An options contract is an agreement that gives a trader the right to buy and sell an asset at a predetermined price before or after a specific date. These contracts are similar to futures contracts in many ways, but they do not force holders to settle their positions.
Options contracts, or options, are derivatives that are based on various underlying assets, such as stocks and cryptocurrencies. They can also be obtained from financial indices. Often, options contracts are used for speculative trading and hedging risks on existing positions.
How do options contracts work?
There are two main types of options, known as puts and calls. Call options give contract holders the right to buy the underlying asset, while put options give the contract owner the right to sell. Thus, traders typically enter a call in anticipation of an increase in the price of an asset, and a put in anticipation of a decrease in the price. They can also use calls and puts in hopes that the price will remain stable, or even a combination of the two types to bet both on and against market volatility.
An options contract consists of at least four elements: size, expiration date, exercise price (strike price) and premium. First, the order size refers to the number of contracts that will be sold. Secondly, the expiration date is the day after which the trader will no longer be able to exercise the option. Third, the exercise price is the price at which the asset will be bought or sold (if the buyer of the contract decides to exercise the option). And fourth, the option premium is the trading price of the contract and indicates the amount an investor will have to pay to purchase the option. Thus, buyers purchase contracts from writers (sellers) that contain a premium value that constantly changes as the option expires.
If the execution price is below the market price, the trader can buy the underlying asset at a discount and, by including the premium, can exercise the contract for a profit. If the option price exceeds the market price, the option is not profitable and is of no interest to traders. In case of non-fulfillment of the contract, the buyer only loses the premium paid at the conclusion of the contract.
It should be noted that although only buyers have the right to choose whether to exercise or not exercise their calls and puts, sellers are subject to the decisions of buyers. Thus, if the trader who purchased the call option decides to exercise his contract, the writer (seller) is obligated to sell the underlying asset at a pre-agreed price. Likewise, if a trader buys a put option and decides to exercise it, the seller is obligated to purchase the underlying asset from the owner of the contract. This means that sellers are exposed to higher risks than buyers. While buyers limit their losses to the premium paid for the contract, sellers in turn can lose much more depending on the market price of the asset.
Some contracts give traders the right to exercise their option at any time before expiration. They are commonly referred to as American options contracts. European options, on the other hand, can only be exercised on the expiration date. However, it is worth noting that these names have nothing to do with their geographical location.
Option premium
Several factors influence the amount of the premium. To make things easier to understand, we can assume that the option premium depends on at least four elements: the price of the underlying asset, the strike price, the remaining time until the expiration date, and the volatility of the relevant market (or index). The influence of factors on the premium amount is shown in the following table.
Having analyzed this table, it can be noted that the asset price and the execution price affect the premium of calls and puts in the opposite way. The less time remains before the contract is executed, the less premium each participant in the transaction can receive. The main reason is that the likelihood of contracts being realized in favor of traders decreases daily. On the other hand, increased levels of volatility usually lead to higher premiums. Thus, the premium on an option contract is the result of a combination of two factors.
Greeks of options
Option Greeks are tools designed to measure individual factors that affect the price of a contract. Specifically, they are statistical values used to measure the risk of a particular contract based on various underlying variables. Below are some of the main Greeks and a brief description of what they measure:
Delta: measures how much the price of an option contract will change relative to the price of the asset. For example, a delta of 0.6 suggests that the premium price is likely to increase by $0.60 for every $1 increase in the asset price.
Gamma: measures the rate of change of delta over time. Thus, if delta changes from 0.6 to 0.45, the option's gamma will be 0.15.
Theta: Measures the change in price relative to a one-day reduction in the contract duration. The premium is assumed to change as the option approaches expiration.
Vega: measures the rate of change in contract price relative to the 1% volatility of the underlying asset. An increase in vega typically reflects an increase in the price of both calls and puts.
Rho: Measures the change in the price of an option in relation to its volatility. A rise in interest rates typically causes calls to increase and puts to decline. Thus, the value of rho is positive for call options and negative for put options.
Options Use Cases
Hedging
Options contracts are widely used as a tool for hedging risks. A very simple example of a hedging strategy is where traders buy a put option on a stock that they have in stock. If the value of these assets begins to decline, using a put option will help the trader prevent further losses.
For example, imagine that Alice bought 100 shares at $50 in the hope that their market price would rise. However, to protect herself from possible losses, she decided to buy a put option with a strike price of $48, paying a premium of $2 for each share. If the market turns bearish and the shares fall to $35, Alice can exercise her contract to reduce her losses by selling each share for $48 instead of $35. But if the market turns bullish, she won't have to exercise her contract and will only lose the premium ($2 per share).
In this case, Alice breaks even and earns $52 ($50 + $2 per share), and in the event of a loss, her loss would not exceed $400 ($200 for the premium and another $200 for selling shares at $48).
Speculative trading
Options can also be used for speculative trading. For example, a trader who believes the price of an asset may rise buys a call option. If the price exceeds the strike price, the trader can use his option to buy the asset at a discount. When the asset price is above or below the strike price, making the contract profitable, the option is considered a winner. An option is also considered a winner if it is at the break-even point, and a loser if the option involves a loss.
Basic Strategies
When trading options, traders can use a wide range of tactics based on four basic positions. If you act as a buyer, you are given the right to buy - a call option or sell - a put option. If you are a writer, you are given the same rights as a buyer, but as mentioned earlier, the differentiating feature is the seller's obligation to buy or sell the asset if the owner of the contract decides to use it.
Different options trading strategies rely on different combinations of calls and puts. Protective put, covered call, straddle and strangle are just some popular examples of strategies.
Protective Put: Involves purchasing a put option on an asset that is held. This is the risk hedging strategy used by Alice in the previous example. It is also known as portfolio insurance because it protects the investor against a potential price decline or bearish trend, while holding assets until a possible bullish trend or increase in stock price occurs.
Covered Call: This strategy is used by investors to generate additional income (option premium). If the contract is not executed, the trader receives a premium while keeping his assets. However, if the contract comes into force due to an increase in price, the owner will be obliged to perform it.
Straddle: Involves buying a call and a put on the same asset with the same strike price and expiration date. This allows you to make a profit as long as the price of the asset changes within a sufficient range in any direction. In other words, the trader is betting on volatility.
Strangle: involves purchasing both a call and a put on the same asset with the same expiration date but a different strike price. Essentially, a strangle is similar to a straddle, but it is less expensive to open positions. However, a strangle requires a higher level of volatility in the market to be profitable.
Advantages:
Great for hedging market risks.
A more flexible solution for speculative trading.
Availability of multiple combinations and trading strategies with unique risk and reward models.
Can be used to make a profit during any market trends: both bullish and bearish, and sideways.
Can be used to reduce costs when opening positions.
Availability for simultaneous execution of several transactions.
Flaws
Difficult understanding of how all mechanisms work and how bonuses are calculated.
Includes high risks, especially for the writer (seller).
More complex trading strategies compared to alternative solutions.
Options markets often suffer from low levels of liquidity, making them less attractive to most traders.
Option premiums are highly volatile and tend to decrease as expiration approaches.
Options vs. Futures
Options and futures are derivative instruments and as such represent some common use cases, but despite the similarities, there are significant differences between them.
Unlike options, futures contracts are always settled upon expiration, meaning the holders of the contract are legally obligated to transact in the underlying asset (or pay a corresponding amount of money). Options are only exercised with the permission of the trader who owns the contract. If the owner of the contract (buyer) exercises the option, the writer (seller) agrees to transact in the underlying asset.
Summary
As the name suggests, options provide the ability for an investor to buy or sell an asset in the future, regardless of the market price. Contracts of this type are very versatile and can be used in different cases, not only for speculative trading, but also for hedging.
It is worth noting that trading options, as well as other derivatives, is associated with many risks. Before using contracts of this type, you must become familiar with how they work. It is also important to have a good understanding of the different call and put combinations and understand the potential risks associated with a particular strategy. In addition, to reduce potential losses, traders should adhere to risk management tactics along with the use of technical and fundamental analysis.