Options
The one instrument where you can be right about direction and still lose everything you put in. Read this before trading one.
12 min read · intermediate · lesson 4 of 6
What this covers
- Define a call, a put, a strike and an expiry
- Split a premium into intrinsic and extrinsic value
- Name what delta, theta, vega and gamma each answer
- Explain the three ways a directionally correct option position loses
- Distinguish defined-risk from undefined-risk structures
The contract
- Call
- The right to buy the underlying at the strike, until expiry. Gains as the underlying rises.
- Put
- The right to sell the underlying at the strike, until expiry. Gains as the underlying falls.
- Strike
- The price at which the right can be exercised. Fixed when the contract is opened.
- Expiry
- The date the right ends. After it, an option that is not in the money is worth nothing.
- Premium
- What the buyer pays. The buyer's maximum loss, and the seller's maximum gain.
- Moneyness
- Where the strike sits against the underlying. In the money has value on exercise today; at the money sits near the current price; out of the money has none yet.
What the premium is made of
Every premium splits into two parts, and keeping them separate explains most option behaviour.
Intrinsic value is what the option would be worth exercised right now. A call struck at 100 with the underlying at 108 carries 8 of intrinsic value. Out of the money, intrinsic value is zero.
Extrinsic value is everything else: what the market pays for the time remaining and the movement expected within it. It decays to zero by expiry, without exception, and that decay is not linear. It accelerates as expiry approaches.
An out-of-the-money option is extrinsic value only. Holding it to expiry without the underlying reaching the strike means holding something guaranteed to become worthless.
What moves a premium
- Delta, the direction sensitivity
- How much the premium moves per unit of movement in the underlying. Low for far out-of-the-money options, which is why a small favourable move can leave the premium barely changed.
- Theta, the time decay
- How much value the option loses per day with everything else held still. Works against buyers and for sellers, and accelerates toward expiry.
- Vega, the volatility sensitivity
- How much the premium moves when expected volatility changes. This is the input that makes a directionally correct position lose money.
- Gamma, the rate of change
- How fast delta itself shifts as the underlying moves. It is why an option's behaviour near the strike close to expiry is unstable, and why dealer gamma levels are watched as reference points.
Three ways a correct direction still loses
Time
An option loses value every day it does not move, and the rate accelerates toward expiry. Right on direction and wrong on timing produces a loss, which no other instrument here does.
Implied volatility
Part of the premium is what the market expects the underlying to move. Buy before an event and that expectation is priced in; after the event it collapses, and the position can lose on a move in its favour.
Distance
The underlying has to travel past the strike by more than the premium paid before the position is profitable. A move in the right direction that stops short of that leaves the option worthless at expiry.
Implied volatility is a price, not a forecast
Implied volatility is the movement the market is currently charging for. It is derived from the premium rather than predicted, so it is better read as the cost of the option than as a view on what happens next.
What matters is where it sits against its own history. The same level is expensive on one instrument and cheap on another, and expensive on the same instrument at a different point in time. Buying an option is buying volatility as well as direction, and buying it when the market is charging a lot for it sets a higher bar for the trade.
Scheduled events are where this bites hardest. Expected volatility rises into an earnings report or a policy decision because the outcome is unknown, and collapses immediately afterwards because it no longer is. The event resolving is what removes the value, whichever way it resolved.
Buying against selling
| Buying an option | Selling an option |
|---|---|
| Loss is capped at the premium paid. | Loss is not capped. It can exceed the account. |
| Time works against the position. | Time works for the position. |
| Requires a move to profit. | Profits if nothing happens. |
| Small losses, occasional large gain. | Small gains, occasional catastrophic loss. |
Defined and undefined risk
A position where the worst case is known before it is opened has defined risk. Buying an option is the simplest case: the premium is the loss, and nothing can make it larger.
Selling an option on its own has undefined risk. The obligation scales with how far the underlying travels, and there is no fixed limit on the upside.
Structures exist that cap that obligation by pairing a sold option with a bought one further away, which converts undefined risk into a known maximum. They cost some of the credit received, and that cost is what the cap is worth.
The rule that matters for a newer trader is simpler than the structures: know the worst case in currency terms before opening the position. If it cannot be stated, the position is not understood well enough to hold.
Assignment, settlement and expiry
A sold option can be assigned, which converts it into a position in the underlying at the strike, at a size set by the contract rather than by choice. An account that cannot support that position still receives it.
Settlement style differs. Some contracts deliver the underlying; others settle in cash. Some can be exercised at any point before expiry, others only at expiry. These are contract specifications, published by the exchange, and they change what happens to an open position.
Expiry arrives on a schedule and does not wait for a thesis to work out. A position held to expiry resolves at whatever the underlying is doing that afternoon.
Selling options without the capital to take assignment is the fastest route to a loss larger than the account. If the structure of a position is not fully understood, that is the signal to leave it alone.
Chains are not uniformly liquid
An option chain lists many strikes and many expiries, and activity concentrates in a small part of it. Near-dated, near-the-money contracts on large underlyings trade tightly. Far strikes and distant expiries frequently do not.
In a thin contract the spread alone can cost several percent of the premium on entry and again on exit, before the position has done anything. Open interest and the width of the quoted spread are the two figures to check before opening, and they matter more here than in any other class covered.
Right on direction, wrong on the trade
IllustrativeAll figures are illustrative.
A stock trades at 100. You buy a call struck at 105 expiring in 30 days, paying 2.00 in premium.
That 2.00 is entirely extrinsic value. The strike is above the current price, so intrinsic value is zero.
Over the next three weeks the stock rises to 104. The direction was correct.
The option is still out of the money, and three weeks of time value are gone. The premium is now worth perhaps 0.40.
At expiry with the stock at 104, the call expires worthless. The full 2.00 is lost on a 4 percent move in the intended direction.
The same view expressed by buying the stock would have been up 4 percent.
What PecuDesk covers
Live option chains on the covered equity underlyings: implied volatility, expected moves, dealer positioning and the greeks.
The platform shows what the chain is pricing. It does not tell you to open a position, and options are the class where that distinction costs the most.
Key takeaways
- A premium is intrinsic value plus extrinsic value. Extrinsic decays to zero by expiry, always.
- An option can lose on a correct direction through time, volatility or distance.
- Implied volatility is the price of the option, not a forecast. Buying it expensive raises the bar.
- A buyer risks the premium. A seller's risk is not capped unless it is paired with a bought option.
- Assignment delivers a position in the underlying whether or not the account can support it.
- Chain liquidity varies enormously. Check open interest and spread before opening.
Common mistakes
- Treating a call as a cheaper way to own the stock.
- Buying premium into a scheduled event and losing on the volatility collapse afterwards.
- Selling options without the capital to take assignment.
- Opening a position in a thin contract where the spread costs several percent each way.
Knowledge check
OptionalRelated
- StocksAsset Classes
- Position sizing and risk per tradeMarket Foundations