Options Trading Guide: Key Things to Know

Jun 27, 2020 08:26 PM ET
Options Trading Guide: Key Things to Know

Options trading introduction

Options are financial derivative instruments that are based on the value of an underlying security, e.g., stocks. Depending on the type of options contract one holds, it offers buyers the freedom to either buy or sell the underlying asset. It is not an obligation for the holder of the options to sell or buy the asset if they do not choose to do so, unlike in the case of futures. 

There are two types of options available, Call Options and Put options. They respectively allow the holder to buy or sell the asset within a specific time limit at a predetermined, stated price. 

There are several reasons why investors and traders buy or sell options. Traders can speculate on options. This allows them to hold a leveraged position in an asset. The costs associated with this are significantly lower than buying actual shares of the underlying asset. 

Investors can use options as a means of reducing their portfolio risk exposure or hedging. The option holders are able to generate income when they either become an options writer or when they purchase call options. Traders also directly invest in oil, using options. 

List of option-able assets

  • Stocks [examples: JPM (JPMorgan), AAPL (Apple), FB (Facebook), MSFT (Microsoft)]

  • Exchange Traded Funds [examples: QQQ (PowerShares QQQ Trust ETF Series 1), IWM (iShares Russell 2000 ETF), SPY (SPDR S&P 500 ETF Trust)]

  • Indexes [ examples: NASDAQ Composite Index, S&P 500, Dow Jones Industrial Average]

Types of Options

There are many types of options available for investors and traders alike. The two most common types are call options and put options. 

  • Call options: Call Options are a type of options contract, providing them the holders freedom to buy a specified amount of any underlying security within a specified time limit at a specific price. The option's expiry date is the specified time frame, while the strike price is the specified price. Traders and investors can either sell call options for income purposes, purchase them for speculation, or for use in combination or spread strategies.

There is no obligation on the option holder to buy an asset if he/she so chooses. Thus. The risk to the call option is limited to the payable premium. Fluctuations of any underlying stocks do not affect call options.

Example of a call option:  An Option holder has a call option contract that gives him/her the right to buy shares of Apple Inc. at $100 till the option expires. The price of the option then goes up because of the increase in the value of the Apple stock. The call option buyer can choose from many expiration dates and strike prices. He/she can proceed to hold the contract until it expires. As a result, they can either receive 100 shares of Apple or sell the option contract at any point in time before it reaches its expiration date. 

  • Put options: Put options are a type of options contract which gives its owner the power to sell short or sell the underlying security in a specified amount at a predetermined price within a particular time frame. Here, the strike price refers to the predetermined price that the put option buyer can sell at. 

The underlying asset price and time decay are two major factors that affect put option prices. Put options lose value as the time to expiration comes closer and increase in value when the price of the underlying asset falls. Put options give trader a short position in the underlying asset when exercised. Investors can either speculate on downside price action or use it for hedging purposes.

Put option example: Let's say that an investor is the owner of one put option on the SPDR S&P 500 ETF (SPY). Its strike price is $260, currently trading at $277.00. The option expires in one month and has a premium of $0.72. Investors here have two options. They could establish a short sell position in SPY on the condition that it initiates from a $260 per share price. He/she can do this if the share value of SPY decreases to $250. 

The investor can also purchase 100 shares of the SPY at a rate of $250 per share, and sell them at $260 each to the option's writer. He/she would then make a total net profit of $928, after subtracting the $72 premium.

  • Straddle: A straddle refers to an options strategy that is neutral in nature. It involves the simultaneous purchase of both a call option as well as a put option with equal strike price and the same expiration date.

Example of a straddle: Consider a stock has a current price of $55. The trader believes that the stock may rise or fall from this level after earnings on March 1. They can thus create a straddle, purchasing a single put and call at the $55 strike price, with March 15 as the expiration date. In this scenario, the traders would get a profit of $2 if the stock fell to $48, as the puts would be worth $7 while the calls would be worth nil when they expire. 

Exotic options

There are several other exotic options that differ from traditional options when it comes to their expiry, strike prices, and payment structures.

These are: 

  • Knockout

  • Knock-in

  • Out of money options

  • Barrier

  • Lookback options

  • Asian options

  • Binary Options

  • Bermudan Options

Why Do Traders Need Options? 

  • Speculation: Speculation is almost like a wager or bet on future price direction. After conducting enough technical and fundamental analysis, a speculator may expect the price of a particular stock to go up. Instead of choosing to outrightly buy the underlying stock, the speculator buys a call option on the stock since it provides leverage. In this scenario, instead of purchasing the stock at $100, for example, they can go for an out of money call option, which costs just a few dollars in comparison. 

  • Hedging: Investors and traders mainly use options for hedging risk. It acts almost similar to an insurance policy as it reduces the risk for a reasonable cost. Here, the holder of an option can use options to secure investments against a future market downturn. For instance, if the holder of an option wants to invest in technology stocks but also wants to limit losses, he/she may use put options. They can thus downturn their risk, enjoying all the upsides in a cost-effective manner. Alternatively, short sellers can use call options to limit losses during a short squeeze, when any stock price rises sharply. 

Options expiration

There are a variety of options expiration dates available. In many cases, short-term options are available for a futures product, which allow traders to expand their trading strategies with greater flexibility and precision. Alternatively, there are some options with expirations that align with the expiry of the underlying futures contract. If we take the example of E-mini S&P 500 futures contracts, there are three types of options available. 

  • Quarterly Options 

  • Monthly Options

  • Weekly Options 

Options and the Greeks

The term "Greeks" in the options market, denotes all the different dimensions of risks involved when one takes an options position. It uses Greek symbols, hence the name "Greeks." Both portfolio managers and investors use them to hedge risk giving them a proper picture of how their profit and loss would behave in relation to the movement of prices.  

Delta, Gamma, Theta, and Vega are all common "Greeks." All of them are the first partial derivatives of the options pricing model. 

  • Delta (Δ): Delta denotes the rate of change between the price of an options contract with a 1$ change in the price of the underlying asset. It is also a representation of the hedge ratio for options traders, who can create a delta neutral position. For example, an individual can sell 40 shares of stock for an American call option with 0.40 delta to be fully hedged.

  • Theta (Θ): Theta denotes the rate of change between the time or time-sensitivity of the option with the option price. In other words, it indicates the amount of decrease of an option's price in relation to the decreasing time to expiration. For instance, if an option has a theta of -0.30, it means that the price of the option would decrease by 30 cents daily till the time of expiration. Thetas tend to decrease when options are "in and out of the money" and increase when they are "at the money." While short calls and short puts have positive theta, long calls and long puts have their theta at negative.

  • Gamma (Γ): Gamma denotes the rate of change between the price of an underlying asset with the option's delta, which makes it a second-order or second derivative price sensitivity. In other words, gamma indicated the change in the delta of an option if there was a $1 move in the price of the underlying security. For example, if a call option has a delta of 0.50 along with a gamma of 0.10, the delta of the call option would increase or decrease by 0.10 if the stock increases or decreases by $1. Options traders have the option to hedge both delta and gamma together to be delta-gamma neutral. This means that the delta would remain close to zero when the underlying price moved.

  • Vega (v): Vega denoted the rate of change between the implied volatility of the underlying asset and the option's value. In other words, it measured the amount of change in an option's price when there was a 1% change in its implied volatility. For example, if the implied volatility moves by 1%, a Vega of 0.10 indicates that the option's value will change by 10 cents.

  • Rho(p): This represents the rate of change between a 1% change in interest rates and an option's value, measuring sensitivity to the interest rate. For instance, if a call option is priced at $1.20 and has a rho of 0.10, the value of the call option increases to $1.30 when interest rates rise by 1%. 

How to control risks in options trading?

Traders and investors use options to minimize risk when making directional bets apart from hedging. Contrary to popular conceptions, leverage applies a little differently when it comes to options. Leverage maintains the same sized position but requires less money to do so in the case options.

Example:

Instead of buying a $50 stock with a capital of $10000, traders can purchase two call option contracts to control the same amount of shares (200). While the total cost of buying 1000 shares would have been $41.750 (each costing $41.75), the trader can buy ten calls to control the same amount of shares. This would provide $25450 in savings. Investors can use the savings, either for greater diversification or for sitting inside a trading account to earn money market rates. The interest, which adds up to about $509 per year, is known as the synthetic dividend.

Conclusion

For a trader or investor to successfully use options, he/she has to take into account all the other factors such as liquidity and volatility. They are used for both hedging instruments as well as speculative instruments. They provide an ideal way for traders to deploy capital efficiently as option premium as well. Both buyers and sellers, however, have to manage the price risk and express their opinion in the marketplace. 


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