To understand the connection, start with the idea that options are rights that carry no obligation. A financial option is the right to buy or sell an asset—a basket of stocks, say—at a specified price (the strike price) on or before a specified maturity date. Call options are rights to buy; they are profitable to own if the price of the underlying asset rises above the strike price. Put options are rights to sell; they pay off when the price of the underlying asset falls. The owner is not obliged to exercise the option; she will do so only when the option is “in the money”: ie, when the strike price is breached.
The key influences on premiums are the gap between the asset’s strike price and its current price, time and expected volatility. A small gap is more likely to be closed than a large one, so options with strike prices close to prevailing prices cost more. Options with a strike price some distance from the actual price are said to be “out of the money” and are cheaper. Similarly, options with a more distant maturity are more expensive than near-dated options. The key variable, though, is volatility. The more violently the price of the underlying asset fluctuates, the more chance there is that an out-of-the-money option will move into the money. When you own options, volatility is your friend.
The range of options you can trade on a stock is a function of investor demand, says Hugh Selby-Smith of Talaria Capital, a Melbourne-based asset manager. If you want an option on, say, a Mexican retailer, you may have to ask an exchange to list an option series for you. But a high-profile stock, such as Tesla or Apple, will have 57 varieties of contract already listed. Tesla calls expiring on Friday January 15th were available this week at $5 intervals. The positions are staggering. There were some 27,000 contracts with a strike price of $1,000, for instance. (Tesla’s share price was around $860 on January 13th.) This kind of call option—deeply out-of-the-money and close to expiry—is favoured by the new cohort of retail investors that has rapidly emerged in America and elsewhere (see article). It has the features of a long-odds sports bet. For a small outlay a call option can pay off handsomely if the stock price suddenly surges. If not, the option expires, worthless, like many a bucket-shop bet.
There are two sides to a market, of course. The specialist traders and hedge funds on the other side of these trades are content to take the premiums from options buyers and to manage the risks of occasional big losses should the punters’ bets pay off. One hedge for a call option is simply to own the stock, which is why long-only equity funds are increasingly being drawn into the market to juice up their returns. “A lot depends on your book,” says a seasoned options trader. If you’ve taken in a lot of put-option premiums, you might write some call options to even things out. Or you could balance the risk from an expensive-looking option—with, say, a round-number strike price of the kind favoured by retail investors—using a cheaper-looking option with a nearby strike price.
