A Very Brief Introduction To Options

Foreword from ShareInvestor

This article “A Very Brief Introduction To Options” by Cai HaoXiang was first published in The Business Times on 08 Aug 2016 and is reproduced in this blog in its entirety.

A nil-paid right can be thought of as being akin to a financial option.

Options are contracts that give you the right, but not the obligation, to buy (“call option”) or sell (“put option”) an underlying asset at a certain price (“strike price”) at a date that can be fixed (“European-style”) or any time up till the expiration date (“American-style”).

There are many ways to value how much an option is worth. Two that crop up are the binomial and Black-Scholes methods.

More simply, option valuation is based on two simple ideas: intrinsic value and time value.

Options have intrinsic value if, upon the exercise of the option, the price of the underlying asset they are supposed to be converted into is higher than the strike price.

This was the value we discussed for nil-paid rights. If Noble mother shares are trading at S$0.20 and you have an option to buy the stock at S$0.11, you can theoretically sell the option for S$0.09.

Options also have time value. This is harder to derive fundamentally, though it can be thought of as the difference between the option price and its intrinsic value.

So on the first day of Noble rights trading, the nil-paid rights had a positive time value of one cent.

To estimate the time value of an option, one needs to know how much time it has to expiry, as well as volatility of the underlying stock.

The more volatile a stock is, the higher the chance of it moving in a direction favourable to the option buyer or seller. Volatility increases option value.

Interest rates and dividend payments can also affect the value of an option.

However, the underlying asset price, volatility and time to expiry are still the most important.

Options are traded on exchanges like the Chicago Board Options Exchange (CBOE), the world’s largest options exchange.

By browsing its quotes, one can observe intrinsic and time value in action, together with potential gains or losses. For example, on July 25, a day before Apple’s third-quarter earnings were due to be announced, the American-style call option on Apple stock that expires Aug 19 with a strike price of US$97.50 last traded at US$2.14.

Apple’s stock closed at US$97.34 that day. So there was no intrinsic value and perhaps US$2 worth of time value. A call option on Apple stock with a similar strike price of US$97.50 that expires in Nov 18, meanwhile, was going for US$4.65, suggesting the longer time period allows a better chance for Apple stock to trade above the strike price, making the option dearer.

Apple stock would soar after its earnings were announced, trading at US$104.21 by the end of the week, up 7 per cent. The US$97.50 options are now “in the money”. This means one can exercise the option to buy Apple shares for US$97.50, and immediately sell the shares for a profit. Though to profit from the option one’s cost to acquire it has to be less than one’s profit from selling the shares.

The Aug 19 call option mentioned earlier went up correspondingly from US$2.14 to US$6.78, more than tripling in value. Intrinsic value now made up the bulk of the option’s value, while time value fell to just a few cents. The Nov 18 option went up similarly in absolute terms but proportionately less, from US$4.65 to US$8.94, with time value there falling to around US$2.