Back to Blog
 
TABLE OF CONTENTS
 
  • What Is an Option?
  • Understanding Options
  • Options Risk Metrics: The Greeks
  • Buying Call Options
  • Selling Call Options
  • Buying Put Options
  • Selling Put Options
  • Real-World Example of an Option
  • Options Spreads
  • Frequently Asked Questions

 

What Does It Mean to Have a Choice? 
Options are derivative financial instruments dependent on the value of underlying securities like stocks. An options contract gives the buyer the choice to buy or sell the underlying asset, depending on the contract type. Unlike futures, the holder of an option is not obligated to buy or sell the asset if they do not wish to. 

 

The holder of a call option can purchase an asset at a certain price within a specified timeframe. Put options allow the holder to sell an asset at a predetermined price within a given timeframe. The holder of each option contract will have a particular deadline by which they must exercise their option. The strike price of an option is the stated price of the option. Online or retail brokers are commonly used to buy and sell options. 

 

Options are financial derivatives that provide buyers with the right but not the obligation to buy or sell an underlying asset at a predetermined price and date. 


Call and put options provide the foundation for a variety of option strategies for hedging, income, and speculation. 
While there are numerous ways to benefit from options, investors should carefully consider the dangers. 



Understanding Alternatives 
Options are a financial product that can be used in a variety of ways. These agreements involve a buyer and a seller, with the buyer paying an option premium in exchange for the contract's rights. There is a bullish buyer and a bearish seller for each call option, while there is a bearish buyer and a bullish seller for each put option.

 

The buyer will pay a premium fee for each contract, which normally represents 100 shares of the underlying securities. Buying one option, for example, would cost $35 ($0.35 x 100 = $35) if the premium per contract is 35 cents. The striking price—the price for purchasing or selling the asset until the expiration date—is used to calculate the premium. The expiration date is also a component of the premium price. The expiration date, like the date on the carton of milk in the refrigerator, specifies when the option contract must be exercised. The use-by date is determined by the underlying asset. It is normally the third Friday of the contract's month for stocks. 

 

Options are bought and sold by traders and investors for a variety of reasons. Options speculation enables a trader to retain a leveraged position in an asset at a lesser cost than purchasing the asset's shares. Investors will employ options to hedge or lower their portfolio's risk exposure. Option holders can make money by buying call options or becoming options writers in specific instances. One of the most direct methods to invest in oil is through options. The daily trading volume and open interest of an option are the two crucial numbers for options traders to keep an eye on in order to make the best investing selections. 

 

European options can only be exercised on the expiration date or the exercise date, whereas American options can be exercised at any time before the expiration date. The term "exercise" refers to the act of using one's right to buy or sell the underlying security. 

 

Risk Metrics for Options: The Greeks 
The term "Greeks" is used in the options market to characterize the various risk aspects involved in taking an options position, whether in a single option or a portfolio of options. Because they are frequently associated with Greek symbols, these variables are referred to as Greeks. Each risk variable is the outcome of a flaw in the option's assumption or link to another underlying variable. Traders estimate options risk and manage option portfolios using several Greek values, such as delta, theta, and others. 

 

The rate of change between the option's price and a $1 change in the underlying asset's price is represented by Delta Delta (). To put it another way, the option's price sensitivity to the underlying. The delta of a call option ranges from zero to one, whereas the delta of a put option ranges from zero to negative one. Consider the case of an investor who is long a 0.50 delta call option. As a result, if the price of the underlying stock rises by $1, the option's price rises by 50 cents. 

 

Delta is also the hedge ratio for constructing a delta-neutral position for options traders. To be fully hedged, you'll need to sell 40 shares of stock if you buy a normal American call option with a 0.40 delta. The hedging ratio of a portfolio of options can also be calculated using the portfolio's net delta. 

The current likelihood that an option will expire in the money is a less typical application of an option's delta. A 0.40 delta call option, for example, has a 40 percent chance of finishing in the money today. 

 

Theta 
Theta () denotes the rate of change in the option price over time, also known as time sensitivity or options time decay. All other things being equal, theta reflects how much an option's price lowers as the time to expiration decreases. Consider the case of an investor who is long a -0.50 theta option. All other things being equal, the price of the option would reduce by 50 cents with each passing day. The option's value would theoretically decline by $1.50 after three trading days. 

 

When options are at the money, theta grows, and when options are in- and out-of-the-money, theta falls. Options with a shorter time to expiration have a faster time decay. Short calls and short puts have positive Theta, while long calls and long puts have negative Theta. A stock, for example, would have 0 Theta because its value is not depreciated over time. 

 

Gamma () is the rate of change between the delta of an option and the price of the underlying asset. Second-order (second-derivative) price sensitivity is what it's called. The gamma value reflects how much the delta would vary if the underlying security moved $1. Assume that an investor owns one call option on the hypothetical stock XYZ. The delta of the call option is 0.50, while the gamma is 0.10. As a result, if stock XYZ rises or falls by $1, the delta of the call option rises or falls by 0.10. 

 

Gamma is used to measure how stable the delta of an option is: greater gamma values imply that delta could shift drastically in reaction to even minor changes in the underlying's price. 

 

Gamma is higher for at-the-money options and lower for in- and out-of-the-money options, and it increases in magnitude as expiration approaches. The further away from the expiration date, the smaller the gamma value; options with longer expirations are less susceptible to delta fluctuations. Gamma values often increase as expiration approaches, as price fluctuations have a greater impact on gamma. 

 

Options traders may choose to hedge not only delta but also gamma in order to achieve delta-gamma neutrality, which means that the delta will remain close to zero while the underlying price fluctuates. 

 

Vega (V) is the rate of change between the value of an option and the implied volatility of the underlying asset. This is the sensitivity of the option to volatility. The Vega indicator shows how much an option's price changes in response to a 1% change in implied volatility. A Vega of 0.10, for example, means that the option's value is likely to vary by 10 cents if the implied volatility changes by 1%. 

 

Increased volatility suggests that the underlying instrument is more likely to encounter extreme values, hence an increase in volatility will raise the option's value. A decrease in volatility, on the other hand, will have a negative impact on the option's value. For at-the-money options with extended expiration durations, Vega is at its highest. 

 

Those who are familiar with the Greek alphabet will notice that the letter vega does not exist. There are several hypotheses as to how this symbol, which resembles the Greek letter nu, came to be used in stock trading jargon. 


Rho 
The rate of change between the value of an option and a 1% change in the interest rate is represented by Rho (p). This is a metric for interest rate sensitivity. Assume that a call option with a rho of 0.05 and a price of $1.25 has a rho of 0.05 and a price of $1.25. If interest rates climb by 1%, the call option's value rises to $1.30, assuming all other factors remain constant. Put options, on the other hand, are the polar opposite. Rho is best for at-the-money options with long expiration durations. 

 

Greeks from the periphery 
Lambda, epsilon, vomma, vera, speed, zomma, color, and ultima are some more Greeks that aren't as well-known. 

These Greeks are second- or third-order derivatives of the pricing model, affecting things like delta changes in response to volatility changes, and so on. Computer software can swiftly compute and account for these complicated and sometimes esoteric risk factors, therefore they're becoming more common in options trading techniques.

 

Buying Call Options: Risks and Gains 
As previously stated, call options allow the holder to purchase an underlying security at the given strike price by the expiration date, which is referred to as the expiry. If the holder does not wish to buy the asset, they are under no duty to do so. The call option purchaser's risk is limited to the premium paid. The underlying stock's fluctuations have no bearing. 

Buyers of call options are positive on the stock and anticipate it will increase over the strike price before the option expires. If the investor's bullish prediction comes true and the stock price rises over the strike price, the investor can exercise the option, buy the stock at the strike price, and sell it at the current market price for a profit. 

 

The market share price less than the strike share price, plus the cost of the option—the premium and any brokerage commission to place the orders—is their profit on this trade. The result would be multiplied by the number of option contracts acquired, then by 100, assuming that each contract represents 100 shares. 

 

The option expires worthless if the underlying stock price does not move above the strike price by the expiration date. The holder is not compelled to purchase the shares, but the premium paid for the call will be forfeited. 

 

Selling Call Options: Risks and Profits 
Writing a contract is the process of selling call options. The premium charge is paid to the writer. To put it another way, an option buyer will pay the premium to the option writer—or seller. The premium received while selling the option is the maximum profit. An investor who sells a call option is bearish, believing that the price of the underlying stock will decrease or remain reasonably close to the strike price over the option's life. 

 

The option expires worthless for the call buyer if the current market share price is at or below the strike price by expiry. The premium is kept by the option seller as profit. Because the option buyer would not acquire the stock at the strike price higher than or equal to the current market price, the option is not exercised. 

 

If the market share price at expiry is higher than the strike price, the option seller must sell the shares to an option buyer at the lower strike price. To put it another way, the seller must either sell shares from their portfolio or purchase the stock at market price to sell to the call option buyer. The contract writer loses money. The size of the loss is determined by the cost basis of the shares they must use to cover the option order, as well as any brokerage order costs, but minus any premium received. 

 

As you can see, the risk to call writers is far higher than the risk to call purchasers. Only the premium is lost by the call buyer. Because the stock price could continue to climb, the writer stands an endless danger of large losses. 

 

Buying Put Options: Risks and Gains 
Put options are investments in which the buyer expects the market price of the underlying stock to fall below the strike price on or before the option's expiration date. The holder can sell shares without being obligated to do so at the indicated strike price per share by the given date once again. 

 

The put option is profitable when the underlying stock's price is below the strike price because put option buyers want the stock price to fall. The investor can exercise the put if the current market price is less than the strike price at expiry. They'll sell the stock at the higher strike price of the option. They can buy these shares on the open market if they want to replace their current holdings. 

 

The strike price less than the current market price is their profit on this trade, plus the premium and any brokerage commission paid to place the orders. The result would be multiplied by the number of option contracts acquired, then by 100, assuming that each contract represents 100 shares. 

 

As the underlying stock price falls, the value of holding a put option increases. The value of a put option, on the other hand, decreases when the stock price rises. Buying put options carries only the risk of losing the premium if the option expires worthless. 

 

Selling Put Options: Risks and Profits 
Writing a contract is another term for selling put options. A put option writer is bullish on the stock because they believe the price of the underlying stock will stay the same or increase over the life of the option. On expiration, the option buyer has the power to require the seller to purchase shares of the underlying asset at the strike price. 

 

The put option expires worthless if the underlying stock's price closes above the strike price by the expiration date. The premium is the writer's maximum profit. Because the option buyer would not sell the stock at the lower strike price when the market price is higher, the option is not exercised. 

 

The put option writer is liable to buy shares of the underlying stock at the strike price if the stock's market value falls below the option strike price. In other words, the option buyer will exercise the put option. Because the strike price is higher than the stock's market value, the buyer will sell their shares at that price. 

 

When the market price falls below the strike price, the put option writer faces a risk. The seller is now obligated to acquire shares at the strike price when the contract expires. The put writer's loss can be large depending on how much the shares have depreciated.

 

The put writer (seller) has two options: keep the stock and hope for a price rise above the purchase price, or sell the stock and accept a loss. However, the premium collected more than compensates for any losses. 

 

An investor may write put options at a strike price that reflects the price at which they believe the shares are a good bargain and would be willing to purchase them. When the price of the stock drops and the option buyer exercises their option, they obtain the stock at the price they wish, plus the option premium. 

 

Pros 
When the stock price is rising, a call option buyer has the right to buy assets at a cheaper price than the market. 
When the market price is below the strike price, the put option buyer can benefit by selling the stock at the strike price. 
For writing an option, option sellers receive a premium fee from the buyer. 


Cons 
In a sinking market, the put option seller may be obliged to pay a greater strike price for the asset than they would normally pay in the market. 


If the stock price rises dramatically and the call option writer is obliged to buy shares at a high price, the risk is limitless. 
Option buyers must pay a premium to the option writers upfront. 


An Option in the Real World 
Assume that Microsoft (MFST) shares are currently trading at $108 a share and that you believe they will rise in value. You decide to purchase a call option in order to profit on a rise in the stock price. 

 

For 37 cents per contact, you buy one call option with a strike price of $115 for one month in the future. The overall cost of the position, including fees and commissions, is $37 (0.37 x 100 = $37). 

 

If the price climbs to $116, your option will be worth $1 since you may exercise it to buy the shares for $115 and immediately sell it for $116. Since you bought 37 cents for the option and gained $1, your profit would be 170.3 percent—much larger than the 7.4 percent increase in the underlying stock price from $108 to $116 at expiration. 

 

In other words, since one option contract represents 100 shares, the profit in dollar terms would be a net of 63 cents or $63 [($1 - 0.37) x 100 = $63]. Your option would expire worthless if the stock fell below $100, costing you $37 in premium. On the plus side, you didn't acquire 100 shares at $108, which would have resulted in a total loss of $8 per share, or $800. Options, as you can see, can assist you to limit your downside risk. 

 

Options spreads are risk-return strategies in which different combinations of purchasing and selling different options are used to achieve a particular risk-return profile. Spreads are built with vanilla options and can take advantage of a variety of scenarios, including high- or low-volatility environments, up- or down-moves, and everything in between. 

 

Bull call spreads and iron condors are examples of spread strategies that may be identified by their payment or visualizations of their profit-loss profile. Learn more about covered calls, straddles, and calendar spreads in our article on 10 basic options spread strategies. 

 

Most Commonly Asked Questions:

What possibilities do you have? 
Options are a sort of derivative product that allows investors to bet on or hedge against an underlying stock's volatility. Options are classified into two types: call options, which allow buyers to benefit if the stock price rises, and put options, which allow buyers to profit if the stock price falls. Investors can sell options to other investors in the same way they sell other assets. Shorting (or "selling") a call option means profiting if the underlying stock falls in value, whereas selling a put option means earning if the stock rises in value. 

What are the key benefits of having options? 
As a source of leverage and risk hedging, options can be quite beneficial. For example, an investor who is bullish on a business's future and wants to invest $1,000 might possibly make a far higher return by acquiring $1,000 worth of call options on that company rather than $1,000 worth of shares. In this approach, call options allow investors to leverage their positions by raising their purchasing power. If, on the other hand, that same investor already had a position in that firm and wanted to lower their risk, they could do so by selling put options against it.

 

What are the most significant drawbacks of options? 
The biggest downside of options contracts is that they are difficult to price and understand. As a result, options have long been seen as an “advanced” sort of investment vehicle, appropriate only for seasoned professionals. However, in recent years, they have grown in popularity among ordinary investors. Because options have the potential for large gains or losses, investors should make sure they fully grasp the ramifications before taking any options positions. Failure to do so can result in catastrophic losses.


You can start building your own Options Trade System with Finage free Options API key.

Build with us today!

Get Free a API key