Part 2 : Discovering Options
This is a continuation of my story from part1.
After learning about futures contract. I had an insane amount of success. I grew to over 2.5 Laksh in 3 weeks. Learnt all kinds of technical analysis. And they were all working for me. This was the month of January 2021. And if anyone takes the chart for that month on NIFTY. There have only been new highs every day. Naturally, I was bound to only succeed. I was carefully selecting stocks that would give me good movement. If I get into the detail of how, I will have to take you through what is Market Profile, Volume Profile, Order flow charts. Each one is a 300–200 page book.
Later, 2 months down the lane I realised that even futures trading is very hard to continue. I will discuss why in a later chapter. But I was high on this streak of success. I forgot about the feedback loop. My loop was not seeing any failure. So there was no correction to be made. Sometimes I wish the failure had come to me quickly.
At this point, I was already selling options on expiry day. Brokers give leverage to trade for intraday(entry and exit on the same day). Meaning if you have 10rs, broker gives you the buying power of 10x. Meaning you can buy/sell for 100rs. But the condition is that you close that buy/sell the same day. Option selling requires a huge amount of capital. This was the reason why I sold options/ write options only on intraday. Also, I had very limited knowledge of options.
Now you must be wondering. Why options writing is so expensive? What in the world are options??
What are Options?
Options are also contracts like futures. Meaning its value is derived from an underlying asset(stock/spot). And just like futures contract even option contracts have an expiry date. In NSE expiry of futures happen monthly. And options happen weekly.
There are two kinds of options CE and ….
Ok, wait.
Assume that you are working at Google. Now you have inside information from a friend that the stock is going to increase by $50. And you are interested in making that $50.
What do you do?
You open your trading account. Make an order for some X quantity and buy them. Say the Google stock is at $100(for simplicity lol) and you bought 1 share. After it reaches $150 you sell the stock and you are wealthier by $50.
The same thing, if you want to do in options. You buy what’s called a CALL option. CALL means the same as buying a share like in the example I told above.
Now, this is where it gets interesting. When you bought the stock you compared it with the price you entered at (which is $100). In otpions you compare it with a price that’s written on your CALL option contract. This is what is called a strike price.
And you have the option to choose a strike price.
Whatever strike price you choose say X. The movement of stock is compared with reference to X. Let us say you bought the CALL option contract for a price of $P and strike X. And the index moved to $150 then the price of $P of the contract will also increase. Since we are assuming an increase of $50. Then the price of the contract will change from $P to $P+($50)*delta. We will talk about delta soon so be patient.
Why doesn’t the price of option contract that you bought at $P increase by $50 and instead only increase by ($50)*delta?
To answer this, we have to look at how options contracts are valued/priced at some $P.
Options prices can be divided into two parts.
Time Value ($T)
Time value is easy to explain. Let us say there are 5 days left for expiry. Then all option contracts regardless of what strike it is. Have a price to it called $T. The further the expiry is, in this case, it’s 5 days. But if the number of days was 10. Then $T for 10 days will be greater in comparison to $T if there were only 5 days left to expire. Meaning $T is directly proportional to the number of days left for expiry (in the last part we have already discussed what expiry is).
The higher the number of days left, the more is the value of $T. So this also means that, as the number of days passes by, the Time value also starts going down. Eventually at expiry $T = 0. This decrease in Time value is what’s called Theta decay. It’s the rate of change $T. All option sellers make money from selling this part of the option pricing (Theta gainers).
Intrinsic Value
Intrinsic value is the difference between the strike written on your contract and the stock price/spot price. In this example since you expect stock to move from $100 to $150, you buy a CALL option of strike $100. Then Intrinsic Value = (100–100) = $0. This means your CALL option has only Time value ($T) and you’ve spent $T to acquire the $100 strike CALL contract. This does not mean that if the stock price is at $90 then the intrinsic value is (90–100) = -$10. Intrinsic value can never be negative. It’s max(Stock Price-Strike Price,0).
When the stock moves to $150. The intrinsic value is now (150–100) = $50. And the Time value is $T’(T prime). Calling it $T’ because of Theta decay. Since time to expiry is constantly decreasing. So you can’t expect the time value of your contract to be the same always. And $T = 0 at expiry. Meaning all option contracts will only have intrinsic value at expiry(I think most of you realise now why selling options are better).
Now many of you may have this doubt in your mind who sets the theta decay?
Nobody sets that. It’s all us. Since I know that there is only going to be the intrinsic value of the option and that expiry is closing in. I will start biding a lower price for it. All these variables are just an attempt at explaining the prices of options before expiry (since we all know the price of options at expiry). The most famous model to determine option pricing is The Black Scholes model. The real equations are far more complex. But this level of understanding is enough to trade-in options.
So in the example if you buy a $100 strike CALL option. You pay $T and when it reaches $150 your contract has a price of $T’+$50*delta. And when you sell it you make ($T’-$T) + $50*delta. And we know that $T’ < $T since theta decay.
Delta
What is Delta? Like theta is the rate of change of option price with respect to time. Delta is the rate of change of option price with respect to stock price(spot price). Notice that, it is not with respect to change in intrinsic value.
We all know now that $T = 0 at expiry and only intrinsic value is the price of the option. Meaning Delta = 1 at expiry. So call option contract of strike 100 at expiry is max(spot-strike, 0)*delta. And delta = 1.
So all CALL options that have a strike> spot price at expiry are valued at $0. And these are the kind of options that are sold by option writers. These options are termed Out Of the Money options (OTM). And sellers/writers make money from $T deteriorating to $0.
When the spot = strike price. Like the one, we purchased at the start. They are called At The Money options. ITM you can take a guess…………………. (In The Money)
Why long term Option buyers are called Gamblers?
I, in general, believe option buying is a gambler’s game. And I term all option sellers as casino owners. Naturally, it takes a good amount of capital to be a casino owner. And less capital to gamble. There is another reason why option selling requires high capital. But the details are not very interesting.
Those who have gone to a casino, know that it’s hard to win big. But easy to lose all. And we all know that the house always wins.
This is true for options too.
In our example of the $100 strike call option. We bought it when the spot was also at $100 and paid $T.
$100 CALL option at expiry
Let’s see the possibilities. The insider information you got was just a prank. And the stock doesn’t move at all. Meaning the spot is at 100. Then the 100 call contract you have is still At the money. And we know $T = 0 at expiry. And your contract has no intrinsic value. So you lose your money paid for the contract as no one will buy it from you for a higher price. Now you can see that at expiry for you to be profitable you need the spot to be at any price above Strike+price you paid for the contract. In this case $100+$T(in the above image I have assumed $T = $50, hence you see green above that spot price)
This is also the reason why option buyers always buy options that are ATM because they only have time value associated with it.
As you can see the probability is low for you to make any money. Because the insider info has to be correct and the stock has to move above (Strike+premium) [price of an option is also called premium] sometimes(in case $T is high like $50)
When the price reaches $150 or when your option is ITM(In the Money) only then you make any money. But sometimes your option can be in the money and still lose money because the Intrinsic value of option at expiry is lesser than the $T you paid for the contract.
This is the reason why option buying is a low-probability setup.
Now you know that the sum of probability = 1. Therefore at the same time if you sell an option you are most likely to make money from selling the time value. And which options have only time value? All options that have no intrinsic value meaning they are OTM(Out of the Money) options.
The other kind of options is called PUT. Put is the straight opposite of a CALL. Now we have covered enough grounds for you to understand what a PUT is by yourself.
Now I leave you with a question. Which OTM option will you sell? given you have the insider information on the stock like in our example.
Suggest you to take some time to revise. And do some amount of reading on Call and Put before you read the disclaimer.
DISCLAIMER
A PUT option below the spot price of $100. Say $80 strike PUT.
CASE 1: your friend plays a prank on you
Now the stock stays at $100. So you make $T from decay.
Now let’s says the stock falls to $90(Since google is a good stock *wink*)
You still make $T at expiry.
CASE 2: you have a good friend(mostly not true)
Now the stock goes to $150 and above. Then too you make $T.
So anywhere it expires above your strike, you make money (inside you are crying as to why you did not buy a call).
So you can see that option selling has only a limited profit. While option buying has an unlimited profit. The inverse is also applicable. I will leave the rest to you readers to figure it out.
