An options contract is an agreement giving the trader the right to buy or sell an asset at a predetermined price before or on a specific date. Although it may seem similar to futures contracts, traders purchasing options contracts are not obligated to settle their positions.
Options contracts are derivative products based on a wide range of underlying assets: stocks, cryptocurrencies, others. These contracts can also be derived from financial indices. Options contracts are generally used to minimize the risks of one's open positions and also to speculate.
How do options contracts work?
There are two types of options contracts, call options and put options. Call options give owners the right to buy the underlying asset, while put options give the right to sell it. Thus, traders generally place calls when they expect the price of the asset to increase and puts when they anticipate a drop in the price. Traders can also use calls and puts hoping the price remains stable - or combine the two - to bet for or against market volatility.
An option contract consists of at least four elements: size, expiration date, strike price and premium. Order size refers to the number of contracts to trade. The expiration date is the deadline to exercise the option. The strike price is the price at which the asset will be bought or sold (if the buyer uses the option). The premium corresponds to the sale price of the options contract. It indicates the price to be paid for an investor to obtain the right to choose. Buyers obtain contracts from sellers (writers) based on the value of the premium. This value changes as the expiration date approaches.
To put it simply, if the strike price is lower than the market price, the trader can buy the underlying asset at a discount and after factoring the premium into the equation, they can choose to use the option to make a profit. If the strike price is higher than the market price, the holder has no interest in using the option, so the contract is deemed useless. When the contract is not exercised, the buyer only loses the premium paid when entering the position.
It is important to note that although buyers can choose whether or not to use their calls or puts, sellers depend on the buyers' decisions. If the buyer of a call option decides to use his contract, the seller is obliged to sell the underlying asset. Similarly, if a trader buys a put option and uses it, the seller is obligated to purchase the underlying asset from the contract holder. Sellers are therefore exposed to much higher risks than buyers. While buyers have losses limited to the premium paid to use the contract, sellers 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 the expiration date. These contracts are called: American option contracts. Conversely, European options contracts can only be exercised on the expiration date. These names have nothing to do with the geographical location of the contracts.
Options premium
The value of the premium depends on several parameters. To simplify, we can assume that the premium of an option depends on at least four parameters: the price of the underlying asset, the strike price, the time remaining until the expiration date and the volatility of the corresponding market (or index). These four parameters have different effects on the premium of call and put options, as illustrated in the following table.
Naturally, the asset price and the strike price influence the call and put premium in opposite ways. On the other hand, moving the expiration date closer generally means lower prices for both types of options. The main reason is that the probability of these contracts being beneficial for traders is low. On the other hand, increasing volatility usually leads to an increase in premium. Thus, the premium of options contracts is the result of the merger of different parameters.
The Greeks of options
Options Greeks (or Greeks) are instruments designed to measure some of the many parameters impacting the price of a contract. More precisely, these are statistical values used to measure the risk of a particular contract based on different underlying variables. Here 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 underlying asset. For example, a Delta of 0.6 means that the premium price is likely to change by $0.6 for every $1 change in the asset price.
Gamma: Measures the rate of change of the Delta parameter over time. So, if Delta goes from 0.6 to 0.45, the Gamma of the option will be 0.15.
Theta: Measures price changes relative to a one-day decrease in contract time. It suggests how the premium is likely to change as the options contract gets closer to its expiration date.
Vega: Measures the rate of change of a contract price relative to a 1% change in the implied volatility of the underlying asset. An increase in Vega normally shows an increase in the price of call and put options.
Rho: measures expected price changes relative to interest rate fluctuations. An increase in interest rates generally leads to an increase in calls and a decrease in puts. Thus, the value of Rho is positive for call options and negative for put options.
Common use cases
Blanket
Options contracts are frequently used to hedge positions. A very simple example of a hedging strategy involves buying put options on stocks that a trade already owns. If the overall value of their major holdings falls due to falling prices, exercising the put option can help them mitigate losses.
Example: Alice buys 100 $50 shares of a company, hoping the price will increase. Alice wants to protect herself against a possible drop in stock price and therefore decides to buy put options with a strike price of $48, paying a premium of $2 per share. If the market becomes bearish and Alice's stock falls to $35, she can mitigate her losses by selling each share at $48 instead of 35. Conversely, if the market becomes bullish, she will not need to use the contract and will only lose the contract premium ($2 per share).
In such a scenario, Alice would break even at $52 ($50 + $2 per share), while her losses would be limited to -$400 ($200 paid for the premium and $200 more if she sells each share at $48).
Speculative trading
Options are also widely used for speculative trading. For example, a trader thinking that the price of an asset is about to rise will buy a call option. If the price of the asset moves above the strike price, the trader can then exercise the option and buy it at a discount. When the price of an asset is above or below the strike price in a way that makes the contract profitable, the option is considered "in-the-money." Similarly, a contract is considered "at-the-Money" if it is on its break-even point, or "out-of-the-Money" if it is at a loss.
Basic strategies
When trading options, traders can use a wide range of strategies based on four basic positions. As a buyer, it is possible to buy a call option (purchase) or a put option (sell). As a seller, it is possible to sell call or put options. As said previously, sellers have the obligation to buy or sell the assets of the contract, if its holder decides to exercise it.
The different options trading strategies are based on the various possible combinations of call and put contracts. Protective puts, covered calls, straddle, and strangle are some basic examples of these strategies.
Protective put: consists of purchasing a put contract of an asset that you hold. This is the hedging strategy used by Alice. It is also known as portfolio insurance, which protects the investor from a possible downward trend while maintaining their exposure in the event of an increase in the price of the asset.
Covered call: involves selling a call option on an asset you already own. This strategy is used by investors to generate additional income (option premium) from their holdings. If the contract is not exercised, they earn the bonus while retaining their assets. However, if the contract is exercised due to an increase in the market price, they are forced to sell their positions.
Straddle: consists of purchasing a call option and a put option for the same asset with identical strike prices and expiration dates. It allows the trader to make profits as long as the asset moves far enough in either direction. In other words, the trader is betting on market volatility.
Strangle: Consists of purchasing both a call option and a put option that are “out-of-the-money” (i.e. the strike price is higher than the market price for call options and lower for put options). Basically, a strangle is like a straddle, but with reduced costs to establish a position. However, a strangle requires a higher level of volatility to be profitable.
Benefits
Suitable for hedging against market risks.
More flexibility in speculative operations.
Allow multiple trading combinations and strategies, with unique risk/reward models.
Potential to profit from bullish, bearish and side-way market trends.
Can be used to reduce costs when taking a position.
Allows you to perform several operations simultaneously.
Disadvantages
The operating mechanisms and calculation of premiums are not always easy to understand.
Contains high risks, particularly for sellers (writers)
More complex trading strategies compared to conventional alternatives.
Options markets are often characterized by low liquidity, making them less attractive to most traders.
The premium value of options contracts is very volatile and tends to decrease as the expiration date approaches.
Comparison of Options and Futures
Options and futures are both derivative instruments and as such have some common use cases. However, despite their similarities, there is a major difference in the settlement mechanism.
Unlike options, futures contracts always execute on the expiration date, meaning that contract holders are legally obligated to exchange the underlying asset (or its respective cash value). Options, on the other hand, are only exercised at the discretion of the trader holding the contract. If the contract holder (buyer) exercises the option, the contract writer (seller) is obligated to trade the underlying asset.
To conclude
As the name suggests, options give the investor the choice to buy or sell an asset in the future, regardless of the market price. This type of contracts is very versatile and can be used in various scenarios, not only for speculative trading, but also for executing hedging strategies.
However, it should be noted that options trading, as well as other derivatives, involves many risks. Therefore, before using this type of contract, traders must understand how they work. It is also important to understand the different combinations of call and put options, as well as the potential risks associated with each strategy. Traders should also consider using risk management strategies as well as technical and fundamental analysis to limit potential losses.
