Options Trading Basics

Content:
  1. What is Derivatives
  2. What are Options
  3. Options Terms
  4. Options Trading Styles
  5. Underlying Assets
  6. Benefits of Options Trading
  7. Options Valuation Factors
  8. Options Trade Settlement

What is Derivatives?

Any instruments whose value is derived from the value of one or more underlying assets are called derivatives. These elements can be as following:

  • Equity / Stocks
  • Agricultural commodities including sugar, coffee beans, grains, soybeans etc.
  • Precious metal like gold and silver, platinum.
  • Foreign exchange rate.
  • Bonds
  • Short tem debt securities like T-bills.

What are Options?

Options are one type of derivative contracts which gives options buyer a right, but not the accountability, to buy or sell an agreed amount of basic asset (a stock or index), at a certain price on or before a specific date. Means trader can not buy or sell the option contract before the options expiration date or at a special rate.

Options are traded on both, exchanges and in the over-the-counter market. Primarily there are two types of options trade available.

Call Option:

With Call option, the contract holder gets a right to achieve an underlying asset at a certain price by a certain date. The option contract holder pays a premium for his/her right. The option contract holder gains, if the market price of the option contract rises above the strike price.

For example, if a trader buys Feb’s one-month call option of ABC shares with a $2100, then he/she have to pay premiums of $50.00. Now following possibilities can happen with this trade:

  • Profit Example:

    If at the expiration time, ABC share price stays at $2500 then he/she will exercise the option. Then the trader will make a profit of $350.

    Formula

    Spot price – Strike price – premium.

    In this case,
    $2500-$2100-$50 = $350

  • Loss Example:

    If at the expiration time, ABC share price stays at $2000, then options trade will not get exercised. Trader will make a loss of $50 (Premium).

long call option trade example

Long call option trade example

Put Option:

With Put option, the contract holder gets a right to sell an underlying asset at a certain price by a certain date. The option contract holder gains, if the market price of the option contract falls below the strike price.

Just like the previous call trade example, if a trader buys an option contract, then there will be a trader who will be selling the option contract and receive the premium from the buyers. So options writer will receive a $50.00 premium. Now following possibilities can happen with this short call trade:

  • Profit Example:

    If at the expiration time, ABC share price stays at $2500 then the buyer will exercise the option. Buyers will make a profit of $350 with the same formula mentioned above.

  • Loss Example:

    If at the expiration time, ABC share price stays at $2000 then options trade will not get exercised. Seller will make a profit of $50 (Premium).

put option trade example

Short call option trade example

The price of the option contract is known as strike price or exercise price.


Options Terms:

  • Options Buyer:

    The trader who buys the option contract by paying a premium is known as options buyer.

  • Options Writer:

    The trader who sells the option contract and receives the premium from other options buyers is known as options writers.

  • Option Price/ Premium:

    The monetary value which option buyers pay to an options writers or sellers is known as premium.

  • Expiration date:

    The date of the option contract is known as expiration date or maturity. This is the date on which the specific option contract is no longer valid.

  • Strike Price:

    As we have mentioned before, the strike price is the price on which both options buyers and sellers agreed with the option contract. Losing or winning in a options trade is depends on the current options price and the strike price.

  • Spot Price:

    The curent price of the underlying security.

  • Long:

    Going long or long is a financial term means buy.

  • Short:

    Going short or short is a financial term means sell.

  • Option Chain:

    It is the listing of options price with the strike price, buyer-seller trade volume, open interest. With the option chain, it is easier to spot all options prices at a different strike price for a specific option contract. All stock exchanges have option chain section for the different option contract.

  • Naked Options:

    Selling any option contract is called as naked options because risk here is unlimited. That’s why it called naked. It is always advised to hedge or have a buy position with the naked option, in order to offset the risk.

  • Vanilla Options:

    Normal options known as vanilla options without any special terms or conditions with less complication. All European & American options are vanilla options. It is just another term in separation to exotic options.

  • At the money (ATM):

    This is a no profit no loss situation. It happens when the security price and the strike price is equal.

  • In the money (ITM):

    It indicates that the options trade is in profit. It happens when in case of call option, security price rises higher than the strike price. For a put option, it happens when security price falls below the strike price.

  • Out of the money (OTM):

    It indicates that the options trade is in a loss. It happens when in case of call option, security price falls below the strike price. For a put option, it happens when security price rises above the strike price.

Options relationship with strike price & spot price, the moneyness of the options:

Condition Call Option Put Option Formula
Spot price > Strike price In the money Out of the money Spot price – Strike price
Spot price < Strike price out of the money In the money Strike price – Spot price
Spot price = Strike price at the money at the money

Options Trading Styles:

American Options:

This type of option contract can be exercised at any time up to the expiration date of the specific option contract.

European Options:

This type of option contract can be exercised on the expiration date of the specific option contract. That means no early closing of options trades.

For this reason, most of the world top stock exchanges use American options. Because it is beneficial for options traders, in case if they made any mistake on their trading decision they can sell or buy it back before maturity.


Options Trading Underlying Assets:

You can trade options with following trading instruments.

  • Stock Options:

    Stock options are basically traded with the stock exchange, for example, stock options for Google(GOOGL) get traded on NASDAQ. Stock options for Tata Consultancy Services(TCS) get traded on BSE, NSE. Stock options for JPMorgan Chase (JPM) get traded on NYSE. Buying or selling one option contract gives a trader rights to buy or sell 100 shares at a definite strike price. However this contract size varies stock exchange to stock exchange, normally it gets traded in lots of 100.

  • Foreign Currency Options:

    Most of the major stock exchanges have the foreign currency option contract, for example, trading EURUSD option contract, or USDINR, GBPUSD option contract etc. Contract lots may vary for currencies to currencies.

  • Index Options:

    Index options allows investor to invest on index’s like S&P 500 Index(SPX), Dow Jones Industrial Index(DJX), NIFTY, SENSEX, FTSE 100 etc.

  • Future Options:

    A trader, trading futures contract is often trading options on it. Generally, a future option get matures before the delivery period of the future contract.

    Upon exercising the call option, holders gain a long position from the writer of that underlying futures contract, plus a cash amount same as future price over the strike price.

    Upon exercising the put option, the investors gain a short position of the underlying futures contracts, plus a cash amount the same as the strike price over the future price.


Benefits of Options Trading:

  • Risk Limit

    Options trading offers a limited risk to buyers. Means, buyers will only lose the price he/she paid as the premium for the option contract, along with the brokerage cost. Options will expire valueless if options buyers do not choose to exercise the option. But options writers of a call option can encounter unlimited risk if they did not hedge the trade with other buy options.

  • Options Leverage

    With options, a trader can invest with a small percentage of the security or share price instead of buying the whole share. But leverage has both a negative and a positive side because it amplifies profit & losses altogether. We also need to keep the time value in mind, longer it takes to expire, more value options gains.

    For example, imagine if an investor buys ABC company stocks call option contract with a strike price of $150. The stock is currently pricing at $147. The options price is $5. So in order to buy 100 call option contract, the trader needs to pay a premium of $5×100 = $500.

    Now, if at the time of expiration stock price stays below 150, then the investor will lose the whole $500. But if the stock price stays above $150, then the call option contract will get exercise. Assuming that stock price goes to $165, then there will be a gain of $20 per share. Total $20*100 = $2000 value. Net profit after subtracting the initial investment with premium $2000-$500 = $1500.

    If the trader bought the ABC shares directly, he/she need to invest $147*100 = $14,700 whereas in case of options he/she only needed $500 for investment. In order to understand more clearly please check the below depiction:

    For Buying Stocks For Buying Options
    Per Share Price : $147
    Buying 100 shares
    Investment Requires: $147 x 100 = $14,700
    Per Options Price : $5
    Buying 100 option contract
    Investment Requires: $5 x 100 = $500
    Current Share Price : $170
    Current Value: $170 x 100 = $17,000


    Ignoring the brokerage cost
    Net Profit: $17,000 – $14,700 = $2300
    Rate of Return on Investment: 16%
    Current Share Price : $170
    Gain $20 per share = $20*100 = $2000


    Ignoring the brokerage cost
    Net Profit: $2000 – $500 = $1500
    Rate of Return on Investment: 300%

    So with the above example, we can cleary see, that buying options required less money to be invested, therefore upon profit it provides higher rate of return.

  • Trade Adjustability

    Options trading provides flexibility to the investors and enables them to execute different types of profit increasing & risk-minimizing strategies. With stock options, traders can protect stock holdings from a declining market price & side by side earn profit from stable stock price movements. Not only this, permits investors to decrease portfolio volatility. Allows them to achieve protection against stock price rise & fall without obtaining the full cost of the share prices. In addition, generates income from a current portfolio.


Options Valuation Factors:

Value of an option depends on the following aspects.

Cause Call Value (Buy) Put Value (Sell)
Asset value increasing Rise Fall
Strike price increasing Fall Rise
An increment in underlying asset price fluctuation Rise Fall
An increment in options expiry time Rise Rise
Stocks dividend amount increases Fall Rise
An increment in interest rate Rise Fall

Time Value of Options:

Options premium depends on the intrinsic value of the options along with the time value of it. The premium price will increase, as long as the options expiration time increases. Only because, if the options stay active for longer time, higher chances there for the share price or security price to move & convert the options into “in the money” state. “At the money” and “out of the money” options only consist of time value and no Instrinsic value. Time value becomes zero on options maturity.

options premium time value decay

Options time value decay chart


Options Trade Settlement:

Option contract settlements are done in three ways.

  • Settlement with Daily Premium:

    In this case options, buyers & options writers(seller) premium payable and receivable amoun get netted to calculate, the net premium amount for individual investor and their each option contract. Once an options get excercise the options writers is liable to pay the cash settlement amount in case of settled options. Daily settlement can get denoted as T+1. Here T stands for trasnaction date, + represents after transaction date how many days, here in this case, after one day.

  • The settlement with Interim Exercise:

    This type of settlements is done on securities option contract, where a trader can exercise his/her “in-the-money” option contract throughout the trading hour. It mostly affects the close of the trading session or on the options exercise date.

  • The Final Settlement:

    This type of options settlement gets enforced on all open long “in-the-money” options strike price, at the close of last trading hour and on the options expiration date. After settlement, investor will receive per unit options exercise settlement value, from the option contract writers. Final settlement sometimes get denoted with T+2 or T+3. That means, two or three days after the transaction date.


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