Option contracts give traders the ability to purchase or sell assets at a specified price. This may seem similar to Futures contracts but option contract buyers are not required to settle positions.
Option contracts can be based upon a variety of underlying assets such as stocks or cryptocurrencies. You can also obtain these contracts from financial indexes. Option contracts are typically used to hedge risk on existing positions or for speculative trading.
What is the working principle of option contracts?
There are two types of options: put and call. Call options allow contract holders to purchase the underlying asset while put options grant the right for the contract holder to sell. So traders will usually place calls when they anticipate the price of the asset to rise and put when it falls. You can also use puts and calls to hope that prices remain stable or a combination of both. There are two types: a bet against or for market volatility.
An option contract must contain at least four components: size and expiry time, strike prices, premium, and strike price. The order size is the number of contracts traded. The expiration date, which is the date that the option ceases to be available to the trader, is also important. The strike price, which is the price at the asset can be purchased or sold if the buyer exercises the option, is third. The premium, which is the option contract’s trading price, is also important. The premium is the price that an investor must pay in order to have the option to choose. Buyers purchase contracts from writers (sellers), based on the premium. This value changes with the expiration date.
The strike price must be below the market price for the trader to buy the underlying asset at a discount. After adding the premium to the equation, he may choose to execute the contract to earn a profit. If the strike price is greater than the market price, then the contract is deemed useless. The buyer does not lose the premium paid for the position if the contract is cancelled.
Important to remember that buyers have the option of executing calls or puts but the sellers (authors) are bound by the buyers’ decisions. If the buyer of the call option decides that he wants to execute his contract the seller must sell the underlying asset. The same applies to a trader who buys a put option. If he exercises it, the seller must buy the underlying assets from the contract holder. Writers are more at risk than buyers. Although buyers are protected by the contract’s premium, the losses of authors can be much greater depending on the market value of the assets.
Certain contracts allow traders to exercise their option at any moment before the expiration date. These contracts are often referred to simply as U.S. options. Contrary to popular belief, European option contracts cannot be executed until their expiry date. It is important to note that these names do not reflect their geographic location.
There are many factors that influence the size of the premium. We can assume that an option’s premium is dependent on four elements. These are the price of the asset, strike price, time remaining before expiration and volatility of the market or index. The premium of call and put options is affected by these four elements in different ways. As shown in the table below,
|Call Options Premium||Premium for Put Options|
|Value of assets grows||Increases||Reduced|
|Higher execution price||Reduced||Increases|
The strike price and asset price have an impact on the premium and call price. Both types of options are usually cheaper if there is less time. This is because traders are less likely to see these contracts as a win for them. Premium prices tend to rise when there is more volatility. These and other factors combine to create the premium for an option contract.
Variants of the Greeks
Greek options are instruments that measure the impact of various factors on a contract’s price. They are statistical values that can be used to assess the risk associated with a contract, based on various variables. Here is a brief explanation of what they are:
- Delta: This is the ratio of the price of an option contract to the price for the underlying assets. A delta of 0.6 means that the markup price is expected to change by $0.60 per $1 increase in assets prices.
- Gamma: This parameter measures the rate at which delta changes over time. If Delta changes between 0.6 and 0.45, Gamma will be 0.15.
- Theta: Measures the price change relative the one-day decrease in the term of contracts. It estimates how much the premium will change as the option contract nears its expiration.
- Vega: This is the ratio of the change in price of a contract to the 1% increase in implied volatility of the asset. Usually, a rise in Vega is a reflection of an increase in both calls or puts.
- Rho: This is the measure of the expected price changes based on fluctuations in interest rates. Higher interest rates are usually associated with an increase in calls and decreases in puts. The Rho value is positive for call options, and negative for put options.
Common Use Cases
Options contracts are commonly used as hedge instruments. An example of a simple hedging strategy is when traders purchase put options on stocks that they already own. Executing a put option may help reduce their losses if the value of their underlying assets decreases due to lower prices.
Imagine Alice buying 100 shares for $50 in the hope that the market would rise. To hedge against falling stock prices, Alice decided to purchase put options at $ 48 to protect herself. The premium was $ 2. Alice can sell each share for $48, instead of $35, if the market turns bearish and the stock prices fall to $35. If the market turns bullish, Alice won’t have to fulfill her contract and will lose the premium ($2 per share).
Alice would make a profit at $52 ($50 + $2) per share, while her losses would be limited to $400 ($200 for the premium and $200 if she sold each share at $48).
Option trading is also a popular option. A trader can purchase a call option if he believes the asset’s price is going to rise. The trader can choose to exercise the option and purchase the asset at a discount if the asset’s price rises beyond the strike price. The option is “in the money” if the asset’s price is greater or less than the strike price. A contract is also considered profitable if it reaches the break-even point or is unprofitable.
Trader can choose from a variety of trading strategies that are based on four positions. You can either buy a call option (right-to-buy) or a puts option (right-to sell). It is possible to either buy or sell options on contracts if you are a writer. If the contract owner wants to sell them, writers must buy or sell assets.
Different trading strategies for options are based upon different combinations of put and call contracts. These strategies include covered calls, strangulation, protective shackles and protected shackles.
- Defensive put: This involves the purchase of a contract with the option to sell an asset already owned. This is Alice’s hedging strategy. Portfolio insurance is also known this way because it protects investors from potential downtrends and helps to mitigate risks in the case of an increase in asset values.
- Covered call: This refers to the sale of a call option for an asset that is already owned. Investors use this strategy to earn additional income (option premiums). Investors receive a premium if the contract isn’t fulfilled while keeping their assets. They are required to sell any positions if the contract is not executed because of an increase in market prices.
- Straddle: This is where you buy a call and place a put on the exact same asset. They have identical expiry dates and strike prices. This allows traders to profit as long the asset moves in the desired direction. A trader is dependent on market volatility.
- Strangulation is the act of buying puts and calls that are not in the bank. The strike price for call options is higher than the market price, and the strike price for put options is lower. Strangulation is essentially a straddle but costs less to open a position. To be profitable, strangulation must have a higher level volatility.
- Suitable for hedging market risks.
- More flexibility in speculative trades
- Multiple combinations and trading strategies can be used with different risk/reward ratios.
- Profit from any bullish, bearish or sideways market trend.
- This can be used to lower the cost of a job.
- Multiple trades can be done simultaneously
- It is not always easy to understand the mechanisms of premium calculation and work.
- High risks are involved, particularly for contract writers (sellers).
- Trading strategies that are more sophisticated than conventional ones.
- Low liquidity levels make option markets less appealing to traders.
- Option contracts are highly volatile and their value tends to decrease as the expiration date nears.
Options vs. Futures
Futures and options are derivatives. They can be used in a variety of situations. Despite their similarity, there are significant differences in the way they calculate.
Contrary to options, futures contracts must be executed at expiration. This means contract holders have to exchange the underlying asset or the cash equivalent. Options can only be exercised by the trader who owns the contract. The option is only available to the buyer (contract holder) and the seller (author) are obliged trade the asset.
Options give investors the ability to purchase or sell assets in the future regardless of market prices. These contracts can be used for both speculative trading and hedging.
It is important to remember that trading options are not like other derivatives. Trader should be able to understand the basics of this contract before they use it. You should also be able to understand the various combinations of calls or puts and the risks associated with each strategy. To limit losses, traders should consider risk management strategies that combine technical and fundamental analysis.