Lessons from the Pros


The Yin and Yang of Options

Yin and Yang? Are they Greek? No, they’re not. But the Greeks do measure certain characteristics of options, and each one of those characteristics affects the two parties to an option contract in equal and opposite ways, like Yin and Yang.

Over the last year I’ve written on many topics related to options, from very basic to fairly advanced. Today I’d like to go back to the basics a bit, and talk about some of options’ underlying concepts.

First, it’s crucial that we understand that an option contract has two parties or sides, an option seller and an option buyer. What an option buyer buys, is a right to make a certain transaction. A Call buyer has bought the right to purchase an underlying asset at a guaranteed price. A Put buyer has bought the right to sell the underlying asset at a guaranteed price. In both cases (call and put) there was an option seller and that seller is now obligated to make that transaction if called upon.  The call seller guarantees to deliver the underlying asset to the call buyer and accept the guaranteed price.  The put seller guarantees to take delivery of the underlying asset from the put buyer and pay the guaranteed price – even if that transaction would be at a loss to the option seller. The option seller is compensated for his possible loss, by receiving money for selling the option.

In most cases, the change in the option’s price is the point of the trade, and the actual transaction in the underlying asset never occurs. Most call buyers never take delivery of the underlying asset, and most put buyers never deliver the underlying asset. They don’t have to, because most option contracts are closed out (offset) before they expire. And with some options, even if they are held until expiration, no physical delivery is even possible. We can buy options on the S&P 500 index (SPX), for example. (I don’t mean options on the tradable SPY exchange-traded fund here, I mean options on the SPX index itself). Since the SPX index is only a mathematical calculation, based on the prices of 500 stocks, the index can’t be owned, bought or sold. It can only be calculated and observed. But we can make bets as to what its level will be. That’s what an index option is. For these options, the option buyer’s and seller’s gain or loss is calculated as if the physical delivery were possible; then for whatever index options are still outstanding at expiration, the winner is paid in cash by the options clearing house and the loser’s account is charged. So wins and losses on the options are made, with no underlying asset ever changing hands.

In a very real sense that’s what every option is – a bet as to a future price level. And like any two-sided bet, every option contract has a winner and a loser. What is won by one side is lost by the other. This is the definition of a zero-sum game.

Strictly speaking, each side also pays a bit for the privilege of trading the option, in the form of the option market-maker’s bid-ask spread and the broker’s commissions. So from the point of view of the option traders it’s actually a slightly negative-sum game.

In options there is another slight wrinkle. In the process of the creation of each new option contract, a clearing house (in the United States, this is the Option Clearing Corporation, or OCC) inserts itself between the buyer and the seller. Both the buyer’s and the seller’s contract is now with the OCC, not specifically with the other party.

Because the option buyer and seller are now separated, either of them can opt out of the contract at any time, without affecting the other party. The option buyer/owner can transfer her right to someone else, simply by selling the option she bought. She may have a profit or a loss, depending on the value of the option at the time she sells it. The new buyer then has the same rights as the original owner. The original option seller still has the same obligation as before, and is not affected in any way.

The original option seller, too, can choose to abandon the arrangement at any time, by buying back (buying to close) the option at its then-current market value. The seller’s obligation has then been transferred to another party. The option seller too may have either a profit or a loss, depending on how much he has to pay to buy back the option.

A certain amount of money was paid by the option buyer (who may have been either a trader or a market maker) to the option seller (who also may have been either a trader or a market maker) to open the contract. From that point in time until the option’s expiration, the value of the option – the amount for which the option buyer/owner could sell it, or that the option seller would have to pay to buy it back – fluctuates. At any given instant, the option’s value is quoted in the market. Either side can buy or sell it at the current price, taking his profit or loss.

The causes of the change in the value of an option are three things:

–        Change in price of the underlying asset

–        Passage of time, as the option contract gets closer every day to its expiration

–        Supply/demand for the option, based on market expectations of volatility

All three of these forces act interdependently to move option prices. Each trader is expressing some opinion (whether he knows it or not) about how each of them is going to affect the option’s price when he enters a trade. Whichever side’s expectations turned out to be more correct will be the winner.

Each of those three forces has a measure, with a Greek letter as its name. If we have a strong opinion about any one of the three, we can make a trade based on that opinion. The Greeks tell us just how much we can get paid for having the right opinion. More about that next week.

For comments or questions about this article contact me at rallen@tradingacademy.com

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

Join over 170,000 Lessons from the Pros readers. Get new articles delivered to your inbox weekly.