Options are essentially contracts that give someone a right, but not an obligation, to sell or buy an asset at a certain price before or on a specific date. Having the right to buy is known as a call option, while a put option is the right to sell. Knowing options trading basics, will help you with your trading strategies.
Those who know derivatives might not see a clear difference between this and what a forward or future contract does. Forwards or futures give the obligation and right to sell or buy sometime in the future. Someone who has a futures contract regarding cattle must deliver the physical cows to the buyer unless their positions are closed out before the expiration date. An options contract doesn’t have this obligation, which is why it’s called such. Get started trading options with these options trading basics.
Call and Put Options
A call option may be considered a deposit for something in the future. As an example, say a land developer wants to have the right to buy a lot that’s vacant sometime in the future but will do so if specific zoning laws are put into place. The developer may choose to buy a call option to purchase the lot at $250,000 sometime in the next three years. The landowner won’t grant this option for free, so the developer needs to provide a down payment to lock down this right.
This is considered the premium and is the price of the options contract. In our example, the developer might pay $6,000 to the landowner to secure the deal. When two years have gone by and the zoning gets approved, the developer can use his option to purchase the land for $250,000. It doesn’t matter if the market value of the plot has increased substantially.
In another scenario, if the zoning doesn’t get approved until the fourth year, the developer is required to pay the market price. The landowner will keep his $6,000 in either case.
You can think of a put option as an insurance policy. Say a land developer owns a substantial portfolio consisting of blue-chip stocks and is worried a recession might occur in the next few years. He wants to ensure that if a bear market occurs and stock prices fall, the portfolio won’t lose any more than 10 percent of the original value. If the S&P 500 currently is trading at a value of 2500, he can decide to purchase a put option, which lets him sell the index at a value of 2250 anytime in the next two years.
If the market crashes by 20 percent in six months, which would be 500 points, he ends up making 250 points since he can sell the index at 2250, even if it’s trading for 2000. The combined loss of this is only 10 percent, even if the market ends up dropping to zero. Buying the option will carry the premium and the premium is lost if the market doesn’t end up dropping during that time. These examples are important, as they show that you have a right but no obligation to do something when buying an option.
An expiration date can pass, but the option will become worthless. You’ll lose all of your investment if this happens, which is what you used to pay the option premium. You should also note that an option is just a contract concerning an underlying asset, which means options are derivatives. The asset is often a stock index or stock, but options can be traded for a variety of different financial securities, including foreign currencies, bonds, and commodities.
Important Points About Buying and Selling Calls and Puts
When you own a call option, you have what’s considered a long position in the stock market, which puts the person selling the call option in a short position. When you own a put option, you have the short position in the market, while the seller has a long position. It’s important to remember these points when you buy or sell calls or puts. Those who purchase options are known as holders, while those who sell options are known as writers of options.
Neither put holders or call holders are obligated to sell or buy. They can decide to exercise their rights if they want to. This reduces the risk of options buyers, so the maximum they can lose is the premium for their options. However, put writers and call writers must buy or sell. That means the seller is obligated to fulfill their promise to sell or buy. It also means there is an unlimited risk with option sellers, so they can lose a lot more than just the price of the premium.
Understanding Options Trading
It’s essential to know the terminology used in the options market. The strike price is known as the price at which an underlying stock can be sold or bought. A stock price must go higher than this price for calls or lower than this for puts prior to a position being exercised for a profit. This also needs to happen before the expiration date. The strike price for the example above was 2250.
The expiration date is when the contract ends. A listed option is an option traded on a national options exchange. They have expiration dates and fixed strike prices and each listed option is equal to 100 shares of stock. The option is in-the-money for call options if the share price is higher than the strike price. A put option is considered in-the-money when the share price is lower than the strike price. The intrinsic value is the value by which the option is in-the-money.
Options are considered out-of-the-money if the price is lower than the set strike price for calls, or higher than the strike price for puts. An option is regarded as at-the-money if the price is close to or on the strike price. The premium is the total price of an option. Several factors determine the price, including the strike price, volatility, stock price, and time left until expiration, or time value. Due to these factors, figuring out the option’s premium is complex.
Employee stock options are not offered for everyone to trade, but they can be considered a call option. Various companies use these options to attract and retain employees who are particularly talented, especially management. These are comparable to normal stock options that the holder has a right to buy company stock. However, the contract is only between the company and holder and can’t be exchanged with anyone else. This is different from a regular option, where two unrelated parties can trade as they wish.
Why Options Are Used
There are many reasons an investor would want to use options. One of these is speculation, which is where a bet is placed on the anticipation of a stock’s future price. A speculator might have a gut feeling that the price of a stock will increase and he aims to make a short-term profit by selling the stock at a greater price. Some traders find this type of call option attractive since it gives them leverage. It may only cost several dollars compared to a $100 stock. This is one of the reasons options are known for being risky.
When you purchase an option, you need to be correct when figuring out which direction the stock will move, in addition to the timing and magnitude of the movement. You need to accurately predict if a stock will go down or up and you must be right about how this price will adjust in addition to how long it will take to happen.
Options were invented for the purpose of hedging, not speculation. This is a type of strategy that decreases risk at a cost that’s reasonable. You can think of options like an insurance policy. Just as you would insure your car or house, options can insure investments to protect against a downturn. However, there are critics who argue that if you’re that unsure of your stock that you feel you need a hedge, you should not make an investment. Many people enjoy them because they can limit their losses while taking advantage of technology stocks and their advantages.
When you use at least two options positions, it’s known as spreading. This combines speculation and, at the same time, reduces losses or hedging. Sometimes the potential upside is limited as well, but people find this strategy desirable since the implementation cost is low. In most spreads, one option is sold to purchase another. This is where there are the most variety of options since a trader can make a spread in order to profit from any market outcome. This includes markets that don’t move either up or down.
A certain type of spread is called a synthetic. The reason for this strategy is to make a position that acts like another position but doesn’t control that asset. If you sell a put while buying a call at the same time that has the same strike and expiration, you’ll create a synthetic long position in that underlying asset. While it makes more sense to purchase the asset, you might be restricted for a regulatory or legal reason from owning. However, you can create this synthetic position.
How Options Contracts Work
Options contracts are the price probabilities for events in the future. The better the chance is that something may occur, the higher the price for an option will be. This is crucial to understanding the relative value of options. For example, say a call option has a strike price of $200 and the company is trading at $175 currently with an expiration date of three months. Having a call option gives you a right but not an obligation to buy shares of this at $200 at any time you wish in the next few months.
If the price goes above $200, you’ve essentially “won.” It doesn’t matter if the price of the option is unknown at the moment. You know that the same option that expires in one month won’t cost as much since there’s a shorter amount of time left for anything to occur with it. The same option will cost more when it expires in a year. Due to this, options go through time decay, where the same option is worth less money the next day if the stock price doesn’t change.
Another factor that will add to the chance of you winning is if the stock price gets closer to $200. The closer the stock price is to the strike price, the better the chance that something will happen. That means the call option premium price will increase as the underlying asset price increases. Similarly, when the price decreases and the difference between the underlying asset price and strike price gest bigger, the option will cost less, overall.
If the price of IBM stock stays at $175, the call that has a $190 strike price will end up being worth more than the $200 strike call. This is due to the chance of a $190 event occurring being higher than $200. The last factor that can improve the odds of an event is if the underlying asset’s volatility increases. Anything that has higher price swings, either down or up, will improve the chance of an event occurring.
This means the bigger the volatility, the bigger the price of the option. These are linked intrinsically to each other. Say that on the first of May, the stock price of a tequila company is $67 and the premium is $3.15 for a July 70 Call. This means the expiration date of it is the third Friday of the month and $70 is the strike price. The price of the contract is $315 (100 shares x $3.15), commissions ignored for this situation.
On the majority of United States exchanges, a stock option contract gives you the option to sell or buy 100 shares. The $70 strike price indicates that the stock price needs to increase over $70 before the call option can be worth something. Since the contract is $3.15 for each share, the break-even price is $73.15. Say the stock price is $78 three weeks later and the options contract has also gone up in value and is worth $825 (100 shares x $8.25). If you subtract the amount you paid for the contract, your profit is $510 ($8.25 – $3.15 x 100).
That means your money doubled in only a matter of three weeks. You have the choice to sell your options, known as closing your position and walk away with your profits. However, you might think the stock price will rise even more. If the price drops to $62 at the expiration date, the contract is worthless since it’s under the strike price of $70 and no time is left.
In reality, most options don’t get exercised. In the example above, money could be made by exercising at $70 and selling the stock to the market at $78, giving you an $8 profit off each share. You can also hold on to the stock since you bought it at a discount compared to the current value. Many times, holders decide to take their profits by closing out or trading out their position. That means writers buy their positions and holders sell their options. An average of 30 percent expire, 60 percent are closed out, and 10 percent are exercised.
How Options Pricing Works
Image via Flickr by kenteegardin
In the example above, the option’s premium increased from $3.15 to $8.25. This is explained by extrinsic and intrinsic value, which is also known as time value. The premium is a combination of these two. Time value is the chance of the options increasing in value, while the intrinsic value is the value in-the-money, which means the strike price and price of the stock are equal. Again, the greater chance that an event will occur, the more costly the option will be.
Options nearly always trade at a level that’s higher than their intrinsic value, due to the chance of an event happening that’s never absolutely zero. While an option price is related to an event that may happen, a pricing model needs to be used so an absolute price can be put on an option. The most famous model is the Black-Scholes-Merton model, which dates back to the 1970s and was even awarded a Nobel prize in Economics. There have been other models to come out since then, such as binomial or trinomial tree models.
What Is An Options Spread?
The least complex options position is a long put or call that’s by itself. This benefits the position if the price increases and the downside is limited to the option premium if it doesn’t. If you buy the put option at the same time with an identical expiration and strike, this is a straddle. This will be to your advantage if the price increases or decreases, but if the price remains about the same, both the put premiums and the call will be lost.
Another option that’s similar is to buy the call, as well as purchase a put that has a lower strike, which is called a strangle. This demands the bigger price moves so it profits, but it isn’t as expensive as a straddle. That said, being short a strangle or straddle means you profit from a market that’s relatively stable. A bull vertical spread or call spread is formed by purchasing a call while selling another call at the same time that has a greater strike.
A butterfly is when you have options with three strikes that are spaced apart equally. All the options are the same (either puts or calls) and have an identical expiration date. For a long butterfly, the outside strikes are purchased in a ratio of 1:2:1, meaning they buy one, sell two, and buy one, while the middle strike option gets sold. If the ratio doesn’t follow this, it’s not considered a butterfly.
The outside strikes are often known as the wings of the butterfly, while the body is the inside strike. A butterfly’s value can never be below zero. An example of this would be a long 70 call, two short 75 calls, and a long 80 call. Long butterflies profit from markets that are quiet. A butterfly spread is considered a neutral options strategy that has limited profit potential, as well as limited risk.
Risks of Options
Options prices are modeled mathematically, so many risks of these options can be understood and modeled. This part of options makes them not as risky as other types of asset classes. Each individual risk is given a Greek letter name. Delta is the difference in option price per point change in the price, so it represents a directional risk. This is interpreted as the same position in an underlying security or the hedge ratio. Long 4000 shares are considered the same as a 4000 delta position.
The delta represents the chance that an option has at being in the money at the end. For example, a 40-delta option would have a 40 percent chance of ending in the money. Options that are at-the-money will always have a 50-delta.
The change in delta per point change for the underlying security is called gamma. This tells you how quickly the delta will move if any points move in the underlying security. This value is essential to watch since it shows you how much larger your directional risk will rise as the underlying changes. Options that are at the money have the biggest gammas, as do those closest to expiring. If volatility is lowered, the gamma increases. Theta is known as the change in option price per day in time.
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