How To Trade Options
Learn all about options; one of the finest ways for traders to gain leverage in financial markets.
- Real Vision
- January 10, 2022
- 4:14 AM
Options are one of the finest ways for traders to gain leverage in financial markets. An option contract (short: option) is a derivative instrument, whose price is based on the price of an underlying asset. As the name suggests, an option contract – depending on its type – gives the buyer the option to buy or sell an underlying asset at a predefined price. At the expiry date of the option contract, the holder can either choose to exercise his option right or refrain from exercising it. This is unlike futures contracts, which contractually require its holders to buy or sell the underlying asset.
When it comes to option trading, there are two different types of option contracts:
- Call options give the buyer the right to buy the underlying asset at the pre-agreed price at a predefined date.
- Put options give the buyer the right to sell the underlying asset at the pre-agreed price at a predefined date.
As with any financial instrument, call and put options can be bought or sold on financial markets. While the buyer of an option has the right to buy (in the case of a call option) or sell (in the case of a put option) the corresponding underlying asset, the seller of an option has the obligation to sell (in the case of a call option) or buy (in the case of a put option) the underlying asset. In order words: If you sell a call option, you have the obligation to sell the underlying asset to the call option holder, provided the latter exercises his right to buy. If you sell a put option instead, you have the obligation to buy the underlying asset from the put option holder, given he exercises his option right to sell.
Watch the video: Understand the basics of the options market
Expiry date and strike price
With every option contract there comes a specific, predefined expiry date. This is the date the option will expire and can be exercised by the option holder at the latest. After this date, the option contract is no longer valid. In the case of an European style option, the option can only be exercised at the expiry date itself. When it comes to Amercian style options, a holder can exercise his right at any time prior to expiration.
At the expiry date, an option holder has the right to buy or sell an underlying asset at a predefined price. This price is called the strike price. Assuming a rational buyer, a call option right will only be exercised if the price of the underlying asset is above the strike price. Likewise, a put option right will only be realized if the price of the underlying asset is below the strike price.
When we put all of this together we can see that on most trading platforms, option contracts are displayed in the following way:
Underlying Asset – Expiry Date – Strike Price – Option Type (either C for call or P for put)
A concrete example could be:
BTC – 27AUG21 – 35000 – P
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What does an option cost?
Since the buyer of either option type has no obligation but gets only the right to buy or sell the underlying asset, acquiring the option right comes at a certain cost. In order to buy an option, the buyer has to pay the so-called option premium. In simple terms, this premium is the loss a buyer would take if he were to exercise the option right away. A seller of either a call option or put option on the other hand is earning this premium in return for granting the option right to the buyer. As the premium is a non-refundable fee, the option buyer has to pay this fee whether or not he exercises his voluntary option right.
An options premium is paid per contract. For example, if an option has a current premium of 20 cents and the option contract represents 100 shares of an underlying asset, buying the option would cost $20 ($0.20 x 100 = $20).
It’s important to note: An option can be bought and the buyer is paying a one-time fee. This very option can then also be traded on the open market. In the open market then, the option’s premium is not a fixed rather but is permanently influenced by market forces. This means that the premium can rise and fall during hte life of its option contract. As the premium reflects an option holder’s right to exercise the option at the expiry date, a change in the option’s underlying asset price will also change the premium, i.e. the option’s price.
There are two basic components that make up the option premium: Intrinsic value and time value.
1. Intrinsic value
The intrinsic value is an option’s current value, if the option were to be exercised right now. In order to determine the intrinsic value one has to take an underlying assets’ current market price and subtract the strike price that was chosen in the option contract.
So the intrinsic value is dependent on market forces, i.e. the option’s underlying asset price. If the price of the underlying asset increases above the strike price, a call option is said to be in the money. This will also make the price, i.e. the premium of the call option, go up. If the underlying asset falls in price and below the strike price, the call option is said to be out of the money, which will make the premium of this call option decrease accordingly.
The contrary is true for put options. The price of holding a put option increases as the underlying asset price decreases. The opposite happens if the price of the option’s underlying asset increases. This will make the put option’ s premium decrease.
2. Time Value
The time value on the other hand is based on time, i.e. meaning the length of the time period the option is existing as well as the implied volatility. Time and implied volatility affect the extrinsic value of an option premium. The higher the implied volatility, the bigger the change, the option will move in either direction, which is good for the option buyer and would make the option more valuable to him (upwards volatility in the case of a call option and downwards volatility in the case of a put option).
At the same time, the potential volatility (and therefore implied volatility) can be greater, the longer an option exists. In absolute terms, the probability is much higher that the volatility for an option running 2 months is higher than an option existing only for two days. Because of this the time value will head towards zero the closer the option gets to its expiry date because less time “available” means less potential for volatility in the eyes of an option holder.
Options versus Futures
Both of these instruments are financial derivatives that are usually used for speculation as well as hedging. Buying either futures or options can potentially get you unlimited profits. In terms of risk though, options have only limited risk, while futures present unlimited risk. This is mainly due to the fact that with a future, a buyer is obligated to follow through on his contract. If the markets develop to the disadvantage of a buyer’s future contract, the potential loss can be unlimited. This is not the case with an option buyer. His loss is ultimately limited to the option premium he is paying upfront. This upfront premium is another difference as a future buyer has no such premium to pay. Because of this premium, the time value of money bears significance on calculating an option’s premium but not a futures’ price.
Things are different for options sellers, also known as ‘writing options’. Whenever you sell an option contract, whether it’s a put or a call, then your potential loss is unlimited because as a seller of either option, you do take on the liability to either buy or sell the underlying asset, no matter the price movements
Read the guide: How To Trade Futures
Options: A tool to trade volatility
When you buy options, you are long volatility and when you sell options you are short volatility. So, when you buy options you are hoping that the market will move more than other people expect it to move. In other words, when you buy a call you are betting the current price of that call is not reflecting as much upside volatility as you expect. By buying this option you can express your view and gain leverage through buying an option.
Similarly, you buy a put when you think that the market is not reflecting as much downside volatility as you expect. Options are really about a trader’s view on volatility and whether the market is currently overpricing or underpricing it.
Buying Options
Advantages:
- The option buyer’s risk is limited to the premium paid.
- An investor can speculate on market movements without having an obligation to act on wrong assessments.
- Through buying an option, a trader can gain leverage.
Disadvantages:
- A premium is paid for every option contract bought.
- If the price of the underlying asset fails to move or moves against the investor’s expectations, the option contract will lose value every day approaching the expiry date.
- There is a limited time frame for an investor’s option play to work out since the option contract has an expiry date.
Selling Options
Advantages:
- An option seller profits by getting the option premium paid to him.
- As an option approaches its expiry date, the time day (time value going down) works in a seller’s favor. If there is no price movement, the option seller will make a profit anyways.
- Through selling an option, a trader can gain leverage.
Disadvantages:
- A trader selling a call option is facing potentially unlimited loss. A trader selling a put option is facing a potentially large loss, but not unlimited.While there could be infinite loss for a call option seller, the maximum profit is the premium received when selling the option.
As you can see, the risk to the call writers is far greater than the risk exposure of call buyers. The call buyer only loses the premium. The writer faces infinite risk because the stock price could theoretically continue to rise, leading to potentially unlimited losses. For this reason, mostly banks and large institutions act as option sellers.
Statistically though, the option seller has higher odds of profiting from a typical option contract. Take for example an option buyer. In order for the option to be profitable to him, the option contract needs to be above the strike price. If the option contract price at expiry is at the strike price or below, it’s the seller who profits. This is why the odds are statistically considered to be in favor of the option seller.
An interesting fact for an option buyer to keep in mind is: Even a call option where the price of an underlying asset soars past the strike price of this particular option, mustn’t necessarily be profitable for the option holder. If the premium he is paying is bigger than the gain he gets from the underlying asset going past the strike price, he might still be losing money.
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