Understanding Stock Option Premiums

Understanding Stock Option Premiums

Some people have a knack for languages. Not me. After living for a year in Japan, the best I could muster was a very basic: ‘Where is the train station, please?’

Sure enough, a handy phrase in a country dominated by rail travel. If you could find the local station, there was always a way home. I picked it out of a traveller’s guide on the flight over, and used it countless times.

The other phrase I mastered was less useful. After playing touch rugby with a few other ex-pats one afternoon, I learned another phrase: ‘Four beers please’. Great if you’re sitting with three other chaps; not such a good look sitting on your own.

The rot started much earlier, when I was (forcibly) enrolled in high-school French. The teacher quickly assessed me as a dullard, and sought to teach me other things. Like odds and probability theory. As it turned out, he had a keen interest in horses.

One of his underlying theories was that you don’t need to be an expert in horses to bet on them. That job, he said, belongs to the bookmaker. It is they that need to know each horse’s form, and how they perform at different tracks and in different conditions.

As it’s their capital on the line, the bookmakers’ livelihood (and longevity) depends on their calculation of the odds. Get the odds wrong, and they could be hit for a big payout. He believed the bookmakers’ odds were the best way to assess the value of a horse. The bookmakers’ odds attach a probability to the likelihood of a horse winning or placing in the top three.

He wasn’t the type to take an early-morning drive to his local track to check out the form in his smoky Citroen.

One of his strategies was based on the idea that punters eliminate those horses from the field whose odds tell you that they have little to no chance of winning. In other words, the long shots. He then spread his bets around those with much more modest odds.

I have no idea how his theory played out — it sounds way too simple to me. The only thing I know about race horses is that I can’t afford one. But, just as some are tempted to punt on horses with long odds, so, too, do some investors when they trade options.

What are the chances?

When some look at option premiums, they’re tempted to try and buy options as cheap as they can. A call option with a strike price way above the share price might only trade for a few cents.

Buying options at this level ­— a long way out-of-the-money (OTM) — can enable an option buyer to really leverage their position. They can buy a lot of option contracts with their capital. A lot more than if they had bought options much closer to the current share price.

The issue is that there is a lot less likelihood of the options having any value at expiry. The further out the strike price, the less chance the option will have value at expiry, and the less premium the option writer will command.

For the option to have any value at expiry — that is, intrinsic value — the share price has to move beyond the strike price, plus the size of the premium (for a call option). And for a put option, the share price has to fall below the strike price, minus the premium.

Of course, there’s always the possibility that a share price will do this, much in the same way that a long shot could potentially win a race. But it’s an unlikely event; one with a low probability.

Another way to view an option premium is the probability of success. Negligible premium equates to a low-probability event.

A trader might think to buy an option that is a long way OTM with the intention of selling it again should the share price spike. But there is another characteristic of options that limit the success of this strategy. And it’s called the delta.

What’s in a delta?

The delta measures how much an option price moves in relation to the underlying share price. The deeper an option is in-the-money (ITM), that is, the more intrinsic value it has, the closer it moves in sync with the share price.

Delta is another way option traders determine the probability of an option having intrinsic value (ITM) at expiry. An option whose strike price is close to the share price — an at-the-money option — will have a delta of around 0.5 for a call option.

It means that its value increases at around half the rate of the underlying share. And that there’s approximately a 50% probability that it will expire in-the-money.

It’s a probability, though, and not a certainty. Incidentally, an ATM put option has a negative delta of 0.5. The option premium decreases in value as the share price increases.

An option that is a long way OTM has a low delta. As such, the share price has to move a long way for the option premium to move a little. That’s another reason buying cheap OTM options is a low probability trade. There’s much less chance of profiting, even if the share price moves the right way.

My French teacher never succeeded in helping me navigate the mysteries of his much-loved language. Quite why nouns have their own gender will always be beyond me. But his tips on probability have stayed with me for a very long time. Who’d have thought I’d be using them to trade options?

All the best,

Matt Hibbard,
For Markets and Money

Matt Hibbard

Matt Hibbard

While many investors chase quick fire gains, Matt takes a different view. He is focused on two very clear goals. First: How to generate reliable and consistent income in a low-interest rate world. And second, how you can invest today to build wealth over the next 10–15 years.

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