In order to understand how options work in practice it is necessary to go back to the most fundamental financial dynamic: the balance between expected return and risk. The problem for all investors is that it is only possible to receive a higher expected return if one also is prepared to take on more risk. But what is acceptable risk – and how should it be managed?

For a financial player the risk is that one a position never guarantees a return. This uncertainty about the future value of an asset is a central issue within all investment decisions. A measure of an asset’s risk in this context is price movements or volatility, which refers to the average deviation from the asset’s historical average value change. In other words, the risk of a stock is dependent on how much and how fast the price moves on the exchange. The problem is that risk is not entirely uniform. A stock portfolio is usually connected to three different types of risks; company risk, industry risk and market risk. The company and industry specific risks – basically all those factors that can affect the unique company or its whole industry negatively – can be eliminated through diversification, achieved mainly by including stocks from several companies from different industries in the portfolio. The third risk, the market risk, is common for all assets on the market and can not be diversified away.

For options the situation is different, since options do not imply the purchasing of assets. Instead, one invests in the opportunity to share the future price change of a stock. Thereby completely new rules are introduced in comparison with trading stocks only – rules that for an outsider just may seem risky and complicated, but which the initiated find as logical as any other mathematical dynamics.

The value of an option is determined by its chance to be exercised with profit on the expiry day. This consists of two parts: the real value and the time value. The real value is the value that is possible to ‘touch’. A call option has a real value if the underlying stock’s price exceeds the option’s strike price. For put options it is the other way around, in that they have real value if the strike price instead exceeds the value of the stock. Conversely the time value is the value of the possibility that good news will occur during the time to maturity in order for an option to have a real value on the expiry day. Time value changes during the maturity period and will always be zero on the expiry day. Options that have a real value are said to be ‘in the money’ and are called plus options by professionals, while options that completely miss real value are ‘out-of-the-money’ and are referred to as minus options. Options where the strike price and stock price corresponds are ‘at-the-money’ and are called pari options.

The value of the option can be estimated with a mathematical formula named Black & Scholes after its inventors. In the formula the price is calculated as a function of the underlying stock value, the strike price, the time to maturity and the level of the risk free interest rate, among others. All terms in the equation can be determined relatively easy except one: the stock’s volatility. The risk measure that is interesting when one deals with options is the so called ‘implied volatility’, which contains the premium that the market has set on the option. Contrary to historical volatility, implied volatility measures the market’s expectations on the future changes in the stock price. This is crucial, as it is when an investor has a different opinion to the general market about the future risk of a stock that it becomes possible to enter and make money from an option, since its premium then will be different than what it ‘should’ be.

There are a large number of strategies that one can use in order to profit from the possibilities of options. Learning the differences and advantages between different options is critical to success, as options can appear superficially similar. It is seldom enough just to look at the option’s premium and the strike price. Real professionals also look at how sensitive the options are for the market climate. By using Black & Scholes’ formula one can derive several important sensitivity measures – commonly mentioned as ‘the Greeks’ since they have been provided with Greek letters – that can clearly tell how an option will react from different market conditions.