Have you wondered why an investment portfolio can still be deeply in the red when the stock market appears to be doing well? Sometimes a stock rises but the portfolio still makes no profit. This does not always mean someone is cheating; it may reflect how options work. Investmat #02 introduces options, from basic concepts to strategies, and the risks involved.
What is an option?
An option is a contract that gives one party—the buyer—the right to buy or sell an asset, such as a stock, gold, or oil, from another party at a set price (the strike price) by a specified date (the expiration date). The two main types are call options, which give the right to buy, and put options, which give the right to sell.
American and European options
The main difference is when the holder may exercise the option. An American option can be exercised at any time before expiration. A European option can be exercised only on its expiration date.
How options can be used
For buyers
An option may limit a buyer’s investment risk. For example, if you expect a stock to rise, you could buy a call option instead of the stock itself. This may reduce the risk if the stock does not move as expected.
For sellers
An option seller, or writer, receives a premium when issuing the contract. Options may also be used for hedging.
What affects an option’s price?
An option’s value depends on factors including the underlying asset’s price, the strike price, time remaining until expiration, implied volatility, and interest rates.
In the money and out of the money
An in-the-money (ITM) option has intrinsic value at the present time. An out-of-the-money (OTM) option has no intrinsic value at the present time.
Delta: how an option’s price may respond to the underlying asset
Delta describes how an option’s price may change when the underlying stock price changes. For example, if a call option has a Delta of 0.50, a THB 1 increase in the stock price corresponds to a THB 0.50 increase in the option price, according to the source article’s example.
Delta can help investors estimate an option’s break-even point and assess investment risk.
Theta: loss of value over time
Theta describes the decrease in an option’s value as time passes. It can have a greater effect on an option’s price as expiration approaches.
New investors may overlook Theta and buy options close to expiration, which carry higher risk.
Leverage and options
Options can provide leverage: because an option may cost less than buying the underlying stock, an investor can control exposure to a larger amount of the asset with less money. Leverage can increase potential returns, but it can also increase losses.
Implied volatility
Implied volatility (IV) is the market’s expectation of future price volatility reflected in an option’s price. Higher IV means the market expects greater price swings and can make options more expensive.
The source article describes speculating on IV by buying options when IV is low and selling when IV is high.
Expiration and settlement
When an option expires, its holder may exercise it or let it expire without value. Settlement depends on whether the option is in the money or out of the money.
Options close to expiration carry higher risk because Theta can reduce their value quickly.
Three rules of thumb in the source article
Options speculation should consider Delta, Theta, and leverage.
1. Delta over Theta
The article recommends choosing options with higher Delta so that price movements in the underlying stock have a greater effect than time decay (Theta).
2. Avoid short-dated options
The article recommends avoiding options with little time remaining to reduce the effect of Theta.
3. Calculate leverage before buying
Before investing in an option, calculate the leverage to assess potential risk and return.
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