Read an option's payoff and its main Greeks, and use implied volatility as information about a stock.
Before a company reports results, plenty of people will tell you what they think the shares will do. You can see what the market as a whole expects without asking anyone, because option prices carry that expectation in a figure you can look up. Options are covered here only to the depth you need to read their prices. Nothing below recommends trading them, and options carry risks that can exceed the money you put in.
Marcus follows a US chip designer. A week before the company reported results, he noticed on its options page that options expiring just after the results were priced much higher than usual, as if someone expected a large move but did not know which direction. The day after results, the shares barely moved and those option prices collapsed. No one needed to tell Marcus what the market expected, because the option prices had already shown it.
A call option gives the buyer the right, but not the obligation, to buy a share at a set price, called the strike, on or before a set date. A put option gives the buyer the right to sell at the strike. Each US equity option contract usually covers 100 shares. The buyer pays the seller a price for the option, called the premium.
Say Marcus's chip designer trades at US$150 (this and the figures that follow are invented examples). A one-month call with a strike of US$150 costs about US$7 a share. If the shares end the month at US$170, the call is worth US$20, and the buyer's profit is US$13 a share after the US$7 paid. The buyer breaks even at US$157. At US$150 or below, the call expires worthless and the buyer loses the US$7.
A one-month put with a strike of US$140 costs about US$2.70. If the shares fall to US$130, the put is worth US$10 and the profit is US$7.30. Above US$140, the put expires worthless.
To value any option at expiry:
For a call, take the share price minus the strike. If that is not positive, the value is zero. For a put, take the strike minus the share price. If that is not positive, the value is zero. Your profit is that value minus the premium you paid.
The seller's payoff is the mirror image of the buyer's. The seller of the US$150 call keeps the US$7 if the share price stays below US$150. Above US$157 the seller starts losing money, and a call seller's loss has no limit as the share price keeps rising.
Option prices move constantly, and traders describe the movement with measures called the Greeks. Two of them, delta and theta, cover most of what you need.
Delta is how much the option price moves for a one-dollar move in the share. The US$150 call has a delta of about 0.53, so if the shares rise US$1, the call rises about 53 cents. Delta is also a rough guide to how likely the market thinks the option is to finish in the money, and 0.53 is close to even odds. Puts have negative deltas: the US$140 put has a delta of about minus 0.25.
Theta is time decay, the value the option loses each day if nothing else changes. With a month to go, the US$150 call loses about 12 cents a day. Time decay speeds up as expiry approaches, which makes buying options and waiting expensive, since time works against the buyer every day the option is held.
Five things go into an option price: the share price, the strike, the time to expiry, interest rates, and how much the share will swing before expiry. Only the last is unknown, so the market has to put a price on it.
Implied volatility is the volatility figure that makes a standard pricing model produce the option's market price. It is the market's price for future swings, quoted as a yearly figure like the volatility in Lesson 2.1, "Volatility: what standard deviation captures and what it misses".
A yearly figure is hard to picture, so convert it to a typical daily move. Take the annual implied volatility and divide it by the square root of about 252, the number of trading days in a year. An implied volatility of 40% means a typical daily move of about 2.5%. At 60%, the typical daily move is about 3.8%.
Implied volatility rises before scheduled events such as results, because a big move is known to be possible. It also rises in market sell-offs, because investors pay up for protection. The VIX index is built from the implied volatility of S&P 500 options and is widely called a fear gauge; Module 10 mentions it again.
When the event passes, implied volatility usually collapses, and option values fall even if the shares do not move. Traders call this a volatility crush. Before results, Marcus's one-month US$150 call had an implied volatility of 60% and cost about US$10.50. The day after results the shares were unchanged, implied volatility had fallen to 35%, and the call was worth about US$6.10. A buyer lost about 40% with the share price where it started.
A high implied volatility before results tells you the size of move the market is already pricing in. Divide it by the square root of 252 to turn it into the typical daily move the market expects around the announcement.
Selling options for income is widely marketed. Most months the option expires worthless and the seller keeps the premium, so the returns look smooth.
Take the stock at US$150 again. Each month you sell a put with a strike of US$130 and collect US$2 a share. For a year or two the stock never falls below US$130 and you keep every premium. Then the company issues a profit warning and the shares drop to US$100. You must buy at US$130 shares now worth US$100, a loss of US$30 a share, or US$28 after the US$2 premium. That one month wipes out fourteen months of income, since 14 months at US$2 is US$28.
Option selling produces many small gains and an occasional large loss, the return shape Lesson 2.3, "Sharpe and Sortino ratios, and when each misleads" warned about. The income looks steady because the large loss is rare, though the risk of it is present in every month you sell.
Your broker's options chain for a large US stock shows implied volatility for each strike and expiry. Look up the at-the-money figure just before and just after the company's last results and note how it changed.
Find the implied volatility of one large US stock before and after its last results, and write down how it changed.
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