of its value rather than a dollar amount. Returns can be scaled over any time frame (daily, monthly, annual), with calculations typically calling for daily returns. The two most common types of returns are simple returns, represented as a percentage and calculated using Equation (1.1), and log returns, calculated using Equation (1.2). The logarithm's mathematical definition and properties are covered in the appendix for those interested, but that information is not necessary to know to follow the remainder of the book.
where
An option is a type of financial derivative, meaning its price is based on the value of an underlying asset. Options contracts are either traded on public exchanges (exchange‐traded options) or traded privately with little regulatory oversight (over‐the‐counter [OTC] options). As OTC options are nonstandardized and usually inaccessible for retail investors, only exchange‐traded options will be discussed in this book.
An option gives the holder the right (but not the obligation) to buy or sell some amount of an underlying asset, such as a stock or ETF, at a predetermined price on or before a future date. The two most common styles of options are American and European options. American options can be exercised at any point prior to expiration, and European options can only be exercised on the expiration date.1 Because American options are generally more popular than European options and offer more flexibility, this book focuses on American options.
The most basic types of options are calls and puts. American calls give the holder the right to buy the underlying asset at a certain price within a given time frame, and American puts give the holder the right to sell the underlying asset. The contract parameters must be specified prior to opening the trade and are listed below:
● The underlying asset trading at the spot price, or the current per share price
● The number of underlying shares. One option usually covers 100 shares of the underlying, known as a one lot.
● The price at which the underlying shares can be bought or sold prior to expiration. This price is called the strike price
● The expiration date, after which the contract is worthless. The time between the present day and the expiration date is the contract's duration or days to expiration (DTE).
Note that the price of the option is commonly denoted as C for calls, P for puts, and V if the type of contract is not specified. Options traders may buy or sell these contracts, and the conditions for profitability differ depending on the choice of position. The purchaser of the contract pays the option premium (current market price of the option) to adopt the long side of the position. This is also known as a long premium trade. The seller of the contract receives the option premium to adopt the short side of the position, thus placing a short premium trade. The choice of strategy corresponds to the directional assumption of the trader. For calls and puts, the directional assumption is either bullish, assuming the underlying price will increase, or bearish, assuming the underlying price will decrease. The directional assumptions and scenarios for profitability for these contracts are summarized in the following table.
Table 1.1 The definitions, conditions for profitability, and directional assumptions for long/short calls/puts.
The relationship between the strike price and the current price of the underlying determines the moneyness of the position. This is equivalently the intrinsic value of a position, or the value of the contract if it were exercised immediately. Contracts can be described as one of the following, noting that options cannot have negative intrinsic value:
● In‐the‐money (ITM): The contract would be profitable if it was exercised immediately and thus has intrinsic value.
● Out‐of‐the‐money (OTM): The contract would result in a loss if it was exercised immediately and thus has no intrinsic value.
● At‐the‐money (ATM): The contract has a strike price equal to the price of the underlying and thus has no intrinsic value.
The intrinsic value of a position is based entirely on the type of position and the choice of strike price relative to the price of the underlying:
● Call options
● Intrinsic Value = Either
● ITM:
● OTM:
● ATM:
● Put options
● Intrinsic Value = Either
● ITM:
● OTM:
● ATM:
For example, consider a 45 DTE put contract with a strike price of $100:
● Scenario 1 (ITM): The underlying price is $95. In this case, the intrinsic value of the put contract is $5 per share.
● Scenario 2 (OTM): The underlying price is $105. In this case, the put contract has no intrinsic value.
● Scenario 3 (ATM): The underlying price is $100. In this case, the put is also considered to have no intrinsic value.
The value of an option also depends on speculative factors, driven by supply and demand. The extrinsic value of the option is the difference between the current market price for the option and the intrinsic value of the option. Again, consider a 45 DTE put contract with a strike price of $100 on an underlying with a current price per share of $105. Suppose that, due to a period of recent market turbulence, investors are fearful the underlying price will crash within the next 45 days and create a demand for these OTM put contracts. The surge in demand inflates the price of the put contract to $10 per share. Therefore, because the put contract has no intrinsic value but has a market price of $10, the extrinsic value of the contract is $10 per share. If, instead, the