Investors who have utilized option contracts know that their prices can change drastically, often in a manner that may be unexpected to the untrained eye. Academics and many practitioners rely on sophisticated pricing tools such as the Black-Scholes model to estimate the value of an option. However, a key variable in any option pricing model is an assumption of future stock price volatility, which is extremely difficult to predict, particularly over the relatively short life of most option contracts. We will spend the majority of this piece walking through the forces that influence option pricing and returns in a more practical and user-friendly way, but nevertheless, the Black-Scholes model is briefly discussed below for context.
The Black-Scholes model for option pricing incorporates five key input variables:1. The strike price of an option contract2. The current stock price3. The contract’s time to expiration4. The risk-free interest rate5. The expected volatility of the underlying stock
The Black-Scholes formula is shown below for context, but like most other complex formulas, we typically rely on software tools such as the Bloomberg terminal to calculate an expected “fair” price for the option using constantly updated inputs.
Within the five key input variables to the BSM listed above, most are easy to observe and are not subjective. However, one variable, expected volatility, is very subjective. Practitioners will use this component of the BSM to estimate what other market participants expect the volatility of the contract’s underlying stock to be based on the current option price and the other four input variables. If the option trader believes that the stock has the potential to move to a greater degree than is implied by the expected volatility of the BSM, then the option is underpriced. If the trader believes that the stock will fluctuate less than is implied by the implied volatility derived from the BSM, then the option contract is overpriced.
At the very basic level, each option has an intrinsic value (“moneyness”) and extrinsic value (“time value”). The intrinsic value represents to portion of the option that is in-the money; meaning the amount of the contract premium that is represented by the value of the option if it were to expire immediately. For example, if an investor held a call option with a contract value of $8 and an exercise price of $100 per share when the underlying stock was trading for $105, then $5 of the $8 premium represents the contract’s intrinsic value (moneyness) and the remaining $3 represents its extrinsic value. Of course, many options do not have any intrinsic value (they would be worth zero if expiring today), so their entire premium represents hope of future profitability.
Extrinsic value is often referred to as time value because it is an estimate of what an investor should be required to pay for the right to the option’s potential to earn additional profit beyond the intrinsic value based on considerations such as time to contract expiration and the expected volatility of the underlying stock. All else equal, more time left until maturity and a more volatile stock should result in a higher time value of the option. In other words, greater time and volatility can lead to larger movements in the underlying stock and larger changes in value of the option contract, thus it should cost more to buy today.
In our next piece, we will further break down some of the components of an option contracts extrinsic value, often referred to as “the greeks”.
When seeking to understand the factors that influence an option contract’s premium value (price), the intrinsic value (moneyness) is relatively easy to understand (the amount of the premium that would be earned if the contract expired today). But, the option’s extrinsic value (time value) can be more nuanced and challenging. Practitioners often look to “the greeks” to help understand the forces having the most significant impact on an option’s time value. They are collectively referred to as the greeks because of their reference to components of the Greek alphabet:
Rho
Rho may be the most simple and least impactful factor that influences an option’s extrinsic value. It represents the rate of change between an option contact’s value and a 1% change in the risk-free interest rate (e.g., the rate on short-term US Treasury bills). For example, an option with a premium of $1.00 and a rho of 0.05 would increase to $1.05.
Delta
Delta is a measure of the expected movement in an option’s price based on the movement of the underlying stock. It is expressed in a range of 0 to 1 for call options and 0 to -1 for put options. For example, if a call option has a delta of 0.5 and its underlying stock increases in value by $1, then the option premium should increase by $0.50. An option with greater intrinsic value (moneyness) is expected to have a higher delta and will move more like the underlying stock, particularly for options that are very in-the-money and near expiration.
Gamma
Gamma may be the most complex of the greeks, as it is the only “second derivative”, meaning it is a function of delta. It represents the rate of change between the option’s delta and the underlying stock as the option moves closer-to or further-away-from the contract’s exercise price. In other words, as a contract moves further toward being profitable at expiration, it’s delta will increase at a faster rate. This non-linear rate of change is measured by gamma. Gamma indicates the amount the delta would change given a $1 change in the price of the underlying stock. For example, assume an investor owns a call option with a delta of 0.50 and a gamma of 0.10. If the underlying stock were to increase by $1, then the call option would increase by $0.50 because of the existing delta, but the delta itself would also increase by 0.10 to 0.60, so the option will have greater delta sensitivity to the next $1 move higher in the underlying stock’s price.
Vega
Vega can be thought of as the sensitivity of an option contract’s price to changes in the implied volatility of the underlying stock. For example, an option with a vega of 0.10 indicates that itsvalue is expected to change by $0.10 for every 1% change in implied volatility. Increased volatility indicates that the underlying stock should have a wider range of expected outcomes, which makes the option more valuable.
Theta
Theta represents the sensitivity of an option contract’s price to the passage of time. Theta is always negative because the value of options continuously declines as the time to expiration decreases, all else equal. For example, an option contract with a value of $1.00 and a theta of -0.05 would lose $0.05 with each passing day. Interestingly, time does not decay an option’s value in a linear fashion. For example, the impact of theta on an option expiring in 11 months vs. 12 months is fairly similar because, despite having an entire month difference in contract life,each option still has a very significant amount of time for the underlying stock to change in value. However, an option expiring tomorrow would be expected to have a much larger theta than an option expiring in one month because the first option’s range of outcomes is effectively limited to how much the underlying stock can change in one day. For options that are near-the-money (the underlying stock is trading close to the contract’s exercise price), theta tends to have a more modest erosion of premium value the further the option is from expiration, but the impact of theta increases at a more rapid rate as the option approaches expiration.
Because of rising fertilizer prices, farmers are planting more soybeans than corn. Soybeans are a legume, meaning that they can fix their own nitrogen in the soil, meaning that they need less nitrogen fertilizer, the price of which is spiking due to rising natural gas prices. Corn, in contrast, needs more nitrogen than most other crops.
High gas prices are rising because of Putin’s war on Ukraine, which is also preventing Ukrainian farmers from planting this year’s wheat crop, while sanctions are likely to disrupt wheat supplies from Russia as well.
Corn and (to a lesser extent, wheat) are both major feedstocks for ethanol, so investors hoping that ethanol producers will benefit from rising gasoline prices (also caused by the war) may be disappointed.
Agricultural disruptions will likely raise the prices of all agricultural commodities, including soy oil, but the large soy planting in the US will moderate this effect on soy oil. Since soy oil is a common biodiesel feedstock, biodiesel producers will see a relative benefit compared to ethanol producers, who are more reliant on corn.
In short, investors looking to biofuels to benefit because of high oil prices should focus on biodiesel producers, rather than producers of ethanol.
ABOUT: Tom Konrad Ph.D., CFA is the Editor of AltEnergyStocks.com and the manager of the Foundation Green Income Fund.
DISCLOSURE: None.
DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results. This article contains the current opinions of the author and such opinions are subject to change without notice. This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
Horrific, Tragic, Unprovoked, Heartbreaking. There is no lack of adjectives to describe Putin’s war on Ukraine. And while there probably can’t be too much coverage of the tragedies and war crimes, many others can write those far better than I.
As an economic and stock market commentator, the adjective I will focus on is world-changing. There is no doubt that the first land war in Europe since World War II, piled on top of a global pandemic, is already reshaping the economy in dramatic ways.
Some of those changes, like Europe switching away from Russian gas and back to coal for electricity generation, will cause environmental harm. Others, like Europe’s longer term efforts to wean itself of dependence on Russia, will accelerate the transition to a clean economy. Below are twelve ways I believe green investors can help the beneficial changes along, while staying out of the way of the financial impacts of the harmful ones.
Substituting for Russian Oil and Gas Imports
In the immediate term, Europe is switching back to coal from Russian natural gas, and looking to import more fossil fuels from the US and other friendly countries. Clearly, green investors should
Avoid shorting US fossil fuel companies.
Consider the benefits to biofuel producers, especially fuels like wood pellets and somebiodiesel and renewable natural gas with non-food feedstocks such as agricultural residues like the corn stocks left in the field after harvest, waste from food processing, such as peels and shells, as well as the organic components of household waste.
Although recycled plastic will probably remain more expensive than virgin plastic made from fossil fuels, the price differential will fall. Plastic recyclers and producers of bioplastics may benefit as rising oil and gas prices erode the price premium for their products.
Food Shortages
The war is sending food prices soaring, and they will remain high for at least a year or two. Not only are Russia and Ukraine two of the largest producers of wheat, but agriculture is heavily dependent on nitrogen fertilizer, which is largely made from natural gas.
Green investors should 4. Not get too excited about the rising prices of biofuels if those biofuels use food
commodities as a feedstock.
5. Consider investments in organic farming and farmland. Not only will the prices of their products rise, but the fact that they don’t use inorganic (fossil fuel based) fertilizer and pesticides will mean that their costs will rise less than their conventional competitors.
Europe’s Long Term Shift Off Fossil Fuels
While in the short term, Europe will simply be substituting fossil fuels from other sources for the ones it imports from Russia, in the longer term the continent’s move to get off fossil fuels entirely will only accelerate. The means they will use to accomplish this shift are myriad, and most are investible.
European renewable energy developers will benefit. This will not just include wind and solar, but also renewable natural gas.
Europe’s push to develop a hydrogen economy will also accelerate, benefiting hydrogen companies.
High gas prices and policy will accelerate the shift to electric vehicles (but beware supply disruptions for critical minerals such as nickel, cobalt, and rare earth elements.
Also driven by high fuel prices, expect a shift back to public transit, like rail and buses. Train and bus manufacturers should benefit. Public transit ridership was hurt badly by the pandemic, but for the most part, governments have stepped up to help fill the revenue gap this caused. While many workers may continue to work from home, others must commute to work, and high fuel prices will accelerate their return to public transit from private vehicles.
Heat pumps and heat pump water heaters are two of the quickest and simplest ways to cut fossil fuel use in buildings. These devices are so efficient at producing heat that, even when operated with electricity generated with natural gas, the overall use of gas declines compared to heating directly with gas. Manufacturers and installers will benefit.
Insulation and air sealing. Building energy use can also be slashed by improving the building envelope by sealing air leaks and improving insulation. Firms that upgrade buildings, as well as insulation manufacturers should benefit.
The indoor unit of an air source heat pump with the colors of a Ukraine flag as background. Photo by author.
Critical Minerals
All the new investment in fossil free technologies will only worsen the shortages of critical minerals mentioned above in the note on electric vehicles. Wind and solar also use rare earth elements, not to mention large amounts of copper and steel.
Even though the price increases the additional demand will be good for mining firms, I am not a fan of the significant environmental trade-offs that are involved in mining. Also, since much mining takes place in unstable countries with unsavory regimes, many mining firms also face significant political risks, and can contribute to funding wars like the one in Ukraine.
12) One way to benefit from rising materials prices without these environmental, political, and moral compromises is by investing in recycling. Given the expected increase in demand for all sorts of metals, minerals, and other materials, recycling will not be able to meet more than part of the world’s demand for decades to come. But that will not stand in the way of recycling of all sorts to rapidly expand the slice of materials it does supply, and for recycling businesses to rapidly grow both their size and profitability.
Conclusion
Although we cannot ignore the tragedy of the war in Ukraine, investors (green and otherwise) also cannot afford to ignore the changes and opportunities it is bringing to the investing landscape.
Fortunately, we do not have to compromise our morals to do so. DISCLOSURE: None.
DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results. This article contains the current opinions of the author and such opinions are subject to change without notice. This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
There are two primary types of options, call options and put options, and each can be bought or sold, resulting in four basic types of option trades. One option contract controls 100 shares of an underlying stock. Purchasing an option contract means the investor is “long” the contract, while selling a contract is a “short” position.
The holder of a call option (the buyer) has purchased the rights from the seller to all future price appreciation of the stock that underlies the option contract above a certain predetermined level (the exercise price) during the life of the contract. In exchange for this right, the seller of the call option receives an upfront cash payment from the buyer. The buyer of the call option believes the stock will appreciate significantly, and the contract allows them to benefit if they are correct by simply paying a contract premium as opposed to purchasing the underlying stock itself, which would require a greater capital outlay.
The holder of a put option has purchased the rights from the seller of the option to be able to sell the underlying stock at the exercise price of the contract even if the price of the stock falls significantly below that level. In exchange for this right, the seller of the put option received an upfront cash payment from the buyer. The buyer of the put option is concerned that a stock will decline and is effectively purchasing insurance against that risk.
Example: Call Options
Suppose the stock of XYZ company is trading at $40. A call option contract with a strike price of $40 expiring in a month’s time is being priced at $2. If an investor believes that the stock will rise sharply during the life of the contract, they could spend $200 to purchase a one call option contract. If the stock appreciates to $50 by contract expiration, the option would now be worth $10, resulting in an $800 gain on the initial $200 investment. Long call options provide unlimited upside potential, but the buyer risks losing their entire premium if the stock does not trade above the exercise price at expiration.
The investor who sold the call option in this example generated an immediate cash flow of $200 ($2 per share). If the stock is trading above $40 at the expiration of the call option, the option will be exercised by the buyer, and the seller will be required to deliver cash or shares in order tosatisfy the obligation. If the stock has traded significantly above $40 and the seller does not own shares in the underlying company, the potential cash outlay to settle the contract could be significantly larger than the original $200 premium received (theoretically, the seller could owe an infinite amount to the buyer if they do not own the underlying stock to deliver shares).
Example: Put Options
Suppose an investor owns a stock trading at $40 per share, but he or she is concerned that its price may decline. A put option contract with a strike price of $40 expiring in a month’s time is being priced at $2. By purchasing the put option for $200, the investor is effectively insuring against any price declines for the position low $40. If the stock were to decline to $30 during the life of the contract, the option will increase in value at expiration to $1,000, providing a hedge against the stock price decline.
Long put options provide guaranteed protection against a decline in a stock below the contract’s exercise price, but the buyer risks losing their entire premium if the stock does not trade below the exercise price at expiration.
The investor who sold the put option in this example generated an immediate cash flow of $200 ($2 per share). If the stock is trading below $40 at the expiration of the put option, the option will be exercised by the buyer, and the seller will be required to purchase the shares at the contract price even if they are trading significantly lower at the time of contract expiration.
Incorporating Options into an Overall Portfolio
An investor can use options to express an opinion on a stock directly and specifically. For example, without options, an investor must simply choose to own a stock or not based on their assessment of it as an attractive investment. However, incorporating options allows the investor to continuously express a thesis on a stock and potentially earn a profit no matter what the direction (or lack thereof) of the stock price (assuming the investor correctly predicts the range of the stock’s movements of course).
For example, let’s say hypothetically that an investor holds shares in a company that is trading for $50, and the investor, based on their analysis, would be comfortable selling the stock at $55. They may sell a call option at an exercise price of $55 and receive an immediate cash payment in order to commit to selling the stock at the price they already planned to sell at anyway. If the stock never trades above $55, the investor keeps both the shares and the cash payment, and the call option contract expires worthless for the buyer. This strategy is commonly referred to as “covered call writing” because the investor is selling (writing) a call option contract while holding shares to “cover” the contract’s obligation.
Example: Covered Call
Assume an investor purchases 100 shares of XYZ stock for $50, and immediately writes (sells) a one-month call option contract with an exercise price of $55 for $2 per share. The investor has spent $5,000 to purchase the shares and received $200 in a cash payment via the option premium by committing to sell the shares at $55 during the life of the call option contract even if the price rises above $55 per share.
On expiration date, if the stock had appreciated to $57, the option would be exercised, and the shares sold to the call option contract buyer for $55. The investor who sold the contract would have made a total profit of $700 after factoring in the $200 in premiums received for writing the call.
If the stock had declined to $45 per share during the contract, the shares would have lost $500, but the call option premium provided a $200 buffer against this loss as the contract would expire worthless to the buyer, and the seller keeps the option premium as well as the shares.
In another example, let’s assume an investor believes that a company is attractive fundamentally (e.g., well managed, healthy balance sheets, good products, definable competitive advantages), but the stock price is currently higher than the investor believes to be fair. In order to gain exposure to the stock and begin to accrue some potential return, the investor may sell a put option at a price he or she believes to be attractive. The investor is committing to buy the stock at a lower price for the duration of the put option contract, and they are receiving an immediately cash payment from the put option buyer in exchange for that obligation.
Example: Selling a Put Option
If XYZ stock is trading at $50, but an investor believes that a more fair price is $45. He or she may sell a put option contract with an exercise price of $45 and collect a $2 premium by committing to purchase the shares at $45 even if they fall below that price. If the shares decline to $40, the investor would incur a loss of $300 ($500 loss on the share price movement, offset by the $200 option premium received).
Option contracts provide investors with multiple avenues to express an opinion on a company, to potentially earn enhanced profits and reduce risk. Understanding the forces that drive their prices is an important component of successful options investing, which we will cover in greater detail in the subsequent article.
