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Options Trading: What It Is, How It Works & BEST Strategies
It’s important to know about all sorts of trading strategies. So let’s take a little time to talk about some options trading examples and how it all works.
Even though I don’t do options trading, that doesn’t mean you can’t or shouldn’t.
Why am I taking the time to do this? Because I understand that trading isn’t one size fits all.
I made my fortune trading penny stocks, and that’s what I teach my students. But I also think it’s important to learn all about the different trading strategies out there so you can decide for yourself what you want to pursue.
Becoming a self-sufficient trader is all about finding out what works for you and refining your methods over time.
For some traders, options have proven a successful strategy. Could it be a good fit for you? Read on to learn more — I’ll cover some fundamental basics, key terms, and strategies for options beginners.
Table of Contents
What Is Options Trading?
Options are a specific type of security called a derivative.
There are lots of examples of derivative investments. They’re a type of financial security that’s valued based on either a single or a group of underlying assets.
Some examples of these underlying assets include bonds, commodities, currencies, stocks, and market indexes.
Derivatives can be traded like stocks, either OTC (over the counter) or via an exchange. Their price can and will fluctuate based on the value of the underlying stock. That’s where the inherent risk comes in.
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Option prices are derivatives of the stocks they represent.
Options Trading Rights and Obligations
With options, you get the right — but not the obligation — to purchase or sell a certain amount of stock (or other securities) at a pre-arranged price and on a specific date. That price is derived from the stock’s price.
Options are contracts, but they give you the rights to buy or sell — not an obligation. They’re different from regular stock plays and futures because you can decide not to go through with the contract.
Options Trading Examples: How Can You Succeed?
Before I answer that question, I gotta say this: I’m not an options trader and I’m in no way giving you trading or financial advice. All trading is risky. Never risk more than you can afford. Do your due diligence.
To succeed as an options trader, your education is vital. You need to know how it works and how trades play out.
Keep reading to learn options trading basics along with some examples to help you start to put it all together.
How Does Options Trading Work?
Think of how options trading works in terms of selling a car to a private buyer.
- You meet the buyer who looks over the car and gives you a deposit to hold the vehicle.
- You get to keep the deposit even if the buyer decides not to return with the full purchase price by the agreed-upon date.
- The prospective buyer has bought the option to buy the car by whatever deadline you set.
- If the buyer doesn’t, you can sell the car to someone else — maybe even for a higher price — and you already have the deposit in your pocket.
Options trading is far more complicated than that, but it can be easier to understand when you have an example outside of stock market options.
I really want to stress that you need to learn the basics of options trading before you execute any contracts.
Otherwise, you’ll lose money like thousands of other traders who jump into options trading without the right knowledge.
Options Trading Brokers
Just like with stocks, you need a broker to trade options. However, not all brokers offer options trading.
If you’re happy with your current broker, check with them first to see if they offer options trading. And if they do, find out what their requirements are.
If your broker doesn’t offer options trading, you’ll need to find one that does. Remember: don’t take this decision lightly. Be sure to do plenty of research on options brokers before settling on one.
While this post focuses on choosing a stockbroker, many of the tips are relevant for choosing an options trading broker too.
Types of Options
With options, you have … well, options. Let’s talk about some of the different types.
Long vs. Short Options
With stocks, you can go long or take a short position. With options, you can trade either call or put options. Here’s a brief synopsis of what they are and how they work…
A call option is a potential future trade.
For example, say you want to purchase 1,000 shares of Stock X at $4.20 per share at some point in the future because you believe it’ll go up in price.
You can purchase a call option to make this purchase at any point within a finite period. You’re kind of calling dibs or locking in that price.
However, the person selling doesn’t necessarily just want you calling dibs without getting something in return.
As the buyer, you’ve got to put down a premium — that’s the price of the options contract.
The benefit is that if the stock goes up in value, you can still complete the purchase at the agreed-upon price during the contract period. The premium you pay acts as a down payment.
However, if the option’s expiration date passes and you don’t move forward, you don’t get the premium back.
A put option is a contract where you as a contract holder have the right to sell the asset in question at any time within a predetermined, finite period.
Say you want to sell shares of a stock. You set your strike price — say it’s $5. With a put option, you can sell your shares for that price at any point before the expiration date.
The benefit of this method is that even if the stock value goes down dramatically, you can still get the agreed-upon price.
A put seller receives a premium or down payment in this case. A single put option represents a specific amount of the underlying asset in question. Frequently, it’s one put option to 100 shares of the underlying asset.
In other words, the “down payment” is 1/100th of the total purchase price.
Trading Call vs. Put Options
- A call option is best when you believe the price of a stock will rise.
- A put option is best when you believe the price of a stock will fall.
Benefits and Advantages of Trading Options
Some of my students have had excellent results with options trading. They’ve studied the market, recognized the potential pitfalls, and traded options with their own risk tolerance in mind.
Why do some successful traders love options trading? Here are some advantages.
Options can give you a ton of flexibility.
Yes, you have to plunk down that premium, but it affords you the flexibility to make the decision of whether to actually exercise the option later.
You don’t have to exercise the option if you choose not to. There’s no punishment. When the expiration date comes, the option becomes null and void.
Yes, this means that you lose the investment that you made for the option premium, but you won’t suffer any additional losses.
Also, since options are a type of derivative, you can use them to trade all sorts of financial securities like commodities and foreign currencies to name a few … It’s not just for stocks.
Limited Risk for Buyers
I’m all about cutting losses and limiting risk. Options can let you limit risk, which is a good thing.
Yes, you do have to put down that premium, and if you don’t exercise the option within a set period of time, you may forfeit that payment. So, in that way, there’s considerable risk depending on the number of shares you intend to buy or sell.
However, that risk can be minimal compared to the potential losses you might suffer if you made the trade without an options contract.
Yep … If you think options sound a bit like prospecting, you’re right. There’s a certain level of speculation involved in options trading.
For instance, if you purchase a call option, you probably have a strong belief that its value will go up in time and that you’ll be able to buy in at a low price. Employing a call option versus simply buying the asset or stock allows you additional time.
But remember the car sale scenario. The buyer puts down a deposit against the agreed-upon price. That’s all well and good. But the seller holds the cards here. If the buyer doesn’t come back, the seller keeps the cash.
It works the same with options trading.
While options buyers often speculate to a certain degree, one of the biggest appeals of options is that you can hedge your bets, so to speak. Hedging is a method of reducing risk.
I hate risk. Have I said that already? Let me say it again: I hate risk. And you should, too.
Like in the car sale analogy, an options premium creates a stopgap. It basically says, “This is the most I’ll lose on this deal if it goes south.”
Basically, you’re guaranteeing that this would be the maximum amount that you’d lose if things don’t go your way. It’s almost like an insurance policy. Yes, you have to pay for insurance, but if something goes wrong, you’re covered.
Some will say that if you’re not sure of a stock investment, you haven’t done enough research and it’s too risky to even pursue.
But some traders think that hedging can be an intelligent approach … you never know what factors will play into a stock’s or asset’s value. Hedging strategies can be extremely valuable, especially when the stakes get high.
Options give you the ability to restrict the potential losses on a given investment, while optimistically trying to make the most of the potential gains. It can be really cost effective when you think of it in that way. You’re paying for peace of mind.
How to Read an Options Table
The first time you try to read an options table, you’ll likely feel overwhelmed. I know I did.
With its staggering series of columns, it can be confusing.
However, once you break it down, it’s really not as complex as it seems. Here’s a cheat sheet of some of the common columns you’ll see in a table and what they mean.
This is short for Option Symbol. This column offers the basics: The stock symbol, the contract date of maturity, and the strike price. It also defines whether it is a call or a put option (specified with a C or a P).
Referred to in points, the bid price is the most up-to-date price offered to buy the option in question. So, if you were to enter a market order to sell the call or put, this would be the price commanded.
Also referred to in points, the ask price is the most up-to-date price offered to sell the option in question. So, if you were to enter a market order to buy the call or put, this would be the price commanded.
This shows the premium of time built into the option price. Since all options lose their time premium when the option expires, this value showcases the amount of time premium currently playing into the option’s price.
Implied Volatility Bid/Ask
Also referred to as the IV Bid/Ask, this column shows the potential level of future volatility. This is based on factors including the option’s current price and the amount of time until the option expires. This value can be determined by a model such as the Black-Scholes Model.
According to “The Economic Times,” the “Black-Scholes is a pricing model used to determine the fair price or theoretical value for a call or a put option based on six variables such as volatility, type of option, underlying stock price, time, strike price, and risk-free rate.”
Ultimately, with a higher IV Bid/Ask, there’s more time premium included in the option’s price.
Historical vs. Implied Volatility
Not sure about the difference between historical and implied volatility? Let’s take a little time out to talk about it.
- Historical volatility is based on historical data –– like actual past price action.
- Implied volatility looks at the past but is forward-thinking. It uses the past to predict what might happen with volatility in the future.
This column tells you how many contracts of a given option were traded during the last market session. Often, options with larger movement and volume will have a tight bid/ask spread, since the competition to buy and sell these options is higher.
This column tells you how many contracts of a given option have been opened, but have not yet been cashed in or sold.
This column tells you the strike price of the option in question. This is the price that the buyer has set to buy or sell the underlying security if he or she chooses to take the option.
Assessing Risks in Options Trading
In addition to the above columns in an options table, you’ll often see a series of columns with headings named after greek letters. One of the unique things about options is that they carry various values that can help you determine the level of risk.
I’m talking, of course, about the infamous “Greeks.”
If you’ve been researching options or looking at options tables, you’ve probably heard about the Greeks — and are likely confused by them. The Greeks include delta, gamma, theta, vega, and rho.
These measure a variety of factors that can affect price regarding a given options contract and are calculated using a theoretical model.
Sound complicated? Stick with me.
In this section, we’ll discuss what the Greek letters mean in options trading and how they can better help you understand an option’s risk and reward potential.
Delta is a Greek value that represents the “stock equivalent position” for an option. The delta for a call option can range from 0 to 100 (and for a put option, from 0 to -100 … yes, that’s negative 100).
In essence, the of-the-moment risk and reward with holding a call option with a delta of 100 is similar to holding the equivalent amount of stock shares.
Gamma is a Greek value that tells you how many deltas the option will gain or lose if the underlying stock rises by one full point.
Theta is the Greek value that indicates how much value an option will lose with the passage of one day’s time based on what’s referred to as “time decay.” This factors in the expiration date of the option.
Vega is a Greek value that indicates the amount by which the price of the option would be affected, either positively or negatively, based on a one-point increase in implied volatility.
Rho is a Greek value which acts to measure an option’s sensitivity to a potential change in interest rate. So, for every rho, the percentage point in interest rates will increase the option value.
How to Make Money Trading Options
When it comes down to making money trading options, you rely on the same logic as trading stocks.
You want to commit to buying or selling prices that will put you in an advantageous position to collect profits. But “call” and “put” don’t tell the entire story…
Successful Options Trading Strategies Explained
There are a ton of different strategies for options trading. Here are some common ones.
Long Call – Options Trading
This is the most basic type of strategy for the call option. Basically, it begins with your belief that the underlying asset will rise in value over time.
You buy a call option with a strike price that you believe the asset will exceed in value over time.
The hard part? You’ve got to determine an expiration date. This is something of a gamble because you hope the value will rise before that date.
You risk losing potential profits by setting an expiration date too soon after the contract begins.
Compared to simply buying shares in full, you gain leverage here because there’s a chance that the value will go up quite dramatically, and then you can buy in for that sweet predetermined price.
However, if the value doesn’t go up by the time that the expiration date is up and you decide not to go through with the order, you won’t get that down payment back.
Long Put – Options Trading
This is the most basic type of strategy for the put option. It begins with you either believing or hedging on the fact that the underlying asset will lose value over time. You buy a put option with a strike price that you believe the asset will sink below over time.
Like with a long call, you have to agree to an expiration date. Once again, this is a gamble because you have to try to determine by what date the asset will go down in value.
Some traders believe that, in comparison to short selling a stock, a long put is easier. For one thing, you don’t have to find shares to borrow, which can prove tricky, especially if you’re into pennystocking.
However, unlike simply selling short, your losses are finite. Selling short carries unlimited profit — but also unlimited losses. So comparatively, the losses can be controlled here.
What I want to point out, though, is that options trading is a zero-sum game. In other words, it’s you against the buyer or seller.
Trading regular stocks opens up the field, kind of like in a horse race. Everyone is betting against one another, which means you have stronger data and a greater opportunity to profit.
This is where things get a little bit more complicated. A call backspread, also referred to as a “reverse call ratio spread,” is a more bullish strategy.
Here, you sell a certain number of call options, then buy more call options of the same underlying asset with a higher strike price.
This is a little bit more aggressive of an approach for purchasing options. It’s most appropriate when you really think that the asset will experience huge growth in the near future.
The call backspread profits when the price goes up sharply and the profits are virtually limitless for the buyer.
The put backspread is the yin to the call backspread yang. It’s also referred to as the “reverse put ratio spread.”
Basically, you sell a certain number of put options, then buy more put options of the same underlying asset, but with a lower strike price.
There are virtually limitless profits available with this strategy, but it also demands greater risk tolerance. The put backspread profits when the price goes down sharply, and the profits are virtually limitless for the buyer.
For buyers who are worried about their assets, the protective put, also referred to as a “put hedge,” is a method of hedging.
When you’re worried about a market downturn or crash, or a change in the value of an asset, you may invest in a protective put to protect from limitless losses.
Here, it’s like you have a previous purchase that you’re protecting with a proverbial insurance policy. This is what differentiates it from a long put — the fact that you’re already in the trade.
In this way, it’s almost like refinancing a house you already own versus buying a new one. But when it comes down to it, the risk is still similar to a long put.
Bear Split-Strike Combo
This is one of the most complicated strategies … and definitely the one that sounds most like a circus sideshow. Here’s how it works.
You have one long put with a lower strike price and one short call with a higher strike price. Yup, you have options in both directions with the same underlying asset and expiration date, but with different prices.
You could call this the ultimate in hedging because you’re putting a wager on whether the asset will go up or down. So if it goes up, you can profit from the call. And if it goes down, you can profit from the put.
Common Options Trading Mistakes
Choosing the wrong strategy. Like with trading, not all strategies are a perfect fit for all traders. It may take trial and error, but it’s important to stick with a strategy that matches your style.
Wrong expiration date. Picking the right expiration date for options contracts is hard … so ask yourself these things first:
- What’s the market liquidity like?
- How long do I think it will take for the price to move higher/lower?
- Do I want to hold this contract through seasonal fluctuations like earnings season?
Going all in. It can be tempting to take a huge position since you only have to pay the premium … but resist the urge. Remember: you can still lose money. Never trade more than you can afford to lose!
Why Do You Need Expert Assistance?
You could learn things the hard way, or you could speed up your learning curve by seeking out assistance.
I won’t be your mentor for options trading. But if this is a strategy you’re interested in, do yourself a favor: find a program or mentor where you can learn all you can before risking your cash!
Like I said before, trading options isn’t my thing. But what I can teach you is how to trade penny stocks. That’s what I focus on with my Trading Challenge.
My goal as a teacher is to help my students forge long-term, sustainable careers as traders.
I focus on all sorts of strategies for trading low-priced stocks. I want you to be adaptable, diverse, and most of all intelligent in your trading.
Articles, daily alerts, webinars, and an extensive video collection are just a few of the many perks you’ll get as a student.
I’m here to help you become a smarter trader who knows how to cut losses and refine successful techniques to keep getting better. You game?
The Final Word on Options Trading
Options trading is appealing to many traders … and with good reason.
It can come with a lot of benefits, including flexibility, limited risk, and the ability to gain profits based on foresight gained through study and research.
However, options trading isn’t without its fair share of risk. It’s so important to become educated on any style of trading you want to pursue. Never just throw your money at the market!
What do you think? Do you trade options? What strategies do you like best?
How much has this post helped you?
Tim Sykes is a penny stock trader and teacher who became a self-made millionaire by the age of 22 by trading $12,415 of bar mitzvah money. After becoming disenchanted with the hedge fund world, he established the Tim Sykes Trading Challenge to teach aspiring traders how to follow his trading strategies. He’s been featured in a variety of media outlets including CNN, Larry King, Steve Harvey, Forbes, Men’s Journal, and more. He’s also an active philanthropist and environmental activist, a co-founder of Karmagawa, and has donated millions of dollars to charity. Read More
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Comments ( 2 )
As many of you already know I grew up in a middle class family and didn’t have many luxuries. But through trading I was able to change my circumstances –not just for me — but for my parents as well. I now want to help you and thousands of other people from all around the world achieve similar results!
Which is why I’ve launched my Trading Challenge. I’m extremely determined to create a millionaire trader out of one my students and hopefully it will be you.
So when you get a chance make sure you check it out.
PS: Don’t forget to check out my free Penny Stock Guide, it will teach you everything you need to know about trading.
Complicated stuff. Wearin a head sized Band Aid right now. Try and guess where.
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Index Options – Explained and Simplified
September 19, 2020 @ 1:45 pm
An index option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying index at a strike price on an expiration date.
Index options give investors the opportunity to trade on entire markets or specific segments of a market with a single transaction. This article will explain everything there is to know about index options so that investors are able to incorporate this investment into their own portfolios.
An index is hypothetical portfolio of stocks representing a particular market or a segment in it. For example, the S&P 500 is an index that is comprised of the 500 largest U.S. publicly traded companies by market value. Therefore, the underlying asset for an index option is not one particular stock but rather is comprised of many stocks.
Index calls and puts are a low-risk way to profit on the directional move of an index. When buying an index call option, the potential profit is unlimited, while the risk is limited to the premium paid for the option. When buying an index put option, the potential profit is capped at the index level minus the premium paid, while the risk is limited to the premium paid for the option.
Index options are typically European-style options. This means that the option contract can only be exercised on the expiration date. This differs from American-style options which can be exercised anytime from the time of purchase until the expiration date.
Let’s look at an example of an investor buying an index option.
Assume the S&P 500 index is at a level of 2,000. An investor buys a call option for the S&P 500 index with a strike price of 2,010. With index options, the contract has a multiplier that determines the overall price. Usually, the multiplier is 100. If, for example, this index option is priced at $20, then the entire contract costs $2,000, or $20 times 100.
In this trade, $2,000 is the maximum amount the investor can lose. This risk is significantly lower than if he tried to invest in each company of the index individually. The lower risk is what makes index options appealing to investors.
The breakeven point in an index call option is the strike price plus the premium paid. In this example, the breakeven point would be 2,030, or 2,010 plus 20. Any level above 2,030 would be a profitable trade for the investor. If the index is at 2,035 at expiration, then the investor would exercise the call option and receive $2,500, or (2,035 – 2,010) x $100. After subtracting the premium, this trade would give the investor a total profit of $500, or $2,500 minus $2,000.
After looking at this example, investors can see how index options can be a way to diversify their portfolios while keeping the risks involved low. Index options are a useful tool to earn a profit off directional moves in certain indices.
Basics Of Options Trading Explained
Before we delve deep into the world of options trading, let’s take a moment to understand why do we need options at all. If you are thinking it is just another way to make money and was created by some fancy guys in suits working in Wall Street, well, you are wrong. The options world predates the modern stock exchanges by a large margin.
While some credit the Samurai for giving us the foundation on which options contracts were based, some actually acknowledge the Greeks for giving us an idea on how to speculate on a commodity, in this case, the harvest of olives. In both cases, humans were trying to guess the price of a food item and trade accordingly (rice in the case of samurais), long before the modern world put in various rules and set up exchanges.
With this in mind, let us try to answer the first question in your mind.
What is options trading?
Let’s take a very simple example to understand options trading. Consider that you are buying a stock for Rs. 3000. But the broker tells you about an exciting offer, that you can buy it now for Rs. 3000 or you can give a token amount of Rs. 30 and reserve the right to buy it at Rs. 3000 after a month, even if the stock increases in value at that time. But that token amount is non-refundable!
You realise that there is a high chance that the stock would cross Rs. 3030 and thus, you can breakeven at least. Since you have to pay only Rs. 30 now, the remaining amount can be used elsewhere for a month. You wait for a month and then look at the stock price.
Now, depending on the stock price, you have the option to buy the stock from the broker or not. Of course, this is an over-simplification but this is options trading in a gist.In the world of trading, options are instruments that belong to the derivatives family, which means its price is derived from something else, mostly stocks. The price of an option is intrinsically linked to the price of the underlying stock.
A formal definition is given below:
A stock option is a contract between two parties in which the stock option buyer (holder) purchases the right (but not the obligation) to buy/sell shares of an underlying stock at a predetermined price from/to the option seller (writer) within a fixed period of time.
We are going to make sure that by the end of this article you are well versed with the options trading world along with trying out a few options trading strategies as well. We will cover the following points in this article. If you feel that you want to skip the basics of options, then head straight to the options trading strategies.
Let’s start now, shall we!
Options trading vs. Stock trading
There must be a doubt in your mind that why do we even have options trading if it is just another way of trading. Well, here are a few points which make it different from trading stocks
- The Options contract has an expiration date, unlike stocks. The expiration can vary from weeks, months to years depending upon the regulations and the type of Options that you are practising. Stocks, on the other hand, do not have an expiration date.
- Unlike Stocks, Options derive their value from something else and that’s why they fall under the derivatives category
- Options are not definite by numbers like Stocks
- Options owners have no right (voting or dividend) in a company unlike Stock owners
It is quite often that some people find the Option’s concept difficult to understand though they have already followed it in their other transactions, for e.g. car insurance or mortgages. In this part of the article, we will take you through some of the most important aspects of Options trading before we get down to the world of options trading.
The Strike Price is the price at which the underlying stocks can be bought or sold as per the contract. In options trading, the Strike Price for a Call Option indicates the price at which the Stock can be bought (on or before its expiration) and for Put Options trading it refers to the price at which the seller can exercise its right to sell the underlying stocks (on or before its expiration)
Since the Options themselves don’t have an underlying value, the Options premium is the price that you have to pay in order to purchase an Option. The premium is determined by multiple factors including the underlying stock price, volatility in the market and the days until the Option’s expiration. In options trading, choosing the premium is one of the most important components.
In options trading, the underlying asset can be stocks, futures, index, commodity or currency. The price of Options is derived from its underlying asset. For the purpose of this article, we will be considering the underlying asset as the stock. The Option of stock gives the right to buy or sell the stock at a specific price and date to the holder. Hence its all about the underlying asset or stocks when it comes to Stock in Options Trading.
In options trading, all stock options have an expiration date. The expiration date is also the last date on which the Options holder can exercise the right to buy or sell the Options that are in holding. In Options Trading, the expiration of Options can vary from weeks to months to years depending upon the market and the regulations.
There are two major types of Options that are practised in most of the options trading markets.
- American Options which can be exercised anytime before its expiration date
- European Options which can only be exercised on the day of its expiration
Moneyness (ITM, OTM & ATM)
It is very important to understand the Options Moneyness before you start trading in Stock Options. A lot of options trading strategies are played around the Moneyness of an Option.
It basically defines the relationship between the strike price of an Option and the current price of the underlying Stocks. We will examine each term in detail below.
When is an Option in-the-money?
- Call Option – when the underlying stock price is higher than the strike price
- Put Option – when the underlying stock price is lower than the strike price
When is an Option out-of-the-money?
- Call Option – when the underlying stock price is lower than the strike price
- Put Option – when the underlying stock price is higher than the strike price
When is an Option at-the-money?
- When the underlying stock price is equal to the strike price.
Take a break here to ponder over the different terms as we will find it extremely useful later when we go through the types of options as well as a few options trading strategies.
Type of options
In the true sense, there are only two types of Options i.e Call & Put Options. We will understand them in more detail.
To Call or Put
A Call Option is an option to buy an underlying Stock on or before its expiration date. At the time of buying a Call Option, you pay a certain amount of premium to the seller which grants you the right (but not the obligation) to buy the underlying stock at a specified price (strike price).
Purchasing a call option means that you are bullish about the market and hoping that the price of the underlying stock may go up. In order for you to make a profit, the price of the stock should go higher than the strike price plus the premium of the call option that you have purchased before or at the time of its expiration.
In contrast, a Put Option is an option to sell an underlying Stock on or before its expiration date. Purchasing a Put Option means that you are bearish about the market and hoping that the price of the underlying stock may go down. In order for you to make a profit, the price of the stock should go down from the strike price plus the premium of the Put Option that you have purchased before or at the time of its expiration.
In this manner, both Put and Call option buyer’s loss is limited to the premium paid but profit is unlimited. The above explanations were from the buyer’s point of view. We will now understand the put-call options from the seller’s point of view, ie options writers. The Put option seller, in return for the premium charged, is obligated to buy the underlying asset at the strike price.
Similarly, the Call option seller, in return for the premium charged, is obligated to sell the underlying asset at the strike price. Is there a way to visualise the potential profit/loss of an option buyer or seller? Actually, there is. An option payoff diagram is a graphical representation of the net Profit/Loss made by the option buyers and sellers.
Before we go through the diagrams, let’s understand what the four terms mean. As we know that going short means selling and going long means buying the asset, the same principle applies to options. Keeping this in mind, we will go through the four terms.
- Short call – Here we are betting that the prices will fall and hence, a short call means you are selling calls.
- Short put – Here the short put means we are selling a put option
- Long call – it means that we are buying a call option since we are optimistic about the underlying asset’s share price
- Long put – Here we are buying a put option.
S = Underlying Price
X = Strike Price
Break-even point is that point at which you make no profit or no loss.
The long call holder makes a profit equal to the stock price at expiration minus strike price minus premium if the option is in the money. Call option holder makes a loss equal to the amount of premium if the option expires out of money and the writer of the option makes a flat profit equal to the option premium.
Similarly, for the put option buyer, profit is made when the option is in the money and is equal to the strike price minus the stock price at expiration minus premium. And, the put writer makes a profit equal to the premium for the option.
All right, until now we have been going through a lot of theory. Let’s switch gears for a minute and come to the real world. How do options look like? Well, let’s find out.
What does an options trading quote consist of?
If you were to look for an options quote on Apple stock, it would look something like this:
When this was recorded, the stock price of Apple Inc. was $196. Now let’s take one line from the list and break it down further.
In a typical options chain, you will have a list of call and put options with different strike prices and corresponding premiums. The call option details are on the left and the put option details are on the right with the strike price in the middle.
- The symbol and option number is the first column.
- The “last” column signifies the amount at which the last time the option was bought.
- “Change” indicates the variance between the last two trades of the said options
- “Bid” column indicates the bid submitted for the option.
- “Ask” indicates the asking price sought by the option seller.
- “Volume” indicates the number of options traded. Here the volume is 0.
- “Open Interest” indicates the number of options which can be bought for that strike price.
The columns are the same for the put options as well. In some cases, the data provider signifies whether the option is in the money, at the money or out of money as well. Of course, we need an example to really help our understanding of options trading. Thus, let’s go through one now.
Options Trading Example
We will go through two cases to better understand the call and put options.
For simplicity’s sake, let us assume the following:
- Price of Stock when the option is written: $100
- Premium: $5
- Expiration date: 1 month after the option is bought
The current price of stock: $110. Strike price: $120
The current price of stock: $120. Strike price: $110
Considering that we have gone through the detailed scenario of each option, how about we combine a few options together. Let’s understand an important concept which many professionals use in options trading.
What is Put-Call Parity In Python?
Put-call parity is a concept that anyone who is interested in options trading needs to understand. By gaining an understanding of put-call parity you can understand how the value of call option, put option and the stock are related to each other. This enables you to create other synthetic position using various option and stock combination.
The principle of put-call parity
Put-call parity principle defines the relationship between the price of a European Put option and European Call option, both having the same underlying asset, strike price and expiration date. If there is a deviation from put-call parity, then it would result in an arbitrage opportunity. Traders would take advantage of this opportunity to make riskless profits till the time the put-call parity is established again.
The put-call parity principle can be used to validate an option pricing model. If the option prices as computed by the model violate the put-call parity rule, such a model can be considered to be incorrect.
Understanding Put-Call Parity
To understand put-call parity, consider a portfolio “A” comprising of a call option and cash. The amount of cash held equals the call strike price. Consider another portfolio “B” comprising of a put option and the underlying asset.
S0 is the initial price of the underlying asset and ST is its price at expiration.
Let “r” be the risk-free rate and “T” be the time for expiration.
In time “T” the Zero-coupon bond will be worth K (strike price) given the risk-free rate of “r”.
Portfolio A = Call option + Zero-coupon bond
Portfolio B = Put option + Underlying Asset
If the share price is higher than X the call option will be exercised. Else, cash will be retained. Hence, at “T” portfolio A’s worth will be given by max(ST, X).
If the share price is lower than X, the put option will be exercised. Else, the underlying asset will be retained. Hence, at “T”, portfolio B’s worth will be given by max (ST, X).
If the two portfolios are equal at time, “T”, then they should be equal at any time. This gives us the put-call parity equation.
Equation for put-call parity:
C + Xe-rT = P + S0
In this equation,
- C is the premium on European Call Option
- P is the premium of European Put Option
- S0 is the spot price of the underlying stock
- And, Xe-rT is the current value (discounted value) of Zero-coupon bond (X)
We can summarize the payoffs of both the portfolios under different conditions as shown in the table below.
From the above table, we can see that under both scenarios, the payoffs from both the portfolios are equal.
Required Conditions For Put-call Parity
For put-call parity to hold, the following conditions should be met. However, in the real world, they hardly hold true and put-call parity equation may need some modifications accordingly. For the purpose of this blog, we have assumed that these conditions are met.
- The underlying stock doesn’t pay any dividend during the life of the European options
- There are no transaction costs
- There are no taxes
- Shorting is allowed and there are no borrow charges
Hence, put-call parity will hold in a frictionless market with the underlying stock paying no dividends.
In options trading, when the put-call parity principle gets violated, traders will try to take advantage of the arbitrage opportunity. An arbitrage trader will go long on the undervalued portfolio and short the overvalued portfolio to make a risk-free profit.
How to take advantage of arbitrage opportunity
Let us now consider an example with some numbers to see how trade can take advantage of arbitrage opportunities. Let’s assume that the spot price of a stock is $31, the risk-free interest rate is 10% per annum, the premium on three-month European call and put are $3 and $2.25 respectively and the exercise price is $30.
In this case, the value of portfolio A will be,
C+Xe-rT = 3+30e-0.1 * 3/12 = $32.26
The value of portfolio B will be,
P + S0 = 2.25 + 31 = $33.25
Portfolio B is overvalued and hence an arbitrageur can earn by going long on portfolio A and short on portfolio B. The following steps can be followed to earn arbitrage profits.
- Short the stock. This will generate a cash inflow of $31.
- Short the put option. This will generate a cash inflow of $2.25.
- Purchase the call option. This will generate cash outflow of $3.
- Total cash inflow is -3 + 2.25 + 31 = $30.25.
- Invest $30.25 in a zero-coupon bond with 3 months maturity with a yield of 10% per annum.
Return from the zero coupon bond after three months will be 30.25e 0.1 * 3/12 = $31.02.
If the stock price at maturity is above $30, the call option will be exercised and if the stock price is less than $30, the put option will be exercised. In both the scenarios, the arbitrageur will buy one stock at $30. This stock will be used to cover the short.
Total profit from the arbitrage = $31.02 – $30 = $1.02
Well, shouldn’t we look at some codes now?
Python Codes Used For Plotting The Charts
The below code can be used to plot the payoffs of the portfolios.
So far, we have gone through the basic concepts in options trading and looked at an options trading strategy as well. At this juncture, let’s look at the world of options trading and try to answer a simple question.
Why is Options Trading attractive?
Options are attractive instruments to trade in because of the higher returns. An option gives the right to the holder to do something, with the ‘option’ of not to exercise that right. This way, the holder can restrict his losses and multiply his returns.
While it is true that one options contract is for 100 shares, it is thus less risky to pay the premium and not risk the total amount which would have to be used if we had bought the shares instead. Thus your risk exposure is significantly reduced.However, in reality, options trading is very complex and that is because options pricing models are quite mathematical and complex.
So, how can you evaluate if the option is really worth buying? Let’s find out.
The key requirement in successful options trading strategies involves understanding and implementing options pricing models. In this section, we will get a brief understanding of Greeks in options which will help in creating and understanding the pricing models.
Options Pricing is based on two types of values
Intrinsic Value of an option
Recall the moneyness concept that we had gone through a few sections ago. When the call option stock price is above the strike price or when put option stock price is below the strike price, the option is said to be “In-The-Money (ITM)”, i.e. it has an intrinsic value. On the other hand, “Out of the money (OTM)” options have no intrinsic value. For OTM call options, the stock price is below the strike price and for OTM put options; stock price is above the strike price. The price of these options consists entirely of time value.
Time Value of an option
If you subtract the amount of intrinsic value from an options price, you’re left with the time value. It is based on the time to expiration. You can enroll for this free online options trading python course on Quantra and understand basic terminologies and concepts that will help you in options trading. We know what is intrinsic and the time value of an option. We even looked at the moneyness of an option. But how do we know that one option is better than the other, and how to measure the changes in option pricing. Well, let’s take the help of the greeks then.
Greeks are the risk measures associated with various positions in options trading. The common ones are delta, gamma, theta and vega. With the change in prices or volatility of the underlying stock, you need to know how your options pricing would be affected. Greeks in options help us understand how the various factors such as prices, time to expiry, volatility affect the options pricing.
Delta measures the sensitivity of an option’s price to a change in the price of the underlying stock. Simply put, delta is that options greek which tells you how much money a stock option will rise or drop in value with a $1 rise or drop in the underlying stock. Delta is dependent on underlying price, time to expiry and volatility. While the formula for calculating delta is on the basis of the Black-Scholes option pricing model, we can write it simply as,
Delta = [Expected change in Premium] / [Change in the price of the underlying stock]
Let’s understand this with an example for a call option:
We will create a table of historical prices to use as sample data. Let’s assume that the option will expire on 5th March and the strike price agreed upon is $140.
Thus, if we had to calculate the delta for the option on 2nd March, it would be $5/$10 = 0.5.
Here, we should add that since an option derives its value from the underlying stock, the delta option value will be between 0 and 1. Usually, the delta options creeps towards 1 as the option moves towards “in-the-money”.
While the delta for a call option increases as the price increases, it is the inverse for a put option. Think about it, as the stock price approaches the strike price, the value of the option would decrease. Thus, the delta put option is always ranging between -0 and 1.
Gamma measures the exposure of the options delta to the movement of the underlying stock price. Just like delta is the rate of change of options price with respect to underlying stock’s price; gamma is the rate of change of delta with respect to underlying stock’s price. Hence, gamma is called the second-order derivative.
Gamma = [Change in an options delta] / [Unit change in price of underlying asset]
Let’s see an example of how delta changes with respect to Gamma. Consider a call option of stock at a strike price of $300 for a premium of $15.
- Strike price: $300
- Initial Stock price: $150
- Delta: 0.2
- Gamma: 0.005
- Premium: $15
- New stock price: $180
- Change in stock price: $180 – $150 = $30
Thus, Change in Premium = Delta * Change in price of stock = 0.2 * 30 = 6.
Thus, new premium = $15 + $6 = $21
Change in delta = Gamma * Change in stock price = 0.005 * 30 = 0.15
Thus, new delta = 0.2 + 0.15 = 0.35.
Let us take things a step further and assume the stock price increases another 30 points, to $210.
New stock price: $210
Change in stock price: $210 – $180 = $30
Change in premium = Delta *Change in 0.35*30 = $10.5
Thus, new premium = $21 + $10.5 = $31.5
Change in delta = Gamma * Change in stock price = 0.005 * 30 = 0.15
Thus, new delta = 0.35 + 0.15 = 0.5.
In this way, delta and gamma of an option changes with the change in the stock price. We should note that Gamma is the highest for a stock call option when the delta of an option is at the money. Since a slight change in the underlying stock leads to a dramatic increase in the delta. Similarly, the gamma is low for options which are either out of the money or in the money as the delta of stock changes marginally with changes in the stock option.
Highest Gamma for At-the-money (ATM) option
Among the three instruments, at-the-money (ATM), out-of-the-money (OTM) and in-the-money (ITM); at the money (ATM) has the highest gamma. You can watch this video to understand it in more detail.
Theta measures the exposure of the options price to the passage of time. It measures the rate at which options price, especially in terms of the time value, changes or decreases as the time to expiry is approached.
Vega measures the exposure of the option price to changes in the volatility of the underlying. Generally, options are more expensive for higher volatility. So, if the volatility goes up, the price of the option might go up to and vice-versa.
Vega increases or decreases with respect to the time to expiry?
What do you think? You can confirm your answer by watching this video.
One of the popular options pricing model is Black Scholes, which helps us to understand the options greeks of an option.
Black-Scholes options pricing model
The formula for the Black-Scholes options pricing model is given as:
C is the price of the call option
P represents the price of a put option.
S0 is the underlying price,
X is the strike price,
σ represents volatility,
r is the continuously compounded risk-free interest rate,
t is the time to expiration, and
q is the continuously compounded dividend yield.
N(x) is the standard normal cumulative distribution function.
The formulas for d1 and d2 are given as:
To calculate the Greeks in options we use the Black-Scholes options pricing model.
Delta and Gamma are calculated as:
In the example below, we have used the determinants of the BS model to compute the Greeks in options.
At an underlying price of 1615.45, the price of a call option is 21.6332.
If we were to increase the price of the underlying by Rs. 1, the change in the price of the call, put and values of the Greeks in the option is as given below.
As can be observed, the Delta of the call option in the first table was 0.5579. Hence, given the definition of the delta, we can expect the price of the call option to increase approximately by this value when the price of the underlying increases by Rs.1. The new price of the call option is 22.1954 which is
Let’s move to Gamma, another Greek in option.
If you observe the value of Gamma in both the tables, it is the same for both call and put options contracts since it has the same formula for both options types. If you are going long on the options, then you would prefer having a higher gamma and if you are short, then you would be looking for a low gamma. Thus, if an options trader is having a net-long options position then he will aim to maximize the gamma, whereas in case of a net-short position he will try to minimize the gamma value.
The third Greek, Theta has different formulas for both call and put options. These are given below:
In the first table on the LHS, there are 30 days remaining for the options contract to expire. We have a negative theta value of -0.4975 for a long call option position which means that the options trader is running against time.
He has to be sure about his analysis in order to profit from trade as time decay will affect this position. This impact of time decay is evident in the table on the RHS where the time left to expiry is now 21 days with other factors remaining the same. As a result, the value of the call option has fallen from 21.6332 to 16.9 behaviour 319. If an options trader wants to profit from the time decay property, he can sell options instead of going long which will result in a positive theta.
We have just discussed how some of the individual Greeks in options impact option pricing. However, it is very essential to understand the combined behaviour of Greeks in an options position to truly profit from your options position. If you want to work on options greeks in Excel, you can refer to this blog.
Let us now look at a Python package which is used to implement the Black Scholes Model.
Python Library – Mibian
What is Mibian?
Mibian is an options pricing Python library implementing the Black-Scholes along with a couple other models for European options on currencies and stocks. In the context of this article, we are going to look at the Black-Scholes part of this library. Mibian is compatible with python 2.7 and 3.x. This library requires scipy to work properly.
How to use Mibian for BS Model?
The function which builds the Black-Scholes model in this library is the BS() function. The syntax for this function is as follows:
The first input is a list containing the underlying price, strike price, interest rate and days to expiration. This list has to be specified each time the function is being called. Next, we input the volatility, if we are interested in computing the price of options and the option greeks. The BS function will only contain two arguments.
If we are interested in computing the implied volatility, we will not input the volatility but instead will input either the call price or the put price. In case we are interested in computing the put-call parity, we will enter both the put price and call price after the list. The value returned would be:
(call price + price of the bond worth the strike price at maturity) – (put price + underlying asset price)
The syntax for returning the various desired outputs are mentioned below along with the usage of the BS function. The syntax for BS function with the input as volatility along with the list storing underlying price, strike price, interest rate and days to expiration:
Attributes of the returned value from the above-mentioned BS function:
The syntax for BS function with the input as callPrice along with the list storing underlying price, strike price, interest rate and days to expiration:
Attributes of the returned value from the above-mentioned BS function:
The syntax for BS function with the input as putPrice along with the list storing underlying price, strike price, interest rate and days to expiration:
Attributes of the returned value from the above-mentioned BS function:
The syntax for BS function with the inputs as callPrice and putPrice along with the list storing underlying price, strike price, interest rate and days to expiration:
Attributes of the returned value from the above-mentioned BS function:
While Black-Scholes is a relatively robust model, one of its shortcomings is its inability to predict the volatility smile. We will learn more about this as we move to the next pricing model.
Derman Kani Model
The Derman Kani model was developed to overcome the long-standing issue with the Black Scholes model, which is the volatility smile. One of the underlying assumptions of Black Scholes model is that the underlying follows a random walk with constant volatility. However, on calculating the implied volatility for different strikes, it is seen that the volatility curve is not a constant straight line as we would expect, but instead has the shape of a smile. This curve of implied volatility against the strike price is known as the volatility smile.
If the Black Scholes model is correct, it would mean that the underlying follows a lognormal distribution and the implied volatility curve would have been flat, but a volatility smile indicates that traders are implicitly attributing a unique non-lognormal distribution to the underlying. This non-lognormal distribution can be attributed to the underlying following a modified random walk, in the sense that the volatility is not constant and changes with both stock price and time. In order to correctly value the options, we would need to know the exact form of the modified random walk.
The Derman Kani model shows how to take the implied volatilities as inputs to deduce the form of the underlying’s random walk. More specifically a unique binomial tree is extracted from the smile corresponding to the random walk of the underlying, this tree is called the implied tree. This tree can be used to value other derivatives whose prices are not readily available from the market – for example, it can be used in standard but illiquid European options, American options, and exotic options.
What is the Heston Model?
Steven Heston provided a closed-form solution for the price of a European call option on an asset with stochastic volatility. This model was also developed to take into consideration the volatility smile, which could not be explained using the Black Scholes model.
The basic assumption of the Heston model is that volatility is a random variable. Therefore there are two random variables, one for the underlying and one for the volatility. Generally, when the variance of the underlying has been made stochastic, closed-form solutions will no longer exist.
But this is a major advantage of the Heston model, that closed-form solutions do exist for European plain vanilla options. This feature also makes calibration of the model feasible. If you are interested in learning about these models in more detail, you may go through the following research papers,
- Derman Kani Model – “The Volatility Smile and Its Implied Tree” by Emanuel Derman and Iraj Kani.
- Heston Model – “A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options”
So far, you have understood options trading and how to analyse an option as well as the pricing models used. Now, to apply this knowledge, you will need access to the markets, and this is where the role of a broker comes in.
Opening an options trading account
How to choose a broker for Options Trading?
Before we open an options trading account with a broker, let’s go over a few points to take into consideration when we choose a broker.
- Understand your aim when you tread the options trading waters, whether it is a way of hedging risk, as a speculative instrument, for income generation etc.
- Does the broker provide option evaluation tools of their own? It is always beneficial to have access to a plethora of tools when you are selecting the right option.
- Enquire the transaction costs or the commission charged by the broker as this will eat into your investment gains.
- Some brokers give access to research materials in various areas of the stock market. You can always check with the broker about access to research as well as subscriptions etc.
- Check the payment options provided by the broker to make sure it is compatible with your convenience.
Searching for the right broker
Once the required background research is done, you can choose the right broker as per your need and convenience. In the global market, a list of the top brokers is provided below:
List of Top International Brokers (Options Trading)
The list of top international options brokers is given below:
- E-trade ($0.65 per options contract)
- Ally Invest ($0.5 per contract traded)
- TD Ameritrade ($0.65 fee per contract)
- Interactive Brokers (starts at $0.25 per options contract)
- Schwab Brokerage ($0.65 per options contract)
List of Top Indian Brokers (Options Trading)
The list of top Indian options brokers is given below:
- ICICI Direct
- HDFC Securites
- Kotak Securities
- Angel Broking
- Axis Direct
Great! Now we look at some options trading strategies which can be used in the real world.
Options Trading Strategies
There are quite a few options trading strategies which can be used in today’s trading landscape. One of the most popular options trading strategies is based on Spreads and Butterflies. Let’s look at them in detail.
Spreads and Butterflies
Spreads or rather spread trading is simultaneously buying and selling the same option class but with different expiration date and strike price. Spread options trading is used to limit the risk but on the other hand, it also limits the reward for the person who indulges in spread trading.
Thus, if we are only interested in buying and selling call options of security, we will call it a call spread, and if it is only puts, then it will be called a put spread.
Depending on the changing factor, spreads can be categorised as:
- Horizontal Spread – Different expiration date, Same Strike price
- Vertical Spread – Same Expiration date, Different Strike price
- Diagonal Spread – Different expiration date, Different Strike price
Remember that an option’s value is based on the underlying security (in this case, stock price). Thus, we can also distinguish an option spread on whether we want the price to go up (Bull spread) or go down (Bear spread).
Bull call spread
In a bull call spread, we buy more than one option to offset the potential loss if the trade does not go our way.
Let’s try to understand this with the help of an example.
The following is a table of the available options for the same underlying stock and same expiry date:
Normally, if we have done the analysis and think that the stock can rise to $200, one way would be to buy a call stock option with a strike price of $180 for a premium of $15. Thus, if we are right and the stock reaches $200 on expiry, we buy it at the strike price of $180 and pocket a profit of ($20 -$15) = $5 since we paid the premium of $15.
But if we were not right and the stock price reaches $180 or less, we will not exercise the option resulting in a loss of the premium of $15. One workaround is to buy a call option at $180 and sell a call option for $200 at $10.
Thus, when the stock’s price reaches $200 on expiry, we exercise the call option for a profit of $5 (as seen above) and also pocket a profit of the premium of $10 since it will not be exercised by the owner. Thus, in this way, the total profit is ($5 + $10) = $15.
If the stock price goes above $200 and the put option is exercised by the owner, the increase in the profit from bought call option at $180 will be the same as the loss accumulated from the sold call option at $200 and thus, the profit would always be $15 no matter the increase in the stock price above $200 at expiry date.
Let’s construct a table to understand the various scenarios.
You can go through this informative blog to understand how to implement it in Python.
Bear put spread
The bull call spread was executed when we thought the stock would be increasing, but what if we analyse and find the stock price would decrease. In that case, we use the bear put spread.
Let’s assume that we are looking at the different strike prices of the same stock with the same expiry date.
One way to go about it is to buy the put option for the strike price of 160 at a premium of $15 while selling a put option for the strike price of $140 for the strike price of $10.
Thus, we create a scenario table as follows:
In this way, we can minimize our losses by simultaneously buying and selling options. You can go through this informative blog to understand how to implement it in Python.
A butterfly spread is actually a combination of bull and bear spreads. One example of the Butterfly Options Strategy consists of a Body (the middle double option position) and Wings (2 opposite end positions).
- Its properties are listed as follows:
- It is a three-leg strategy
- Involves buying or selling of Call/Put options (unlike Covered Call Strategy where a stock is bought and an OTM call option is sold)
- Can be constructed using Calls or Puts
- 4 options contracts at the same expiry date
- Have the same underlying asset
- 3 different Strike Prices are involved (2 have the same strike price)
- Create 2 Trades with these calls
Other Trading Strategies
We will list down a few more options trading strategies below:
We have covered all the basics of options trading which include the different Option terminologies as well as types. We also went through an options trading example and the option greeks. We understood various options trading strategies and things to consider before opening an options trading account.
If you have always been interested in automated trading and don’t know where to start, we have created a learning track for you at Quantra, which includes the. “Trading using Option Sentiment Indicators” course.
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