Equity Options, part 2

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    1st Place! Best Binary Broker 2020!
    Best Choice for Beginners — Free Education + Free Demo Acc!
    Sign-up and Get Big Bonus:

  • Binomo
    Binomo

    2nd place! Good choice!

Contents

Equity 101 Part 2: Stock option strike prices

This article is part 2 of our series on the basics of startup stock options. Here’s part 1 and part 3. Follow us on Twitter @cartainc for more educational content.

Part 2: Strike prices and dilution

When a company offers you stock options, the hope is you’ll be able to sell them for more than you paid for them. If you’ve ever wondered what determines these prices and how to figure out how much your options could be worth, we’ve got you covered. Here, we’ll cover:

1. Strike prices (the price you pay to purchase shares)

3. Stock dilution (how the number of shares issued affects how much of the company you own)

Stock option strike prices

Remember: stock options are the right to buy a set number of company shares at a fixed price, typically called a strike price, grant price, or exercise price. In this example, your stock option strike price is $1 per share.

To come up with that $1 price, Meetly (our example company) had to determine its fair market value (FMV). For private companies, FMV is essentially what the price would be if the stock were traded publicly on the open market. Your stock option strike price is usually equal to the FMV of the company’s stock on the day the option is granted.

It’s easy for public companies to determine their strike price: all they have to do is look at what the stock is currently trading at. That’s the price that people are willing to pay on the open market. If Facebook, for example, is trading at $180 per share, their FMV is $180 that day.

If we try to look up Meetly on an online brokerage platform, we won’t find anything—and not just because we made the company up. Like all startups, Meetly is a private company, and the stock can’t be traded publicly until an IPO or other public listing of the company’s stock on an exchange.

To determine the fair market value of their common stock, private companies usually use an independent 409A valuation provider like Carta. This can help protect them from costly audits and their employees from significant penalties.

How stock options gain value

“At-the-money” stock options

In the graph above, the blue line represents your strike price. The strike price doesn’t change at all over time because it’s a fixed price. The yellow line is Meetly’s stock price (or FMV). Right now, those prices are the same. If you decide to exercise your options and buy your shares, you would have to pay $1 to get $1 in return. In this situation, your options are considered “at-the-money.”

“In-the-money” stock options

When the stock’s value increases, the difference between the FMV and your strike price is called “the spread.” This is the underlying value of the stock. When the spread is positive, your options are considered “in-the-money.”

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    1st Place! Best Binary Broker 2020!
    Best Choice for Beginners — Free Education + Free Demo Acc!
    Sign-up and Get Big Bonus:

  • Binomo
    Binomo

    2nd place! Good choice!

If you buy at a strike price of $1 and sell when Meetly’s FMV is $5, your spread is $4 (per share).

Underwater stock options

Unfortunately, things don’t always go well for startups.

If Meetly’s FMV goes down to $0.75, your spread becomes negative, and your options are “underwater.” Since you would have to pay $1 to get $.75 in return, you decide not to exercise your options. (Meetly could choose to reprice the options, or replace the worthless options with new ones at a different strike price.)

Stock dilution

Stock dilution is when a company issues additional shares and subsequently reduces how much of the company you (and the other shareholders) own. It usually happens when a company raises money.

When you received your options from Meetly, they had 5,000 shares outstanding. In other words, they’ve issued 5,000 shares in total to all of their shareholders.

This means your 100 shares represent 2% ownership of the company:

One year later, Meetly decides to raise another round of financing. It creates 2,000 new shares to issue to the new investors.

While you still own 100 shares, the new shares cause your ownership percentage to drop. Your 100 shares divided by the new total (7,000) equals 1.4%. The effect the increased amount of shares outstanding has on your ownership percentage is called stock dilution.

Now let’s look at what your shares were/are worth before and after the new investors came in.

Before the new financing round, Meetly was valued at $100 million, so your 2% stake was worth $2 million. After the new fundraising, Meetly’s stock value increases to $120 million.

In the above example, your 1.4% of $120 million is still equal to $2 million. Even though your ownership percentage was diluted, the value of your options stayed the same. You essentially own a smaller piece of a bigger pie.

Here’s a quick recap of what we covered:

  1. We defined strike price. This is a fixed price you pay to buy one share of stock.
  2. We discussed the economic value of your options, which is basically the spread between your strike price and the FMV of the company’s common stock.
  3. We explained dilution, or how your ownership percentage can change if the company issues more stock to other shareholders.

These are the three things you should consider when determining the value of your option grants. We’ll cover exercising options and the tax implications in part three.

Special thanks to Alex Farman for writing the first version of this article.

DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta, Inc. (“Carta”). This communication is not to be construed as legal, financial or tax advice and is for informational purposes only. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.

Jenna Lee

Jenna is on the content team at Carta. Despite working in Fintech her entire career, she has never had a La Croix.

Stay up to date with monthly blog highlights

Thanks, you are now subscribed to Carta emails.

What is stock dilution?

DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta, Inc. (“Carta”). This communication is not to be construed as legal, financial or tax advice and is for informational purposes only. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume […]

What is fair market value (FMV)?

Unlike public companies where value is set by the market, private companies use independent appraisers to assess their value. Fair market value is the current value of a private company’s common stock and it determines the strike price.

How to value your equity offer (free startup equity calculator)

Learn how to evaluate the equity portion of your job offer and download our free equity calculator to see what your options could be worth.

Equity 101 Part 1: Startup employee stock options

This article is part 1 of our series on the basics of startup stock options. Here’s part 2 and part 3. Follow us on Twitter @cartainc for more educational content.

Part 1: Startup stock options 101

Companies often offer stock as part of your compensation package so you can share in the company’s success. But they don’t usually explain what you need to know so you can make informed decisions. Here’s how to make sense of your offer letter and option grant.

Imagine you just got a job offer from a new startup called Meetly. In your letter, they offer an annual salary of $100,000 and 100 stock options.

Like most offer letters, it does not tell you what stock options are, what to do with these options, what kind of options you get, or how much they are worth. Unfortunately, this is pretty standard at most companies (though we’re trying to get companies to send better, more transparent offer letters).

There are four basic things you should understand to properly evaluate your offer.

Types of startup stock options

Stock options aren’t actual shares of stock—they’re the right to buy a set number of company shares at a fixed price, usually called a grant price, strike price, or exercise price. Because your purchase price stays the same, if the value of the stock goes up, you could make money on the difference. We’ll elaborate on this in part 2 of our equity 101 series.

There are two types of employee stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). These mainly differ by how and when they’re taxed—ISOs could qualify for special tax treatment.

Note: Instead of stock options, some companies offer restricted stock, such as RSAs or RSUs. Restricted stock is different than stock options and is treated differently for tax purposes.

Stock option agreement

While your offer letter might mention how many stock options the company is offering, you need to receive and sign the stock option agreement (also called an option grant) if you want to purchase your shares someday—just signing the offer letter isn’t enough.

Stock option grants are how your company awards stock options. This document usually includes details like the type of stock options you get, how many shares you get, your strike price, and your vesting schedule (we’ll get to this in the vesting section).

Your stock option agreement should also specify its expiration date. In general, ISOs expire 10 years from the date you’re granted them. However, your grant can also expire after you leave the company—you may only have a short window of time to exercise your options (buy the shares) after you leave. Make sure you know when your grant expires—if you don’t exercise your options before then, you’ll lose the opportunity to purchase them.

Your option grant will probably look similar to Meetly’s, pictured above. Ask your company if you didn’t receive one. If you just joined in the last month or two, it’s possible that the board has not approved your options yet, in which case you should receive it shortly after the next board meeting.

Remember: If you hope to purchase and sell your stock someday, accepting your stock option agreement is the first step you have to take. It doesn’t cost anything to accept the agreement, and you’re not obligated to actually exercise your options. By accepting it, you’re simply giving yourself the opportunity to exercise in the future.

Keep in mind that if your company uses Carta to issue options, you won’t receive a paper version of your stock option agreement. Instead, simply log into your portfolio to accept, view, and print the actual agreement.

Vesting

Vesting means you have to earn your employee stock options over time. Companies do this to encourage you to stay with them and contribute to the company’s success over many years.

Meetly has a traditional vesting schedule. The first part is called a “cliff.” A cliff is the first chunk of shares that vest. In this example, you have a one year cliff, which is standard. This means after one year of working at Meetly, you can buy a quarter of your options, or 25 shares.

Without the cliff, you could accept the offer, work at Meetly for a month, buy a bunch of the company’s stock, and then quit. If your option grant includes a cliff, it prevents that.

The other piece of your vesting schedule to keep in mind is the total length of the vesting schedule. This outlines how often, and for how long, your shares will vest. In this example, after you reach your cliff, your remaining shares will continue to vest for three years—two shares each month.

Termination

If you leave the company, your shares will stop vesting immediately and you can only buy shares that have vested as of that date. And you only maintain this right for a set window of time, called a post-termination exercise (PTE) period. Historically, many companies made this period three months. However, some companies offer more generous PTE periods now. At Carta, for example, you have as long as you worked at the company to buy your shares.

Don’t forget about these windows. Your company isn’t obligated to remind you when you leave — they usually only tell you in your option agreement when you first join.

Below is a quick recap of what we’ve covered:

  1. We described the two kinds of employee stock options — ISOs and NSOs.
  2. We went over stock option agreements: an important document you want to make sure you receive and sign.
  3. We covered vesting schedules and how companies use cliffs to incentivize employees to stay longer.
  4. Finally, we discussed what happens to your stock options if you leave the company.

These are the four things that every startup employee should think about when they receive their offer letter and join a new company. In our next section, we cover how to think about what your options are actually worth.

Special thanks to James Seely for writing the first version of this article.

DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta, Inc. (“Carta”). This communication is not to be construed as legal, financial or tax advice and is for informational purposes only. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.

Jenna Lee

Jenna is on the content team at Carta. Despite working in Fintech her entire career, she has never had a La Croix.

Stay up to date with monthly blog highlights

Thanks, you are now subscribed to Carta emails.

What are incentive stock options (ISOs)?

ISOs are a type of stock option that qualifies for special tax treatment. Unlike other types of options, you usually don’t have to pay taxes when you exercise (buy) ISOs. Plus, you may be able to pay a lower tax rate if you meet certain requirements. Here’s what you need to know.

What are non-qualified stock options (NSOs)?

Non-qualified stock options (NSOs) are a type of stock option that does not qualify for favorable tax treatment for the employee. Learn more about when you can exercise (buy) your shares, when you can sell them, and how they’re taxed.

What are employee stock options?

Stock options aren’t actual shares—they’re the opportunity to exercise (purchase) a certain amount of company shares at an agreed-upon price. Learn more.

How Do Stock Options Work? Part 2: Common Options Strategies

Stock options can be confusing to many investors because they can be used to make bets on a wide variety of market outcomes. They have been marketed as portfolio insurance, a way to turbocharge returns, or a way to make money no matter which way the stock market moves.

In Part 1 of this post, I explained how stock options work and how they are valued. In Part 2 of this post, I will describe some common stock option strategies.

Stock Option Strategy #1: Buy Calls or Puts to Make Leveraged Bets

This is the most straightforward bet using stock options. For example, consider a scenario where you purchase a call option to buy Apple stock (current price: $132) for $135 by March 17, 2020. The price of this option is $1.00 per share. If AAPL is trading at $150 on March 17, 2020, I could exercise my right to purchase 1 share of Apple for $135, and then immediately sell it at $150. Taking into account my original option purchase price of $1, I would have made $14. However, if Apple is less than $135 on March 17, 2020, I would choose to let the option expire worthless, because it would be cheaper to buy the stock on the open market than by exercising my option. I would have lost only $1.

Notice that for only $1 per share, you are able to make 5x, 10x, or even 25x your money. This would not be possible if you simply purchased Apple stock for the regular price of $131.53. Even better, if the stock falls significantly, you will have lost less money with the stock option than if you had purchased the stock outright. Unfortunately, if the stock ends up trading at $135 on the expiration date, you will lose your entire option value, but would have made money if you bought the underlying stock.

Stock Option Strategy #2: Covered Calls Or Buying Puts As Portfolio Insurance

Let’s say you already own 1 share of Apple stock. You can write (sell) 1 call option and receive $1. If Apple rises, you will have to sell your stock to the call option buyer for $135. That’s OK, because you made money on the stock, and got the $1 when you sold the option. If Apple’s stock falls, you get to keep the $1, since the option buyer will not exercise the option. Even though the stock fell, you are better off than if you had not written the call option. It’s a win-win, right?

The problem is that you are capping your upside, while only partially limiting your downside risk. If Apple rises to $150, the option will be exercised, and you are forced to sell it for only $135. You missed out on $15/share of upside because you sold the option.

Another way to use stock options as portfolio insurance is to buy puts. This is done by owning a stock and buying a put option with a strike price below the current stock price. You have now bought insurance against a steep decline in the stock. If the stock drops below the strike price, you can exercise your put option and sell your shares at a higher price than its current price. If the stock price goes up, than your insurance (put option) is worthless, but it’s fine because the stock you own is rising.

The worst-case scenario when buying puts as portfolio insurance is if the stock doesn’t move or falls slightly. If the stock falls, but remains above the strike price, then you have lost money both on your stock investment and your put option.

Stock Option Strategy #3: Make Money in Any (Volatile) Market with Straddles

When you purchase a call option and a put option simultaneously, this is called a straddle. In its simplest form, both the call and the put would have the same strike price. If the stock were to move significantly in either direction, one option will expire worthless, but the other will be valuable, hopefully overcoming the loss on the other option. This enables you to make money whether the market goes up or down. However, this requires a volatile market where the stock moves a lot. If the stock is at the same price as the strike pric e at expiration, both options will expire worthless. Remember that the stock options are valued based on the assumed volatility of the stock, so you will likely only make money if the stock is more volatile than is expected when you purchased the options.

Conclusion

Stock options can be used to bet on a wide variety of market outcomes. What do you think? Have you ever tried any of these options strategies?

STOCK OPTION COUNSEL®

Early Expiration of Startup Stock Options – Part 2 – The Full 10-Year Term Solution

Stock Option Counsel, P.C. – Legal Services for Individuals. Attorney Mary Russell counsels individuals on equity grants, executive compensation design, employment agreements and acquisition terms. She also counsels founders on their personal interests at incorporation, financings and exit events. Please see this FAQ about her services or contact her at (650) 326-3412 or by email.

The startup scene is debating this question: Should employees have a full 10 years from the date of grant to exercise vested options or should their rights to exercise expire early if they leave the company before an IPO or acquisition?

FULL 10-YEAR TERM SOLUTION

Some companies are saving their optionees from the $1 million problem of early expiration stock options by granting stock options that have a full 10 year term and do not expire early at termination. The law does not require an early expiration period for stock options. Ten years from date of grant is usually the maximum exercise period, as the legal landscape for stock options makes anything beyond a 10 year exercise period impractical in most cases. The 10 year exercise window (without an early exercise period) enables employees to wait for a liquidity event (IPO or acquisition) to pay their exercise price and the associated taxes. This extended structure is designed to compensate employees in a way that makes sense for them.

Startups who choose a full 10-year term in place of early expiration may do so because their recruits or founders have faced the problem of early expiration at prior companies and become disillusioned with stock options as a benefit. Or their recruits may have read about the issue and asked for it as part of their negotiation. Or their founders may have designed their equity plan to be as favorable to employees as possible as a matter of principle or as a recruiting tool.

Other companies are extending their early expiration period for existing stock options. One example of this is Pinterest, which extended the term in some cases to 7 years from the date of grant. This move was in response to their valuation and extreme transfer restrictions that made the early expiration period burdensome for option holders.

An exercise more than 90 days after the last date of employment changes tax treatment for options originally granted as Incentive Stock Options (ISOs). Such an exercise will be treated as the exercise of a Non-Qualified Stock Option (NQSO) instead. Most employees would prefer to have the choice that an extended exercise period allows, the choice between exercising within 90 days of termination of employment for ISO treatment or waiting to exercise and being subject to NQSO treatment.

You can see a list of companies that have adopted an extended option exercise period or changed from the short early expiration period to longer periods.

CREATIVE MODIFICATIONS TO THE FULL 10-YEAR TERM SOLUTION

Companies may prefer early expiration of stock options because terminated stock options reduce dilution for other stockholders. Or they may prefer that their employees are bound to the company by the “golden handcuffs” of early expiration stock options as a retention tool.

For companies that are concerned about excessive dilution, it might make sense to eliminate early expiration only if the company’s value has increased since grant. In other words, employees have a full 10-year term only if the FMV of the common stock on the date of their departure is greater than the exercise price of the stock option. This targets the solution (tax deferral) to the problem (owing tax at exercise before liquidity). If the FMV at exercise is equal to the exercise price, then there is no taxable income to report at exercise. Therefore, an extended exercise period is not necessary to defer taxes until liquidity. This solution does not address the problem of high exercise prices; companies with high exercise prices due to high valuations may want to use RSUs instead of stock options to solve the exercise price problem.

Attorney Augie Rakow, a partner at Orrick who advises startups and investors, has another creative modification to the full 10-year term solution. He has advised clients to find a middle ground by extending exercise periods only for longer-term contributors. This addresses the company concern about retention while solving the early expiration problem for longer-term employees. For example, option agreements might allow three years to exercise after departure only if an employee has been with the company for three years. He notes that “it’s a good solution for companies that want to let long-term contributors participate in the value they help create, without incentivizing employees to leave prematurely.”

CAN I REALISTICALLY EXERCISE THE STOCK OPTIONS IF THE COMPANY IS A SUCCESS?

Due to the prevalence of early expiration stock options at startups, this becomes an essential question in evaluating an equity offer: “Can I realistically earn the value of vested equity if the company is a success?” If the option grant has a very high exercise price or could potentially lead to a huge tax bill at exercise, it may not be feasible to exercise during an early expiration period at the end of employment, making the value of vested equity impossible to capture. Clients have negotiated the removal of early expiration or other creative structures to solve this problem if it arises in the employment offer.

I hope this post has illuminated the usefulness of a full 10-year term as a solution to the problem of early expiration of startup stock options. For other alternatives to structuring startup equity, see Early Expiration of Startup Stock Options – Part 3 – Examples of Good Startup Equity Design by Company Stage. See also Early Expiration of Startup Stock Options – Part 1 – A $1 Million Problem for more information on the issue.

Stock Option Counsel, P.C. – Legal Services for Individuals. Attorney Mary Russell counsels individuals on equity grants, executive compensation design, employment agreements and acquisition terms. She also counsels founders on their personal interests at incorporation, financings and exit events. Please see this FAQ about her services or contact her at (650) 326-3412 or by email.

THANK YOU

Thank you to JD McCullough for editing this post. He is a health tech entrepreneur, interested in connecting and improving businesses, products, and people.

Thank you to attorney Augie Rakow, a partner at Orrick who advises startups and investors, for sharing his creative solution to this problem

Essential Options Trading Guide

Options trading may seem overwhelming at first, but it’s easy to understand if you know a few key points. Investor portfolios are usually constructed with several asset classes. These may be stocks, bonds, ETFs, and even mutual funds. Options are another asset class, and when used correctly, they offer many advantages that trading stocks and ETFs alone cannot.

Key Takeaways

  • An option is a contract giving the buyer the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) the underlying asset at a specific price on or before a certain date.
  • People use options for income, to speculate, and to hedge risk.
  • Options are known as derivatives because they derive their value from an underlying asset.
  • A stock option contract typically represents 100 shares of the underlying stock, but options may be written on any sort of underlying asset from bonds to currencies to commodities.

Option

What Are Options?

Options are contracts that give the bearer the right, but not the obligation, to either buy or sell an amount of some underlying asset at a pre-determined price at or before the contract expires.   Options can be purchased like most other asset classes with brokerage investment accounts. 

Options are powerful because they can enhance an individual’s portfolio. They do this through added income, protection, and even leverage. Depending on the situation, there is usually an option scenario appropriate for an investor’s goal. A popular example would be using options as an effective hedge against a declining stock market to limit downside losses. Options can also be used to generate recurring income. Additionally, they are often used for speculative purposes such as wagering on the direction of a stock. 

There is no free lunch with stocks and bonds. Options are no different. Options trading involves certain risks that the investor must be aware of before making a trade. This is why, when trading options with a broker, you usually see a disclaimer similar to the following:

Options involve risks and are not suitable for everyone. Options trading can be speculative in nature and carry substantial risk of loss.

Options as Derivatives

Options belong to the larger group of securities known as derivatives. A derivative’s price is dependent on or derived from the price of something else. As an example, wine is a derivative of grapes ketchup is a derivative of tomatoes, and a stock option is a derivative of a stock. Options are derivatives of financial securities—their value depends on the price of some other asset. Examples of derivatives include calls, puts, futures, forwards, swaps, and mortgage-backed securities, among others.

Call and Put Options

Options are a type of derivative security. An option is a derivative because its price is intrinsically linked to the price of something else. If you buy an options contract, it grants you the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date.

A call option gives the holder the right to buy a stock and a put option gives the holder the right to sell a stock. Think of a call option as a down-payment for a future purpose. 

Call Option Example

A potential homeowner sees a new development going up. That person may want the right to purchase a home in the future, but will only want to exercise that right once certain developments around the area are built.

The potential home buyer would benefit from the option of buying or not. Imagine they can buy a call option from the developer to buy the home at say $400,000 at any point in the next three years. Well, they can—you know it as a non-refundable deposit. Naturally, the developer wouldn’t grant such an option for free. The potential home buyer needs to contribute a down-payment to lock in that right.

With respect to an option, this cost is known as the premium. It is the price of the option contract. In our home example, the deposit might be $20,000 that the buyer pays the developer. Let’s say two years have passed, and now the developments are built and zoning has been approved. The home buyer exercises the option and buys the home for $400,000 because that is the contract purchased.

The market value of that home may have doubled to $800,000. But because the down payment locked in a pre-determined price, the buyer pays $400,000. Now, in an alternate scenario, say the zoning approval doesn’t come through until year four. This is one year past the expiration of this option. Now the home buyer must pay the market price because the contract has expired. In either case, the developer keeps the original $20,000 collected.

Call Option Basics

Put Option Example

Now, think of a put option as an insurance policy. If you own your home, you are likely familiar with purchasing homeowner’s insurance. A homeowner buys a homeowner’s policy to protect their home from damage. They pay an amount called the premium, for some amount of time, let’s say a year. The policy has a face value and gives the insurance holder protection in the event the home is damaged.

What if, instead of a home, your asset was a stock or index investment? Similarly, if an investor wants insurance on his/her S&P 500 index portfolio, they can purchase put options. An investor may fear that a bear market is near and may be unwilling to lose more than 10% of their long position in the S&P 500 index. If the S&P 500 is currently trading at $2500, he/she can purchase a put option giving the right to sell the index at $2250, for example, at any point in the next two years.

If in six months the market crashes by 20% (500 points on the index), he or she has made 250 points by being able to sell the index at $2250 when it is trading at $2000—a combined loss of just 10%. In fact, even if the market drops to zero, the loss would only be 10% if this put option is held. Again, purchasing the option will carry a cost (the premium), and if the market doesn’t drop during that period, the maximum loss on the option is just the premium spent.

Put Option Basics

Buying, Selling Calls/Puts

There are four things you can do with options:

  1. Buy calls
  2. Sell calls
  3. Buy puts
  4. Sell puts

Buying stock gives you a long position. Buying a call option gives you a potential long position in the underlying stock. Short-selling a stock gives you a short position. Selling a naked or uncovered call gives you a potential short position in the underlying stock.

Buying a put option gives you a potential short position in the underlying stock. Selling a naked, or unmarried, put gives you a potential long position in the underlying stock. Keeping these four scenarios straight is crucial.

People who buy options are called holders and those who sell options are called writers of options. Here is the important distinction between holders and writers:

  1. Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights. This limits the risk of buyers of options to only the premium spent.
  2. Call writers and put writers (sellers), however, are obligated to buy or sell if the option expires in-the-money (more on that below). This means that a seller may be required to make good on a promise to buy or sell. It also implies that option sellers have exposure to more, and in some cases, unlimited, risks. This means writers can lose much more than the price of the options premium.   

Why Use Options

Speculation

Speculation is a wager on future price direction. A speculator might think the price of a stock will go up, perhaps based on fundamental analysis or technical analysis. A speculator might buy the stock or buy a call option on the stock. Speculating with a call option—instead of buying the stock outright—is attractive to some traders since options provide leverage. An out-of-the-money call option may only cost a few dollars or even cents compared to the full price of a $100 stock.

Hedging

Options were really invented for hedging purposes. Hedging with options is meant to reduce risk at a reasonable cost. Here, we can think of using options like an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn.

Imagine that you want to buy technology stocks. But you also want to limit losses. By using put options, you could limit your downside risk and enjoy all the upside in a cost-effective way. For short sellers, call options can be used to limit losses if wrong—especially during a short squeeze.

How Options Work

In terms of valuing option contracts, it is essentially all about determining the probabilities of future price events. The more likely something is to occur, the more expensive an option would be that profits from that event. For instance, a call value goes up as the stock (underlying) goes up. This is the key to understanding the relative value of options.

The less time there is until expiry, the less value an option will have. This is because the chances of a price move in the underlying stock diminish as we draw closer to expiry. This is why an option is a wasting asset. If you buy a one-month option that is out of the money, and the stock doesn’t move, the option becomes less valuable with each passing day. Since time is a component to the price of an option, a one-month option is going to be less valuable than a three-month option. This is because with more time available, the probability of a price move in your favor increases, and vice versa.

Accordingly, the same option strike that expires in a year will cost more than the same strike for one month. This wasting feature of options is a result of time decay. The same option will be worth less tomorrow than it is today if the price of the stock doesn’t move. 

Volatility also increases the price of an option. This is because uncertainty pushes the odds of an outcome higher. If the volatility of the underlying asset increases, larger price swings increase the possibilities of substantial moves both up and down. Greater price swings will increase the chances of an event occurring. Therefore, the greater the volatility, the greater the price of the option. Options trading and volatility are intrinsically linked to each other in this way. 

On most U.S. exchanges, a stock option contract is the option to buy or sell 100 shares; that’s why you must multiply the contract premium by 100 to get the total amount you’ll have to spend to buy the call.

What happened to our option investment
May 1 May 21 Expiry Date
Stock Price $67 $78 $62
Option Price $3.15 $8.25 worthless
Contract Value $315 $825 $0
Paper Gain/Loss $0 $510 -$315

The majority of the time, holders choose to take their profits by trading out (closing out) their position. This means that option holders sell their options in the market, and writers buy their positions back to close. Only about 10% of options are exercised, 60% are traded (closed) out, and 30% expire worthlessly.

Fluctuations in option prices can be explained by intrinsic value and extrinsic value, which is also known as time value. An option’s premium is the combination of its intrinsic value and time value. Intrinsic value is the in-the-money amount of an options contract, which, for a call option, is the amount above the strike price that the stock is trading. Time value represents the added value an investor has to pay for an option above the intrinsic value.   This is the extrinsic value or time value. So, the price of the option in our example can be thought of as the following:

Premium = Intrinsic Value + Time Value
$8.25 $8.00 $0.25

In real life, options almost always trade at some level above their intrinsic value, because the probability of an event occurring is never absolutely zero, even if it is highly unlikely.

Types of Options

American and European Options

American options can be exercised at any time between the date of purchase and the expiration date. European options are different from American options in that they can only be exercised at the end of their lives on their expiration date. The distinction between American and European options has nothing to do with geography, only with early exercise. Many options on stock indexes are of the European type.   Because the right to exercise early has some value, an American option typically carries a higher premium than an otherwise identical European option. This is because the early exercise feature is desirable and commands a premium.

There are also exotic options, which are exotic because there might be a variation on the payoff profiles from the plain vanilla options. Or they can become totally different products all together with “optionality” embedded in them. For example, binary options have a simple payoff structure that is determined if the payoff event happens regardless of the degree. Other types of exotic options include knock-out, knock-in, barrier options, lookback options, Asian options, and Bermudan options.   Again, exotic options are typically for professional derivatives traders.

Options Expiration & Liquidity

Options can also be categorized by their duration. Short-term options are those that expire generally within a year. Long-term options with expirations greater than a year are classified as long-term equity anticipation securities or LEAPs. LEAPS are identical to regular options, they just have longer durations.

Options can also be distinguished by when their expiration date falls. Sets of options now expire weekly on each Friday, at the end of the month, or even on a daily basis. Index and ETF options also sometimes offer quarterly expiries. 

Reading Options Tables

More and more traders are finding option data through online sources. (For related reading, see “Best Online Stock Brokers for Options Trading 2020”) While each source has its own format for presenting the data, the key components generally include the following variables:

  • Volume (VLM) simply tells you how many contracts of a particular option were traded during the latest session.
  • The “bid” price is the latest price level at which a market participant wishes to buy a particular option.
  • The “ask” price is the latest price offered by a market participant to sell a particular option.
  • Implied Bid Volatility (IMPL BID VOL) can be thought of as the future uncertainty of price direction and speed. This value is calculated by an option-pricing model such as the Black-Scholes model and represents the level of expected future volatility based on the current price of the option.
  • Open Interest (OPTN OP) number indicates the total number of contracts of a particular option that have been opened. Open interest decreases as open trades are closed.
  • Delta can be thought of as a probability. For instance, a 30-delta option has roughly a 30% chance of expiring in-the-money.
  • Gamma (GMM) is the speed the option is moving in or out-of-the-money. Gamma can also be thought of as the movement of the delta.
  • Vega is a Greek value that indicates the amount by which the price of the option would be expected to change based on a one-point change in implied volatility.
  • Theta is the Greek value that indicates how much value an option will lose with the passage of one day’s time.
  • The “strike price” is the price at which the buyer of the option can buy or sell the underlying security if he/she chooses to exercise the option. 

Buying at the bid and selling at the ask is how market makers make their living.

Long Calls/Puts

The simplest options position is a long call (or put) by itself. This position profits if the price of the underlying rises (falls), and your downside is limited to loss of the option premium spent. If you simultaneously buy a call and put option with the same strike and expiration, you’ve created a straddle.

This position pays off if the underlying price rises or falls dramatically; however, if the price remains relatively stable, you lose premium on both the call and the put. You would enter this strategy if you expect a large move in the stock but are not sure which direction.   

Basically, you need the stock to have a move outside of a range. A similar strategy betting on an outsized move in the securities when you expect high volatility (uncertainty) is to buy a call and buy a put with different strikes and the same expiration—known as a strangle. A strangle requires larger price moves in either direction to profit but is also less expensive than a straddle. On the other hand, being short either a straddle or a strangle (selling both options) would profit from a market that doesn’t move much.   

Below is an explanation of straddles from my Options for Beginners course:

Straddles Academy

And here’s a description of strangles:

How to use Straddle Strategies

Spreads & Combinations

Spreads use two or more options positions of the same class. They combine having a market opinion (speculation) with limiting losses (hedging). Spreads often limit potential upside as well. Yet these strategies can still be desirable since they usually cost less when compared to a single options leg. Vertical spreads involve selling one option to buy another. Generally, the second option is the same type and same expiration, but a different strike.

A bull call spread, or bull call vertical spread, is created by buying a call and simultaneously selling another call with a higher strike price and the same expiration. The spread is profitable if the underlying asset increases in price, but the upside is limited due to the short call strike. The benefit, however, is that selling the higher strike call reduces the cost of buying the lower one.   Similarly, a bear put spread, or bear put vertical spread, involves buying a put and selling a second put with a lower strike and the same expiration. If you buy and sell options with different expirations, it is known as a calendar spread or time spread. 

Spread

Combinations are trades constructed with both a call and a put. There is a special type of combination known as a “synthetic.” The point of a synthetic is to create an options position that behaves like an underlying asset, but without actually controlling the asset. Why not just buy the stock? Maybe some legal or regulatory reason restricts you from owning it. But you may be allowed to create a synthetic position using options.   

Butterflies

A butterfly consists of options at three strikes, equally spaced apart, where all options are of the same type (either all calls or all puts) and have the same expiration. In a long butterfly, the middle strike option is sold and the outside strikes are bought in a ratio of 1:2:1 (buy one, sell two, buy one).

If this ratio does not hold, it is not a butterfly. The outside strikes are commonly referred to as the wings of the butterfly, and the inside strike as the body. The value of a butterfly can never fall below zero. Closely related to the butterfly is the condor – the difference is that the middle options are not at the same strike price. 

Options Risks

Because options prices can be modeled mathematically with a model such as the Black-Scholes, many of the risks associated with options can also be modeled and understood. This particular feature of options actually makes them arguably less risky than other asset classes, or at least allows the risks associated with options to be understood and evaluated. Individual risks have been assigned Greek letter names, and are sometimes referred to simply as “the Greeks.” 

Below is a very basic way to begin thinking about the concepts of Greeks:

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    1st Place! Best Binary Broker 2020!
    Best Choice for Beginners — Free Education + Free Demo Acc!
    Sign-up and Get Big Bonus:

  • Binomo
    Binomo

    2nd place! Good choice!

Like this post? Please share to your friends:
Binary Options Trading Wiki
Leave a Reply

;-) :| :x :twisted: :smile: :shock: :sad: :roll: :razz: :oops: :o :mrgreen: :lol: :idea: :grin: :evil: :cry: :cool: :arrow: :???: :?: :!: