Gain a broad understanding of how options, as financial derivatives, work, as well as some reasons for investing in them; acquire the skills to distinguish between call and put options; identify the components of an options contract on a trading platform; make certain decisions in the options; market as a contract writer or owner; view different stock options positions; tell whether a given position is in- or out-of-the-money; understand some of the benefits and critical risks faced by equity options traders and know how to describe stock options function as derivatives.
To introduce you to equity options, we’ll provide you with a broad overview of this often-complex asset class, including how they function as financial derivatives, as well as some of the reasons traders decide to use them.
In broad terms, an option is a derivative – and while the word ‘derivative’ may bring back some memories of calculus class, in finance, a derivative can be thought of, very simply, as one financial instrument whose value is derived from the performance of another.
The value of an equity option, for example, is essentially derived from the performance of a stock, exchange-traded fund (ETF), or similar product.
Here’s an easy concept to help you understand how a derivative in finance can work:
Let’s look at a proposed financial product called a ‘movie derivative’, which, as you will see, has a lot in common with ways in which we can think about options.
A movie derivative, which was proposed – and failed to gain support – in 2010, aimed at allowing investors to speculate on the future box office performance of a theatrical movie release.
For illustrative purposes:
Let’s say you think a movie scheduled for release next summer is going to be a hit, and you’ve learned that if you invested in a certain movie derivative, it would earn you a nice profit if you were right.
You may ask, for example:
- Why would audiences flock to the theater to see it?
- Have people on social media been eagerly awaiting its release?
- Who are the people behind the project, or in front of the camera?
- What is the creative team’s track record of success?
- How widely distributed will the movie be?
- What’s the marketing strategy?
- Does the trailer alone provide sufficient stimulus to want to buy a ticket and go see it?
Let’s say all signs indicate that you should buy the movie derivative, but you’re still not entirely convinced you should.
You may then want to find out:
- What do other investors in the market think?
- How much interest does this movie derivative have has among buyers and sellers?
In this case, investors are more interested in purchasing this movie derivative than those shorting – or selling it – by a ratio of at least 10 to 1, with the lion’s share of the speculation saying that box office revenues will exceed $100 million in the film’s first weekend of release.
If you buy this movie derivative, and the movie makes more than $100 million in its first weekend, you stand to make a profit on your investment. But if you’re wrong, you would lose your investment – or the premium – you paid to the seller of the product.
Further due diligence and decision
Still unresolved, you decide to conduct further research, and hear talk among some trusted industry experts that there’s a strong risk the film is going over-time on production and over-budget, and it’s very likely not going to meet its release date – all very worrying signs, that are further compounded by scattered rumors that the director may walk off set before production ends.
Given this news, you begin to believe that all the hype is just to provide cover for the failing project, and you’re willing to accept the premium from the buyer on this movie derivative as opposed to taking the risk, paying it, and losing your investment.
A couple of weeks before the film is due to be released, news surfaces on some major media channels that, indeed, the film is over-budget, and there are concerns about its release date.
At this stage, you may think you’ve made the right decision, but—
On opening weekend, lines stretched out the door for the movie. It showed in just about every major U.S. city, as well as at almost every local theater across the country. In most major cineplexes, it showed on at least four screens. And although several high-profile critics panned it, audiences couldn’t get enough, and soon everyone was talking about it.
Box office intake for the movie neared $150 million on its first weekend.
Given this outcome, you’ve now found yourself on the wrong side of the trade, and while you collected your premium, buyers of this movie derivative fared much better on their investment.
You likely gleaned from this example that the challenge with trading movie derivatives would have been in accurately gauging how audiences would respond to the movie.
While you may hear all kinds of rumors, do research on the track record of the creative team involved in the film, the star power on screen, and the marketing forces that push the product, uncertainties over the film’s effect on the audience, it’s accessibility and availability to be seen, as well as its word-of-mouth reputation once it’s released, basically drive the size of its box office revenues.
What does this example have to do with options trading?
Similar to how the movie derivative’s value would be based on the future box office performance of a film, traders use options to speculate on the future performance of:
- Indexes and
- Foreign currencies.
A trader of stock options, for example, would generally want to analyze a multitude of factors about the underlying stock to gauge whether its price will rise or fall over a certain, limited period of time, much like the audience’s response to a movie around its release date – will they stand and applaud or sink back in their seats?
As a buyer or seller of stock options, you may consider all of the same fundamental and / or technical analyses that equity analysts use, among other methods that are more specific to the options market –to ultimately help inform your decision as to whether a particular stock will rise or fall within a pre-determined timeframe.
Options traders also have a slew of other measures by which they may analyze the potential performance of these instruments, including implied volatility, as well as a host of different sensitivity values, and while we’ll explore these concepts more in depth later in the course, it’s important to keep in mind that stock options traders are generally concerned with whether they believe a given underlying stock will rise or fall over a given period of time. This is the derivative nature of these products.
Meanwhile, beyond the speculation, traders may look to the equity options market for a variety of reasons, including income generation, as well as tools for hedging against existing positions in various risk mitigation strategies.
While we’ll also be diving more deeply into these topics, we’ll next explore some critical terms and meanings in the options market, as well as examine the roles and obligations of buyers and sellers of stock options contracts.
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: 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.