An options contract is an agreement that allows a trader to buy or sell an asset at a predetermined price before or on a specific date. While options contracts may sound similar to futures contracts, traders who buy options contracts are under no obligation to settle their position.
Options contracts may be derived from a variety of underlying assets, including stocks and cryptocurrencies. These contracts may also be derived from financial indices. Options contracts are often used to hedge the risk of existing positions and conduct speculative transactions.
How do options contracts work?
There are two basic types of options namely call options and put options. A call option gives the contract owner the right to buy the underlying asset, while a put option gives the contract owner the right to sell the underlying asset. Therefore, traders typically select call options when they expect the price of the underlying asset to increase and put options when they expect the price to decrease. They may also use call and put options with the goal of keeping prices stable, or even use a combination of the two options to bet on market fluctuations.
An options contract consists of at least four parts: size, expiration date, exercise price and premium. First, order size refers to the number of contracts to be traded. Second, the expiration date is the date when the trader can no longer exercise the option. Again, the strike price refers to the price at which the asset will be bought and sold (if the buyer of the contract decides to exercise the option). Finally, premium refers to the price at which an options contract trades. The price represents the amount an investor must pay to obtain the option. Therefore, the buyer obtains the contract from the writer (seller) based on the value of the premium, which continuously changes as the expiration date approaches.
Basically, if the exercise price is lower than the market price, traders will buy the underlying asset at a discount, and after factoring in the premium, they may choose to exercise the contract and make a profit. However, if the exercise price is higher than the market price, the option holder has no reason to exercise the option, and the contract will be deemed invalid. If the contract is not exercised, the buyer only loses the premium paid when opening the position.
It is important to note that while the buyer can choose whether to exercise call and put options, the action of the writer (seller) depends on the decision of the buyer. That is, if the buyer of a call option decides to exercise his contract, the seller is obligated to sell the underlying asset. Likewise, if a trader buys a put option and decides to exercise it, the seller is obligated to buy the underlying asset from the contract holder. This means that the author is at higher risk than the buyer. While the buyer's losses are limited to the premium paid for the contract, the author's losses may be greater depending on the market value of the asset.
Some contracts give traders the right to exercise the option at any time before expiration. This type of contract is often called an American options contract. In contrast, European options contracts can only be exercised on the expiration date. But it’s worth noting that the names of these contracts have nothing to do with their geographic locations.
option premium
The value of the royalty is affected by a variety of factors. Simply put, the premium we can set for an option depends on at least four factors: the price of the underlying asset, the exercise price, the time remaining to expiration, and the volatility of the corresponding market (or index). These four components have different effects on call and put premiums, as shown in the table below.
We can easily see that the asset price and strike price have opposite effects on call and put premiums. In contrast, shorter time periods generally mean lower premiums for both options. The main reason is that the shorter the timeframe, the less likely traders are to have the contract move in their favor. On the other hand, rising volatility levels typically lead to rising premiums. Therefore, options contract premiums are the result of a combination of these and other factors.
option price sensitivity
Option price sensitivity is a tool used to measure some of the many factors that affect a contract's price. Specifically, they are statistical values that measure the risk of a specific contract based on different underlying variables. Here is a brief explanation of some of the main option price sensitivities and what they measure:
Delta: Measures the change in the price of an option contract relative to the price of the underlying asset. For example, a delta of 0.6 means that for every $1 change in the asset's price, the premium is likely to change by $0.60.
Gamma: Measures the rate of change of Delta over time. Assuming Delta changes from 0.6 to 0.45, the option has a Gamma of 0.15.
Theta: Measures the price change associated with a contract time reduction of one day. It indicates the expected change in premium as the option contract expiration date approaches.
Vega: Measures the corresponding change rate of the contract price for every 1% change in the implied volatility of the underlying asset. Increases in Vega typically reflect increases in call and put prices.
Rho: A measure of expected price changes associated with interest rate fluctuations. Rising interest rates typically cause call options to increase in price and put options to decrease in price. Therefore, a call option has a positive Rho value and a put option has a negative Rho value.
Common use cases
Hedging
Options contracts are widely used as hedging tools. A very basic example of a hedging strategy would be for a trader to purchase a put option on a stock that they already own. If the overall value of a major holding is lost due to a price decline, exercising a put option can help traders mitigate losses.
For example, suppose Alice buys 100 shares of stock at a price of $50, hoping that the market price will increase. But in order to hedge against the possibility of the stock price falling, she decided to buy a put option with an exercise price of $48, paying a premium of $2 per share. If the market turns bearish and the stock price falls to $35, Alice can exercise the contract to mitigate her loss and sell the stock at $48 per share instead of $35 per share. But if the market turns bullish, then she does not need to exercise the contract and will only lose the premium paid ($2 per share).
Alice would then break even at $52 ($50 + $2 per share), and her loss would be capped at $400 (the $200 premium paid, plus the $48 per share price to sell the stock, with a maximum loss of $200).
speculative trading
Options are also widely used for speculative trading. For example, a trader who believes an asset price is about to rise might buy a call option. If the asset price is higher than the strike price, the trader can exercise the option and buy it at a discount. When the price of an asset is higher or lower than the strike price, making the contract profitable, the option is said to be "in the money." Accordingly, if the contract is at the break-even point, it is called an "at-the-money option"; if it is at a loss, it is called an "out-of-the-money option."
basic strategy
When trading options, traders can employ a variety of strategies based on four basic positions. A buyer can buy a call option (the right to buy) or a put option (the right to sell). The writer can sell a call or put option contract. As mentioned earlier, if the contract holder decides to exercise the option, the author is obligated to buy or sell the asset.
There are different options trading strategies to choose from based on the various possible combinations of call and put contracts. Some basic examples of these strategies are: protective puts, covered calls, straddles, and wide straddles.
Protective put: A put option contract involving the purchase of an existing asset. This is the hedging strategy used by Alice in the previous example. This strategy is also known as portfolio insurance because it protects investors from potential downward trends while maintaining their exposure in case asset prices rise.
Covered Call: A call option involving the sale of an existing asset. Investors can use this strategy to earn additional income (option premiums) from their stock holdings. If the contract is not exercised, the investor can earn a premium while retaining the asset. But if the contract is exercised because the market price rises, the investor is obligated to sell the position.
Straddle arbitrage: refers to buying call options and put options on the same asset with the same exercise price and expiration date. As long as the price of an asset rises or falls by a large enough amount, traders can make a profit. Simply put, traders are betting on market movements.
Wide straddle: Involves the simultaneous purchase of “out of the money” call options and put options (i.e., buying call options at an exercise price above the market price and buying put options at an exercise price below the market price). A wide straddle is basically the same as a straddle, but the cost of opening a position is lower. However, wide straddles require higher levels of volatility to be profitable.
advantage
Suitable for hedging market risks.
More flexibility in speculative trading.
A variety of portfolios and trading strategies can be employed with unique risk/reward patterns.
It is possible to profit from all market trends (bull, bear and bull markets).
It can reduce the cost of opening a warehouse.
Allows multiple transactions to be executed simultaneously.
shortcoming
The mechanics and royalty calculations are sometimes difficult to understand.
High risks involved, especially for the author (seller)
Trading strategies are more complex than traditional alternative strategies.
Options markets often suffer from low liquidity levels, making them less attractive to most traders.
The premium value of an options contract fluctuates widely and decreases as the expiration date approaches.
Options and Futures
Options contracts and futures contracts are both derivatives and therefore present some of the same use cases. Despite their similarities, there are huge differences in settlement mechanisms.
Unlike options, futures contracts typically execute on the expiration date, which means the contract holder is legally obligated to trade the underlying asset (or cash with their respective values). Options, on the other hand, can only be exercised at the discretion of the trader holding the contract. If the contract holder (buyer) exercises the option, the writer (seller) is obligated to trade the underlying asset.
Summarize
As the name suggests, options allow investors to choose to buy or sell an asset in the future, regardless of market price. Such contracts are versatile and can be used in a variety of situations: not only for speculative trading, but also for executing hedging strategies.
But it's important to note that trading options and other derivatives involves many risks. Therefore, before using this type of contract, traders should carefully understand how it works. It is also important for traders to fully understand the different combinations of call and put options, as well as the potential risks involved with each strategy. Additionally, traders should consider employing risk management strategies as well as technical and fundamental analysis to control potential losses.
