Stumped By Stock Options? Here’s The Intuitive, Chart-Free Explanation You Need
By: Erik Bassett
Tags: Money, Personal Finance, Investing, Options, Options Trading

If the market thinks vacuum prices are extremely stable at $100 give or take a buck, then a $105 call (buy) option good for three months will only be worth a little bit. The market assumes very little volatility, which plays out as very low contract prices.

But what if you have reason to think vacuum prices are actually quite volatile but the market just hasn’t realized it yet? In fact, you believe they’re on the verge of spiking to $150 and staying there for ages, but the market hasn’t caught on to that and therefore hasn’t priced it into the options yet.

If you’re right, then that same three-month $105 call is about to become extremely valuable, since $105 is a massive discount from that likely future price! Depending on your confidence (and appetite for risk), you could load up on several contracts in hopes of selling them later on for a profit.

You could even buy a call for a strike price that’s already less than the market price — let’s say for $95 — in hopes that it will get even more valuable. The fact that it’s in the money today means it’s less risky, since it has intrinsic value even if vacuum prices never rise after all. As long as it vacuum prices don’t fall below $95, it’s still worth at least a little bit (minus whatever time value has passed). But that contract’s lower risk also means it’s more expensive.

The key dilemma as a trader is that if the spike never happens — perhaps vacuum prices push up against $105 but never cross that point — then you lose money on that $105 option. You can sell it at a loss while it still has extrinsic (time) value left. You can also hold it right up until expiration, in hopes of a last-minute price spike, but it’ll more than likely expire worthless. You’re out the money you paid upfront, but no more than that.

It’s an equal but opposite situation with put (sell) options.

Say your fellow chair enthusiasts think government regulations will keep chairs selling for around $50. You, on the other hand, prognosticate a flooded marketing that drives them down to $10 at best. You might load up on put options (the right to sell) for $50 or a little less. If prices drop below whatever price you chose, then you’re in the money and walk away with a handsome profit. If not, then you’re out most or all of the amount you spent on the contract.

A quick note on risk

Of course, nobody wants to lose everything if they’re wrong. We may have strong and reasonable theories about the future, and we may even be right most of the time, but we don’t know the future. After all, that’s why there’s an options market in the first place.

That also means we have to be careful about risk. Risk gets very technical, very quickly, so we won’t even go there for now. Suffice to say that some options gain value when others lose value, so you can combine the two to balance each other out. You stand to earn less but also to lose less. Most importantly, you reduce or eliminate the chance of losing all you have and then some.

But that’s a topic for another day.

The view from the other side of the table

We’ve talked a lot about the option buyer’s perspective, but not so much about the option seller’s. Let’s briefly detour into the latter, since it brings up one last, critical point about the options market.

The vacuum itself will have value after next Saturday. Odds are good it’ll have value a year or even a decade after next Saturday, for that matter.

That’s in stark contrast to your vacuum-buying contract, which is worth something up through expiration, but not a penny after expiration.

What’s more, remember that the contract lost a little value each day up until expiration (assuming the price swing you expected didn’t happen). It also lost that value at an increasing rate as time went by.

If I wrote you a contract one month ago, but prices barely budged, then I could buy the contract back from you at a lower price today. If it expires tomorrow, the price will be dramatically lower than if it’s still good for another month. Less time means less potential for crazy things to happen, which means less value in the contract. This is the phenomenon of time decay in a nutshell.

That’s my profit and your loss, but we both benefit in other ways. You recoup at least some of your premium. I no longer have to bear the risk of fulfilling the contract at a huge loss if prices do swing at the last minute after all.

If the expected price swings don’t happen, then the option buyer loses money due to time decay while the option seller gains money due to time decay. It’s not strictly a zero-sum game, but it often looks that way on paper.