What is an option?
An option contract is an agreement between buyer and seller over an agreed upon number of shares at
a price agreed upon today for delivery at a set time in the future.
The buyer has the right, but not the obligation, to take delivery of, or to deliver, that set number of
shares at or before the time the contract expires at a fixed price and regardless of where the share price
is trading at the time that the option is exercised. The buyer pays the seller a premium for the right to
buy or sell at this fixed price at a later date. We’ll return to buying and selling rights very shortly.
In exchange for taking in the premium, the option seller has the obligation to deliver, or take delivery of,
those shares at that fixed price if the buyer exercises his right to call away the shares, or put the shares
to the seller.
A word about risk – The Buyers’ risk is limited to the cost of owning the contract. The buyer pays that
fixed cost and has the right to exercise the contract by or at expiration under specific circumstances.
We’ll come to a clear example in a moment.
But the risk to a seller can be substantial. An option seller may be taking in a relatively small premium
and agreeing to act as either the buyer or seller to the owner of the option contract. If the contract
owner proves correct and has locked in at a better price to buy or sell, it may cost the option seller more
in the open market to fulfill his obligation to sell shares to the contract owner unless the seller holds the
shares. An unhedged seller of call options could feasibly face unlimited losses. For that reasons, options
trading is not suitable for all investors. More on what hedging is at a later point.
Types of options – While an option contract can be bought or sold, there are two types of options. Call
options give the buyer that right to buy shares at a fixed price. A seller of call options expects the share
price to remain below a specific price through an agreed upon date and time, and accepts a premium for
bearing the risk that it does not.
Put options give the buyer that right to sell shares at a fixed price. A seller of put options expects the
share price to remain above a specific price through an agreed upon date and time, and accepts a
premium for bearing the risk that it does not.
TWS Option Chain – Let’s look at TWS Mosaic and think about the basic concept of options and then
we’ll look at a quote monitor for option prices. We can do that by looking to the right of the Order Entry
panel and selecting from the dropdown menu – Option Chain. You can learn quite a bit about the key
concepts of options by studying this panel.
TWS Option Chain Layout – Notice down the middle of the panel is a color-coded area displaying the
Strike prices. Remember we mentioned earlier the agreed upon fixed levels for option contracts? These
are known as the strike prices and can be compared to the underlying price of the shares we are looking
at. To the left are premiums or quotes for Call options – contracts to buy a fixed amount of shares at
that strike price. To the right of the panel are quotes for put options – contracts to sell shares at a fixed
Strike prices and expiration dates – We also noted that each contract has a specific lifetime; these
expiration dates are displayed as tabs above the series of strike prices. Click on a different tab to display
quotes for each expiration and then refer to different strike prices to see how the quotes differ. If you’d
rather see a long list of quotes by expiration date, click on the Tabbed dropdown and select List View.
Option characteristics – time – If you compare prices of two identical call options with different
expiration dates, you might quickly notice that the contract with the longest life is more expensive.
Simply, that is because the greater length of time increases the likelihood that the underlying share
price could reach the strike price by expiration. You can see that a one month contract generally costs
less than a two month contract for call options.
To see more or fewer strike prices, select from the Strike dropdown menu. To the upper right is the
Trading Class for the stock’s options and the multiplier. The multiplier tells us how many shares each
option contract covers. For most US stocks, a single option contract covers 100 shares.
Option characteristics – strike price – You will also notice that call options at the same expiration date
with lower strike prices are more expensive than calls at higher strike prices. Call options with strike
prices below the current trading price of the shares are said to be in-the-money. If they could be
exercised today they would have intrinsic value and are more valuable than call options with higher
strike prices. Call options whose strike prices are above the current price of the underlying shares are
said to be out-of-the-money and would have no value if exercised now.
The relationship for put options runs the opposite way. Higher strike put options are more expensive
than those at lower strikes. Put options with strike prices above the current share price are said to be in the-money and would have intrinsic value if exercised today. Conversely, put options with strikes below
the current share price are said to be out-the-money and would have no value if exercised now.
In the upper left corner of the Option Chain window is the ticker symbol we have selected. Enter a
different ticker or select from prior tickers using the dropdown arrow. If you look across to the right, you
will see the live quote, dollar and percent change on the session and a series of configuration icons.
If you ever get lost with this panel, click on the question mark symbol to boot up the Cheatsheet.
Use the color chain to group windows together. Currently this window is grouped to other panels on this
page – so when I select any other ticker, the Option Chain will display option chains for that stock.
Use the pushpin to keep the window on top of others. Remember that you could unlock the layout and
add this panel permanently if you want to. Or select option-dedicated layouts from the Layout Library.
The dropdown arrow allows users to minimize all TWS windows or print specific panels. In the upper
right corner are reduce, expand and close icons. By the way – you can also access the Option Chain from
the Blue New Window button in the upper left corner of Mosaic by selecting it from the Quotes menu.
Configuration – Let’s look at the Configuration wrench. Click it and you can either change the font size or
else go into configuration settings. With the Option Chain header expanded on the left panel, you will
see three selections for Settings, Hotkeys and Layout.
Settings – As well as altering the font size from the Settings menu, users can show option prices in
volatility terms instead of in dollars and cents. As you learn more about options, this will become more
significant. Down the center of the Option Chain window are the strike prices. The Setting menu allows
users to change the color scheme between blue, gray or autumn colors. The color gradient reflects price
moves expressed in standard deviations. See that there are two selections to choose from in the
dropdown menu. Click Apply to enforce changes and keep the Configuration menu open. Click OK when
you want to apply and close the menu.
Hotkeys – The Hotkey selection allows users to assign a single keystroke to create, modify, transmit and
request order cancellations as well as access various tools.
Layout – The Layout panel allows users to configure the Option Chain panel with more than the default
settings. The left window shows currently displayed headers. The Available columns are shown on the
right. So for example, if we want to display a reading for delta in the option chain window, expand and
select from the Greeks menu. Click and highlight the desired column header, and then click Add from
the central panel to enable it in the Shown Columns. Notice the search box above – if you don’t know
where your selection might be grouped, type it here to search. Let’s look for implied volatility in the
search bar and add that to the layout too. When you have made your selections, click OK. The readings
for Delta Implied Volatility are now shown in the display.
Implied volatility – Some stock prices are relatively stable over time and tend to reflect the broad path
of the stock market as a whole. Others are more erratic. Measuring the standard deviation of a share
price over the past several weeks will provide us with a historic reading of just how volatile a stock has
been. This is an important concept, because option traders need to price option premiums and need a
measure of expected volatility. This reading of implied volatility is a crucial input to an options price. All
else being equal, a stock with lower implied volatility will have cheaper premiums associated with its
options than a stock with higher implied volatility. You can see readings for implied volatility on many
places in TWS. In the Option Chain panel, you can see the 30-day implied volatility reading for the stock
as a whole below the trading class and multiplier. But if you glance down the column for implied
volatility we just added to the panel next to each strike, you will see individual volatilities by strike price.
Note also that call and put volatility readings are likely to be different.
If we click on a random ticker symbol, the share price will display in the chart window. You can see that
its price has traded over the last year in a range of $25-$35 and is currently trading at $33. We can add
both historic and implied volatility readings to this chart by selecting from Edit menu and selecting Chart
Parameters. Investors may want to know whether shares have been more or less volatile than the
market as a whole, whether they have been volatile recently or where volatility readings typically trend
before and after quarterly earnings.
Call option example – Let’s ignore the reasons why, but just assume that a bullish investor expects that
within three months shares in this company will be trading above $38. And so rather than buying shares
in the company, the investor looks to the option market to speculate.
You can see the list of call option premiums for the stock. The 38 strike price is quoted at xx-cents for
the three-month expiration. You will see that if you look at higher strike prices for the same expiration,
premiums are smaller. Remember that, for call options, the further away from the strike price, the lower
is the chance the share price will rise that far. Sellers are prepared to accept a lower premium to take on
that risk. The closer the strike price is to the share price, the greater the risk and so option sellers
demand a greater premium. Click on the ask price for the call option. This causes the Order Entry
window to populate with the option quote but because we clicked the Ask price, TWS created an order
Strategy Performance Graph – To add perspective to the meaning of the premium demanded relative to
the anticipated share price by this bullish investor, locate from the blue New Window button the
Strategy Performance Graph located under the Option Analysis menu. Use the pushpin to keep this plot
on top or expand the plot using the maximize button to the upper right. This displays the expiration
profile for the selected option.
The P&L plot compares the profit and loss profile today to the P&L at the expiration date of the option
contract. P&L is measured to the right and the price of the underlying is displayed beneath the chart.
Hover the cursor over either date line to view the associated P&L labels on the x-axis. If you hold the
cursor at the strike price, you can contrast the monetary impact of time on the option position. Should
the share price rise to the strike price today, the profile calculates the expected premium of the option
and so you can see an associated profit, relative to the current market price of the option. However, the
value of the option at the strike price at expiration reflects a loss, which is equal to the current price of
the option. The difference between the two lines illustrates time value or THETA as it’s known in Greek
terms. More on the Greek values in a later chapter.
P&L for a long call option position – A long call position will incur a loss for the investor at expiration at
all prices below the strike price. The loss is equal to the premium paid for the option. This is because the
investor paid a fixed premium for the option that is worthless at or below the strike price. The long call
profile reaches breakeven at the strike price plus the premium paid. For example, for an option with a
$35 strike price and a $1 premium, the investor would breakeven at $36. At expiration, the investor can
“call” shares from the option seller at that fixed price of $35 per share. If the investor paid $1 for that
right, this cost plus the cost of commissions must be factored in. Beyond the strike price, you can see
that the P&L plot rises at a 45-degree slope, cutting that horizontal breakeven line above the strike by
the cost of the option. So while each long call plot will look the same as this, that breakeven value will
change depending on the strike price, premium, and commissions paid for the option contract.
Please note that for the sake of simplicity we are not including the cost of commissions in the breakeven
calculation, but you should be aware that commissions are an added cost and should be considered
when calculating break-even points. Additional information on commissions and fees can be found on
the IB website.
P&L for a short call option position – Let’s look at the P&L plot for a short call. Many investors sell
options specifically in order to take in the premium of an option. And don’t forget, you can buy back an
option at any time and so speculators might sell with the specific aim of profiting by buying back the
same option at a later date. For the premium received, they risk having to deliver shares under those
specific circumstances at or before the expiration date. If we click on the bid button, a sell order is
generated and the P&L profile automatically populates the Strategy Performance Graph.
This time the P&L profile displays a fixed profit below the strike price. In other words, at all prices for the
underlying below that strike, the seller has no obligations and gets to keep the premium paid by the
buyer. If the seller has to deliver shares at any price above the strike price, losses occur. For a short call
option, the breakeven price to the seller is the strike price plus the premium received and the cost of
commissions. So for an option with a strike price of $35 and a $1 premium, the seller starts to lose
money as the share price rises above $36 and beyond that point, losses increase penny for penny with
increases in the price of the underlying.
A more advanced version of this performance graph is available via the Order Preview window. Use the
Advanced button to generate an Order Preview and check the Performance Profile box to view the
Margin/Performance menu. Clicking this button creates the at-expiration Performance Profile. This
version offers user-driven scenario analysis allowing users to see P/L and Greek values for a given change
in the share price. Use the date drop down box in the upper right to select any date through expiration.
Use the selector in the upper left corner to select from P&L or any of the Greek values. Note that at
expiration, amongst the Greek values only Delta will display.
Put option example – So let’s look at an example of a put option. An investor wishing to protect a long
stock position, anticipating a temporary share price decline, might consider buying put options to
protect from losses. A bearish investor might buy put options just to speculate on rising premiums for
put contracts in anticipation that the premiums might rise should the price of the underlying fall. To see
what the Performance Profile might look like in such event, an investor could select a contract with
appropriate expiration date, click on the ask price for a put option at an out-the-money strike and
examine the profile based upon those bearish assumptions. Once again, hover the mouse above either
line to contrast the expected P&L at increasingly lower prices for the shares. The investor might not
want to hold the position through expiration, rather he may want to see the expected P&L 10-or 20 days
from today. Use the date selector to adjust the view and once again use the mouse to view expected
profit or loss as of the new date versus that for the current date.
Charting option prices – When using windows grouping, note that the price of the option is plotted over
time. You should note that since many options typically have a short life, the best display is over a short
time frame. And as they can be infrequently traded, it is best to configure the chart to display a line.
Start with a one-week time frame and then work out in time to display longer periods. Use the Max line
setting to get a full history. As with underlying shares, you can often get a good sense of whether the
stock is in bullish or bearish mode. And while you can see the range over time for the premium of the
option, remember that its price is influenced by the price of the underlying, the remaining time value
and the implied volatility and that because we are pricing premiums, these generally decay to zero for
ANY option that is out-of-the-money at or near expiration For call options, contracts with strike prices
that are above the price of the stock are out of the money and for put options contracts with strike
prices below the price of the stock are out of the money.
Disclosure: Interactive Brokers
The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
Supporting documentation for any claims and statistical information will be provided upon request.
Any stock, options or futures symbols displayed are for illustrative purposes only and are not intended to portray recommendations.
Disclosure: Margin Trading
Trading on margin is only for sophisticated investors with high risk tolerance. You may lose more than your initial investment.
For additional information regarding margin loan rates, see ibkr.com/interest
Disclosure: Options Trading
Options involve risk and are not suitable for all investors. For more information read the “Characteristics and Risks of Standardized Options” also known as the options disclosure document (ODD). To receive a copy of the ODD call 312-542-6901 or click here. Multiple leg strategies, including spreads, will incur multiple commission charges.