OptionsThe Right to Act, But Not the Obligation
All options qualify as derivative instruments. Derivatives acquire their value based on another investment instrument which they represent. That investment is called the “underlying investment”. The underlying can be anything traded in the marketplace, as long as the underlying’s price is easily obtainable. Derivatives are often only traded during the same market hours as their underlying instruments to ensure that’s possible. Derivatives neatly fit into two major categories, forwards or options.
Options are derivatives giving the purchaser the ability to take a conditional action before an expiration date. Note the word ability: if you have an option you have the right, but not the requirement, to take an action. Options should only be exercised if they result in profit. The profit is determined by the market price’s relation to the strike price. For an option to be exercised, the relation should result in profit.
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All options qualify as derivative instruments. Derivatives acquire their value based on another asset which they represent. That asset is called the “underlying investment”. The underlying can be anything traded in the marketplace, as long as the underlying’s price is easily obtainable. Derivatives are often only traded during the same market hours as their underlying assets to ensure that’s possible. Derivatives neatly fit into two major categories, forwards or options.
Calls give the buyer the right, but not the requirement, to purchase the underlying asset at the exercise or strike price from the writer. The buyer hopes the market price will exceed the strike price plus cost of premium, also called “in the money”. The writer hopes the market price will stay below the strike price plus premium cost, or “out the money”.
Calls give the buyer the right, but not the requirement, to purchase an underlying asset at the exercise (or strike) price from the writer. The buyer hopes the market price will exceed the strike price plus cost of the premium to reach “in the money” status. The writer hopes the market price will stay below the strike price plus premium cost, or the “out the money” status. In the money calls are worth more than out the money calls, and their value increases the further into the money they rise. Out the money calls are cheaper to buy. They decrease in price the further out the money they fall, to offset the higher risk price they won’t reach “in the money” status. If they do reach “in the money” status, they will deliver higher profit.
Selling Calls & Writing Calls
Selling Calls & Writing Calls
Selling Calls, also known as Writing calls can generate a profit when shares are decreasing in value. The writer hopes the market price will stay below the strike price plus premium cost, or “out the money”. This is a bearish move. In the money calls are worth more than out the money calls to buyers, but as a writer your “out the money calls” have a far lower chance of being exercised.
Puts give the buyer the right to sell an underlying asset to the put’s writer at the exercise price at or before expiration. The price paid for the right to sell the underlying asset is the premium. The buyer’s goal is to sell the asset for more than it is worth. The buyer of a put anticipates the underlying asset’s market price falling below the exercise price. The writer expects the opposite to occur.
Puts give the buyer the right to sell an underlying asset to the put’s writer at the exercise price at or before the expiration date. The price paid for the right to sell the underlying asset is the premium. A put buyer’s goal is to sell an asset for more than its worth. The buyer of a put anticipates the underlying asset’s market price falling below the exercise price. This allows them to exercise their option and sell the underlying asset at a higher exercise price and earn a profit. The writer of a put expects the price of the put to rise or stay the same price, so they won’t incur a loss by paying more for an asset than it is worth. If the underlying’s market price falls below the exercise price, the put is “in the money” for the buyer. If the underlying’s market price is above the exercise price, the put is “out the money” for the buyer. The formula for a put holder’s profit is as follows…
Selling Puts & Writing Puts
Selling Puts & Writing Puts
Puts give the buyer the right to sell an underlying asset to the put’s writer at the exercise price before expiration. The price paid for the option to sell the underlying asset is the premium. The buyer’s goal is to sell the asset for more than it is worth. The buyer of a put anticipates the underlying asset’s market price falling below the exercise price. This allows them to exercise their option and sell the underlying asset for a higher value exercise price, earning a profit.
Trading options can be a dedicated speculative strategy or assist your investment strategies of the underlying instruments. You have many reasons to trade options if they are available to you. Options have multiple functions in the marketplace including hedging risks, speculation and capitalizing on arbitrage opportunities.
Options Trading Basics
Options Trading Basics
Trading options can be a dedicated speculative strategy or assist investment strategies targeting the underlying assets. Your first decision is trading forwards contracts on an exchange or over the counter.
Options can be divided into multiple categories depending on which underlying assets they represent. The more renown categories of underlying assets are Bonds, Commodities, Currencies, Equities, Futures, Indexes, Interest Rates, and Yields.
Options can be divided into categories by their actual function. These divisions offer varying strategic options for writers and callers, and the one you use should be dependent on your goals and your investment strategy. All of these options can only be exercised once.
Option prices are printed in publications, though this is very little help for someone trading in real time. It’s far more useful for you to gain financial information from websites or digital price streams. These sources update rapidly, within seconds or minutes. If you’re trading based on printed sources showing yesterday’s price, you’ll be behind.
Options Clearing & Settlement
Options Clearing & Settlement
Exchange based trading has a long process that begins when investors deposit money into the fund. Option exchanges work to ensure every trade party acts as agreed. The exchange sets the rules for trading. Exchange clearing and settlement starts when the exchange requires you actually deposit your initial margin.
Purchases and sales of options cannot be canceled once they are ordered. You cannot simply stop the trade once you’ve bought or sold an option, you are bound by contract to meet obligations at expiration. The consequences of your options positions are canceled by acquiring a perfectly offsetting position, neutralizing your exposure.
Historical volatility (HV) measures the previous rate of change in underlying asset’s pricing. This is calculated at the end of every trading day, typically by using standard deviation. They measure the deviations from the average price, and then create an average of those deviations.
Implied Volatility (IV) estimates an underlying asset’s lifelong volatility levels, and is derived from changes in price. As the option trades, IV estimates the option’s lifelong volatility based on multiple factors, including market conditions. Volatility is displayed as an annualized number.
Greeks & Options
Options are affected by multiple indicators symbolized as Greek characters. Each Greek character represents a differing aspect of options trading. The Greek symbols are “Delta”, “Gamma”, “Rho”, “Theta”, and “Vega”.
Delta is the change in value of an option in relation to the change in the underlying asset’s price. Each time the underlying asset moves 1 percentage point, the price of the option also moves. If the percentage of movement in the option is the same as the underlying, the option has a delta of 1. If less, the amount of movement is between .99 and 0.01. If there is no movement in the option when the underlying moves at all, delta is zero. Delta is often expressed without the decimal point. A delta of .99 would be expressed as 99.
Each Option has an individual “delta”, the change in value of an option in relation to the change in the underlying asset’s price. Combined option positions add positive deltas and subtract negative deltas from each option until they arrive at the “Position Delta”.
Gamma is the rate that the delta of an option changes. This change is in comparison to changes in the underlying’s price. Gamma measures the increase or decrease in the amount delta changes for a single point change in the underlying asset’s price. A higher gamma responds more to the underlying price changes; a lower gamma is less responsive. Delta has different rates of change, and therefore different gammas, based on the underlying market price’s relation to the strike price. Gamma’s formula makes detecting these changes easy.
Theta records the decrease in the premium as time to expiration decreases. Each day, the premium falls. Theta measures the one-day negative change in premium until the expiration date. The actual amount of premium lost is called alternating terms, such as premium decay or premium erosion. Theta is also called Time Decay.
Vega displays the price change of an option due to a single point change in an underlying asset’s implied volatility. The impact of Vega is expressed in decimals of currency: it’s the actual amount the price will increase or decrease. A higher Vega means a higher price change per single point movement, a lower Vega means less. Note that Vega doesn’t change or modify the option’s actual value.
Option derivatives are heavily useful for direct speculation and underlying investment strategies. Options are used to boost earnings from strategies, protect long and short trades, create profits from excessive movements in either directions, or earn profit from no movement at all.
Protective Calls & Puts
Protective Calls & Puts
A protective call involves the short sale of an underlying asset along with a long call option. This strategy offers you some insurance against price rises of underlying assets you’ve short sold. One call is purchased for every 100 underlying assets short sold. A protective put involves the purchase of an underlying asset along with a put option. This strategy offers you some insurance against price declines of underlying assets you’ve purchased. One call is purchased for every 100 underlying assets short purchased.
Covered Calls & Covered Puts
Covered Calls & Covered Puts
Covered option strategies attempt to reduce risk. A covered call combines a long purchase of an underlying asset with a written call. A covered put combines a short sale of an underlying asset with a written put. Both are balanced in equal amounts. If you’re long (or short) 1,000 units of the underlying investment, calls (or puts) would represent all 1,000 units. It can represent less, but should never represent more.
A long straddle is constructed by purchasing put and call options that expire at the same time at the same strike price. The price must exceed, or fall below, the strike price plus the premium cost in either a positive or negative direction. If the market price’s movement exceeds the premium cost in absolute value, you earn returns from volatility. A long straddle will pay off if the market price has higher volatility.
A short straddle operates opposite to a long straddle. Instead of purchasing the put and the call, you write put and call options which expire at the same time at the same strike price. You earn a profit if the market price stays between the bounds created by the premium earned. A short straddle is a bet on low volatility.
A strangle is a modified straddle. Straddles utilize options to benefit from a large, or alternatively small, amount of price volatility. A long strangle is created by purchasing a put and call with the same expiration date with a spread between the put and call’s strike prices. A short strangle is created by writing equal amounts of puts and calls on an underlying asset with the same expiration date.
Strips & Straps
Strips & Straps
A strip purchases 2 puts for each single call at the same expiration date and same exercise price. It bets on volatility with higher profit from downward movement if holding a long strip, and bets on lower volatility and slightly upward movement if writing a short strip.
An options spread position buys or writes multiple options on the same underlying asset with one or more of the following: differing prices, differing expiration dates, or differing underlying assets. There are also other possibilities, such as differing Greek indicators. Options Spread positions modify the indicators: the combined options’ Greek values combine to a different overall amount than either option alone. A spread can profit from holding the position until expiry or unwinding the position before the expiration date.
Vertical spreads are also called money spreads. They are constructed with options at different strike prices. The first may be an out, at, or in the option depending on the risk desired. The second is a further out of money option. Each option is on the opposite side of the transaction, one will be written and the other will be purchased. They have the same expiration with a differing strike price. You can use two calls or two puts for vertical spreads, but both must be the same option type.
A Horizontal Spread, also called time or calendar spread, is constructed with the same strike price and differing monthly expiration dates. Horizontal spreads split into long or short categories based on their construction. These constructions also determine whether positions have an initial outflow or inflow. A horizontal debit sells the front month, and buys the back month. A horizontal credit buys the front month, and sells the back month.
A Diagonal spread utilizes aspects from both vertical and horizontal spreads. These strategies use the differing expiration prices of vertical spreads with the differing expiration dates of horizontal spreads. The unification of the two strategies results in a highly variable strategy that balances neutral underlying price expectations with bullish or bearish occurrences thereafter. You can use puts or calls to create diagonal spreads. The Diagonal Spread, like both horizontal and vertical spreads, offers limited risk in exchange for limited potential profit.
Collars are a strategic combination of covered calls and protective puts which control risk. Collars give you financial protection. The costs of collars are reduced, since the premium of one option purchased is offset by another option written. The options are created with the same expiration date.
Condors consist of 4 options in two spreads combined together, facing the other. The initial stock price will be somewhere between the two inner options. Condors can use four calls or four puts, but all options are the same. For a mix of puts and calls see an Iron condor.
Iron Condors are highly similar to regular condors, but utilize a mix of puts and calls to construct the position. Iron Condors consist of two outer options and two inner options combined into two spreads which face each other. The stock price will be somewhere between the two inner options. The two lowest strike price options are puts, and the two highest strike price options are calls.
A butterfly spread consists of multiple options traded at 3 varying strike prices, with double the amount of options at the middle strike price. It should be constructed using all calls or all puts. A butterfly spread constructed from a mix of calls and puts is known as an Iron Butterfly Spread. Any “long” butterfly spread position is a bet on low volatility: the underlying asset price will remain within the range until expiration. A “short” butterfly spread is a bet on high volatility: the underlying asset’s price escaping that range.
A butterfly spread consists of multiple options traded at 3 equidistant strike prices with a differing amount per strike price. A butterfly constructed from a mix of calls and puts is known as an “Iron Butterfly”. Any “long” Iron Butterfly position is a bet on low volatility: the underlying asset price will remain within the range until expiration. A “short” Iron Butterfly position is a bet on high volatility: the underlying asset’s price will escape that range.
A Combination simultaneously purchase one kind of option while selling another option at the same strike price. Long combinations synthetically create a position which emulates owning an underlying asset. Short combinations emulate short selling an underlying asset.
A “Roll” is a method of adjusting options trade by closing existing positions and selling into slightly different new trades. The value of the position closed offsets the price of the new position. Rolling is usually used to avoid assignment losses on short sales but is sometimes used to increase potential profits on long buys. If correctly executed the adjusted position will succeed at either goal. If poorly executed rolling will compound your losses or erase profits.
American style options, generally used for equities, can be assigned at any point. Assignment ruins simple trading strategies and destroys complicated strategies. If you sold any option or have short options in your strategy, you have the chance to be assigned.
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