Options, one form of an equity linked derivative, used to be the purvey of the wealthy and sophisticated investors. Traders used them for one way short term bets or bets on volatility, while portfolio managers used them for hedging purposes. Nowadays, options investing has gone mainstream. Retail investors have piled into options, so much so that they seem to be causing new market dynamics for these securities.
Wall St. can’t even keep up. Many market watchers like myself were amused at recent stories that explained how institutional investors like Prudential and traders like Susquehanna have turned to Reddit and Twitter to gauge how retail investors may be trading. They call it momentum data collecting, but it’s essentially combining traditional market data with scrolling through Twitter and up until a few months ago, analyzing Robintrack.net to pick up on momentum trends of retail investors.
2020 has been the year of the retail investor in general. In plain old stocks, or cash equities in Wall St. terminology, retail investors now make up almost 20% of trading. This is a change from around 15% in recent years and has doubled since just after the financial crisis.
Source: Wall Street Journal
However options trading is up 80% year over year from August 2019 at 18.4 million contracts according to the CBOE. YouTube even offers tutorials for novice investors on how to purchase options on apps like Robinhood.
It’s pretty easy to tell who is driving the market by the types of contracts they buy. Large institutional investors usually don’t buy small lots, a lot being an option that represents 100 underlying shares, but options on 10 lots or less has been driving as much as 60% of all trades in the market as described by Baron’s.
Source: Bloomberg
Is there danger though in this new interest in options? Do investors really understand what it is they’re buying and the risks it entails? Or could we start to see the diffusion of tactics like using options to hedge or amplify returns in the same way that the wealthy or professional portfolio managers have been utilizing for years?
Options Basics
For those that are unaware, it first helps to understand what a stock option is.
An option represents the ability to buy or sell a lot of underlying shares at a particular price. An option to buy a share at a particular price is a call option and option to sell a share at a particular price is called a put option. Options have expiration dates covering a certain time period which could be a week a month or over a year, but they do expire at some time. This is best explained with an example.
Let’s say you bought 1 call option on 1 share of Apple with an expiration date of March 15, 2021. Apple trades around $116 a share today. All options have a strike price above, below or at the current price. The strike price is the fixed price at which you can exercise the option. If the price anytime before that expiration rises above the strike price of the call, the call now has value and the term for this is that the option is “in the money”. Let’s say in this case the strike price is $117 a share. Once the underlying share price is above this price before expiration, you can exercise the call option and receive the underlying shares for $116 each or you can just sell the call on the open market to another buyer.
Most retail investors will never actually exercise the options. This would mean they have to have the capital to be able to purchase the underlying shares. In the example above, this would mean for a 1 lot trade of call options, the person who exercises the option would have to be able to purchase $11,600 worth of shares of Apple. You can also sell the option in the market before it expires, this is what most investors end up doing.
How to Value Options and When They Make a Profit
One of the more confusing elements for new traders to options is how they are priced. I won’t get too into the theory but what I find interesting about financial markets sometimes is that usually the practice comes first and the theory follows it. This was the case for options, which were traded for many years before any academics came up with a theory to how they were priced.
But first the basics, let’s stay with our example of Apple shares at $116 a share and 1 lot of options contracts. Let’s now assume that the strike price on an option which expires on March 15, 2021 is $115 instead of the $117 we used before. Since it has an identifiable value immediately of $1 per share, this option would be called in the money. The premium is what you pay to buy a the option and is priced based on the value per share. You may see this option premium quoted as $2.00, which would mean to buy one contract you need to pay $200. If you were to exercise the contract now, receive the underlying shares then sell them immediately, you would actually have a loss of $100, so why isn’t the contract priced at $2.00 per share and not $1.00 per share?
That gets into a bit of the theory, which breaks options pricing up into extrinsic and I intrinsic value. The difference between the $115 strike price and the $116 price of shares today is called the intrinsic value. The extra $1.00 on top of that for the premium is called the extrinsic value.
Although the extrinsic value was observed for many years, it’s wasn’t until the Black-Scholes model came along were people actually able to have a testable model to estimate what the price should be. However, this model only works for European options, which can be exercised only on a single date. American options can be exercised anytime prior to expiration so we still only have basic underlying theories as to how they are priced.
The generally accepted theory is that there are time and volatility components to the extrinsic value. Greater time to expiration and greater volatility mean higher extrinsic value. Why time? Because time means the underlying stock has more time to go way up or way down before the option expires and this has value to the holder. This value will fall over time as the option moves closer to expiration, this is sometimes referred to as decay. On the other end, higher volatility means prices could go up and down but on any given day the stock could have large swings in any direction. This makes the option more valuable to the holder because they can take advantage of these swings to sell the option for a profit.
Either way, you need the option to increase in value above the premium you paid which includes both the intrinsic and extrinsic value. Once you are above that premium, you get the same payoff as if you were holding that underlying $11,600 worth of Apple stock. This is why options investing has become so hot with retail investors, it allows those with little capital to get the payoffs if someone with much more capital. With that payoff comes greater risk. A holder of the shares has an unlimited time horizon and can eventually make back the value of what they lost if the stock later goes up. If options expire with no value, then the holder loses all of their money. The payoff chart of a call option is one of the basic charts learned by traders and finance students and can be seen below. The flat part represents the cost paid for the premium, once the stock price rises above that, the return jumps up quickly. Below the strike price as well as the break even price (where the return equals intrinsic and extrinsic value) the holder loses money but at a maximum loss. Above this, the upside is unlimited.
Source: optiontradingtips.com
Of course, what I have explained is just on a simple call option on a security. I haven’t even gone into puts, which protect you on the downside or combining puts and calls or combining puts and calls with holding (or shorting) the underlying stock. Once you understand the basics of how calls work you can get into these more advanced techniques.
Why Now?
So the question becomes then, why now is it that so many retail investors have embraced options when they have been around for so long? Some speculation in the mainstream press has centered around people being out of work and wanting to gamble on the stock market but here I believe Robinhood deserves some innovation credit. The layout and the simplicity of how options are displayed makes it intuitive and simple to understand, at least from the 10,000 foot view. Popular stocks are displayed with the current price, the option strike prices, premiums and the return needed until they are profitable shown. This is an extremely user friendly way to display option pricing which also belies the bit of complexity when it comes to pricing that I described above. It actually could be that simple: that a user friendly and intuitive display, combined with zero commission trading has done more for the options market than any retail innovation before it.
Source: warriortrading.com
However, as with many things today, I am painfully aware of the short attention spans of many people and the lack of patience for learning that is required for more complex topics. Options trading definitely falls within this category. If retail investors are too heavily weighted towards being long on call options, volatility to the downside could wipe out huge numbers of those retail investors. Not having the skills to hedge or at least understand why they lost all their money may burn a whole new generation of investors that is just starting to dip their toes into this type of investing.
The other point to note is that with all these new investors to options trading, they have yet to experience the tax bill for profitable options trades, which won’t come due until next year. Holding a stock or bond for over a year allows one to reap substantial tax benefits in the form of being taxed as a long term investment whereas payoffs on all options are taxed on a short term basis. There could also be additional taxes assessed by state governments meaning that those payoffs you see people bragging about on r/wallstreetbets could be taxed as high as 50% in some places, not exactly the bragging rights some people were looking for.
So if you are interested in options or already trading them, the good news is that more and more great and free resources are becoming available to teach you how to value and trade options, but don’t think there is some secret to trading them or they will be a new investing holy grail that Wall St. has kept away from the masses this whole time. Risk to go with the reward is ever-present in the markets, knowledge and taking personal responsibility are your best friends.
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