You will be able to read an option's payoff and the main Greeks, and use implied volatility as information.
A week before his US chip designer reported results, Marcus noticed something odd on its options page. The price of options expiring just after the results was much higher than usual, as if someone expected a large move but didn't know which way. The day after the results the shares barely moved, and those option prices collapsed. Nobody had to tell him what the market expected. The options prices had already said it.
This lesson teaches options to the depth you need to read their prices. It doesn't recommend trading them, and options carry risks that can exceed the money you put in.
A call option gives the buyer the right, but not the obligation, to buy a share at a set price, the strike, on or before a set date. A put option gives the right to sell at the strike. Each US equity option contract usually covers 100 shares, and the buyer pays the seller a price for it, the premium.
At expiry, a call is worth the share price minus the strike if that's positive, and nothing if it isn't. A put is worth the strike minus the share price if that's positive, and nothing otherwise.
Here are made-up figures for Marcus's chip designer at US$150. A one-month call with a strike of US$150 costs about US$7 a share. If the shares end at US$170, the call is worth US$20 and the buyer's profit is US$13 a share. At US$157 the buyer breaks even. 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, a profit of US$7.30. Anywhere above US$140 it expires worthless.
The seller's payoff is the mirror image. The call seller keeps the US$7 if the price stays below US$150, and loses without limit as it rises above US$157.
Option prices move every second, and traders describe how with a set of measures called the Greeks. Two of them 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. Puts have negative deltas: the US$140 put's delta is about minus 0.25. Delta is also a rough guide to how likely the market thinks the option is to finish in the money, so a delta of 0.53 sits close to even odds.
Theta is time decay: how much value the option loses each day if nothing else changes. The US$150 call loses about 12 cents a day with a month to go, and decay speeds up as expiry approaches. That's why buying options and waiting is expensive. Time works against the buyer every day.
The inputs to an option price are mostly known: share price, strike, time to expiry and interest rates. The one nobody knows is how much the share will swing. Implied volatility is the volatility figure that makes a standard pricing model produce the option's market price. It's 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.
You can turn it into a daily move. Divide implied volatility by the square root of about 252 trading days. An implied volatility of 40% means a typical daily move of about 2.5%. At 60% it's about 3.8%.
Implied volatility rises before scheduled events, such as results, because everyone knows a big move is possible. It rises in market sell-offs, because investors pay up for protection. The VIX index, which module 10 mentions, is built from the implied volatility of S&P 500 options and is widely called a fear gauge for this reason.
Here's what happened to Marcus's options page, with made-up figures. Before results, implied volatility on the one-month US$150 call was 60%, and the call cost about US$10.50. The day after, with the shares unchanged, implied volatility fell to 35% and the call was worth about US$6.10. The buyer lost about 40% without the shares moving at all. Traders call it a volatility crush. The lesson for reading prices: a high implied volatility before results is the market telling you the size of move it's already pricing in.
Selling options for income is widely marketed. Sell a put, collect the premium, and most months the option expires worthless and you keep the cash. The return looks smooth.
Run it with made-up figures. Each month you sell a put with a strike of US$130 on a stock at US$150 and collect US$2 a share. For a year or two, the stock never falls below US$130 and you collect every month. Then one month the shares drop to US$100 after a profit warning. You must buy at US$130 shares worth US$100, a loss of US$30 a share, less the US$2 premium: US$28. That one month wipes out fourteen months of income.
This is the shape lesson 2.3, Sharpe and Sortino ratios, and when each misleads, warned about: many small gains and an occasional large loss. The income looks steady because the risk is rare, not because it's absent.
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 for one large US stock before and after its last results and note how it changed.
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