What is the Gamma in Options Trading?
- What is the Implied Volatility Of Options – Important Or Not?
- What is the Theta in Options Trading?
- What Is The Vega Of An Option?