An option contract is an agreement that gives the trader the right to buy or sell an asset for a predetermined price, either on or before a specified date. Although options contracts may look similar to futures contracts, traders who want to buy options contracts are not obligated to settle their trades.
In addition, options contracts are a type of derivative that deals with a variety of underlying assets, including stocks and digital currencies. These contracts may also derive their value from financial market indices. Options contracts are usually used to hedge risks related to existing transactions, and are also used in speculation.
How do options contracts work?
There are two basic types of options contracts, a put option and a call option. The buy option gives owners the right to buy the underlying asset, while the put option gives them the right to sell it. That is, traders conclude a purchase option when they expect the price of the underlying asset to increase, but if they expect the price to decrease, they offer a sell option. In addition, a call option or put option may be used in the hope that prices will continue to stabilize - or a combination of the two types - for speculative purposes in order to support or counter market volatility.
An option contract consists of at least four elements: volume, expiration date, strike price, and the price paid (down payment). First, the order size refers to the number of contracts available for trading. Second, the expiration date refers to the date after which the trader cannot execute the option contract. Third, the strike price is the specified price for buying or selling the asset (if the buyer of the contract decides to execute the option contract). Finally, the amount paid, which is the price paid to start trading the options contract. It refers to the amount that the investor pays in order to obtain the power of choice. So the buyer obtains the contract from the contract writer (the seller) according to the price value, which changes constantly, as the contract expiration date approaches.
In general, if the strike price is below the market price, the trader has the option to buy the underlying asset for a discount, and also has the option to execute the contract at a profit after adding the price to the equation. However, if the execution price is higher than the market price, the contract owner will not benefit from executing the option contract, as the contract will then be worthless. If the contract is not executed, the buyer loses only the value of the price paid when entering the deal.
It should be noted that while the buyer has the choice whether or not to execute with regard to purchase and sale contracts, the drafter (seller) always awaits the buyer's decision. If the buyer of the call option decides to execute his contract, the seller is obligated to sell the underlying asset. Likewise, when a trader buys a put option and then decides to execute the contract, the seller is obligated to buy the underlying asset from the owner of the contract. That is, editors are exposed to higher risks than buyers. While the buyer's losses are limited to the price he paid to purchase the contract, the editors are exposed to much greater losses that depend on the price of the asset in the market.
Some contracts give traders the right to execute an option contract at any time before the contract's expiration date. This type of contract is usually called American options contracts. In contrast, European options contracts can only be executed by the contract's expiration date. It is worth noting that there is no relationship between these names and the geographical location attributed to him.
the price
The price value is affected by several factors. To simplify the idea, assume that the price in an option contract is determined based on at least four factors: the price of the underlying asset, the strike price, the time remaining until the contract expires, and the volatility of the relevant market (or index). These four elements represent different effects on the price in purchase and sale contracts.
Typically, the asset price and the strike price affect the price in call and put options in an inverse manner. Conversely, approaching time remaining until expiration usually leads to a lower price in both options contracts. The main reason for this is that traders are less likely to benefit from these contracts. In contrast, a higher level of volatility usually causes the price to rise. The bottom line is that the price paid in the option contract is determined based on these and other factors.
Risk metrics in options contracts
Risk metrics in options contracts are a set of tools used to measure factors that affect the price of a contract. Specifically, they are statistical values to measure the risk in a contract based on a number of fundamental variables. Below we present some risk measures with a brief explanation of the factors that are measured:
Delta: Used to measure how much the price of an option contract depends on the price of the underlying asset. For example, a delta of 0.6 indicates that the price will change by $0.60 for every $1 change in the asset price.
Gamma: Used to measure the change of delta over time. If delta changes from 0.6 to 0.45, gamma in that contract will be 0.15.
Theta: Used to measure the price change based on the expiration of the contract decreasing by one day. It indicates the expected rate of change of the price as the expiration of the option contract approaches.
Vega: Used to measure the rate of change of a contract's price based on a 1% change in the implied volatility of the price of the underlying asset. An increase in the vega rate usually indicates an increase in the price of both call and put options.
RO: Used to measure expected price change based on fluctuations in interest rates. Generally, an increase in interest rates results in an increase in the price of a call option and a decrease in the price of a put option. Therefore, the Rho value is positive for call options and negative for put options.
Common use cases
Hedging
Options contracts are widely used as hedging instruments. One of the most common examples of hedging strategies is when a trader buys a put option on a stock he already owns. If the trader loses the total value of the underlying assets as a result of the price decline, executing a put option may help him limit the loss.
For example, imagine that Alice bought 100 shares for $50, expecting their market price to increase. In order to hedge against the possibility of a fall in the stock price, you decide to buy put options for a strike price of $48, paying a price of $2 per share. If the market falls and the stock price falls to $35, Alice can execute her contract to limit losses, and then sell the stock for $48, not $35. However, if the market rises, she will not have to execute the contract and her loss will be limited to the value of the price she paid ($2 per share).
According to this scenario, Alice reaches the break-even point at $52 ($50 + $2 per share), and her loss is limited to no more than $400 ($200 she pays to the platform and an additional $200 if each share is sold for $48).
Speculative trading
Options contracts are commonly used in speculative trading. For example, a trader who expects the price of an asset to rise may buy a call option contract. If the price of the asset exceeds the strike price, the trader can then execute the option contract and buy it at a reduced price. When the asset price is above or below the strike price in a profitable way, the option contract is then “within the target amount.” Also, the contract is “at the target amount” at breakeven, or “outside the target price” in the event of a loss.
Basic strategies
When trading options contracts, traders have a variety of strategies available, with four basic situations. For the seller, he has two options: either buy a call option contract (the right to buy) or a put option contract (the right to sell). As for the editor, he has the option to sell buy or sell options contracts. As mentioned, editors are obligated to sell or buy assets if the owner of the contract decides to implement it.
Options trading strategies are based on applicable combination strategies between buying and selling options contracts. Examples of these strategies include the precautionary buying strategy, the precautionary selling strategy, the compound option strategy, and the restriction strategy.
Precautionary Buying Strategy: It is based on buying a put option contract on an asset that the trader owns. This is the hedging strategy that Alice used in the previous example. It is also known as a portfolio insurance strategy because it protects the investor from a possible decline in the market, while at the same time maintaining his position in the event of an increase in the price of the asset.
Precautionary selling strategy: It is based on selling a call option contract on an asset that the trader owns. Investors use this strategy to make additional profit (option contract price) from their holdings. If the contract is not executed, they receive the price and keep their assets. But if the contract is executed as a result of a rise in the market price, they are obligated to sell their positions.
Compound option strategy: It relies on purchasing a call option and a sell option for the same asset with the same strike price and expiration date. This strategy allows the trader to profit from the transaction provided that the asset price moves sufficiently to execute the buy or sell option. Simply put, a trader speculates on the volatility of the market.
Limit Strategy: It is based on purchasing a call option and a put option “outside the target amount” (i.e. the strike price for the call option is higher than the market price and lower than the market price for the put option). In general, the limit strategy is similar to the compound option strategy, but it is less expensive in terms of settling the trade. Keeping in mind that the limit strategy requires a higher level of volatility in order to achieve profits.
Advantages
Suitable for hedging market risks.
It is characterized by being more flexible in speculative trading.
It allows the use of different combination and trading strategies, with unique risk-reward calculation models.
The potential to profit from all bullish, bearish and horizontal market trends.
Used to reduce costs when entering new trades.
It allows the execution of more than one trading operation simultaneously.
Defects
The working mechanisms and installment calculations are sometimes not easy to understand.
High risk, especially for contract drafters (sellers)
They are characterized by more complex trading strategies compared to traditional alternatives.
Options markets usually face the problem of low levels of liquidity, which makes them less attractive to the majority of traders.
The value of premiums in options contracts is highly volatile and often declines as the contract's expiration date approaches.
The difference between options and futures contracts
Options and futures are two types of financial derivatives that, therefore, share some use cases. But despite the similarities, there is a significant difference in the settlement mechanism between them.
Unlike options contracts, futures contracts are typically exercised upon the expiration date of the contract, i.e. the owner of the contract is legally obligated to trade the underlying asset (or its cash value). In contrast, options contracts are only executed after consulting the trader who owns the contract and obtaining his approval. If the contract owner (buyer) decides to execute the option contract, the contract writer (seller) becomes obligated to trade the underlying asset.