An option contract is an agreement that provides a person with the right to buy or sell an asset at a predetermined price on or before a certain date. Although they appear similar to futures contracts, traders who buy options contracts do not have to execute their positions.
Options contracts are derivatives that can be used for many different types of underlying assets, including stocks and cryptocurrencies. These contracts may also be derivatives of financial indices. Option contracts are often used to offset risk on existing positions and for speculative trading.
How do option contracts work?
There are two basic types of options, put and call options. Call options give the contract owner the right to buy the underlying asset, while put options give the right to sell it. Accordingly, traders generally enter into call options when they expect an increase in the price of the underlying asset and put options when they expect a decrease. In addition, they can bet against or favoring market volatility by using call and put options (or even a combination of them) when they think prices will remain stable.
An option contract consists of at least four elements: size, maturity, strike price, and premium. First, the size of the offer refers to the number of contracts to be bought and sold. Secondly, maturity refers to the last date on which one can exercise the option. Third, the strike price is the price at which an asset will be bought or sold (if the contract buyer chooses to exercise the option). Finally, the premium is the buying and selling price of the option contract and represents the price the investor must pay to own the option power. That is, buyers purchase contracts from sellers (sellers) according to the premium value, which constantly changes as maturity approaches.
Most basically, if the strike price is lower than the market price, the trader can buy the underlying asset at a discount and decide to execute the contract to make a profit after adding the premium to the equation. But if the strike price is higher than the market price, there is no reason for the contract owner to exercise the option and the contract becomes useless. When the contract is not implemented, the buyer only loses the premium he paid when entering into the contract.
It is important to note that while buyers have the option to choose whether or not to execute purchases or sales, printers (sellers) are up to the buyers' preferences. So if a call option owner chooses to exercise his contract, the seller is obligated to sell the underlying asset. Similarly, if a trader buys a put option and decides to exercise it, the seller must purchase the underlying asset from the contract owner. This means printers are exposed to higher risk than buyers. While losses for buyers are limited to the premiums they paid for the contract, printers can incur much larger losses depending on the market price of the asset.
Some contracts give traders the right to exercise options at any time before the expiration date. These are often called American-style option contracts. In contrast, European option contracts can only be exercised on the maturity date. However, it should be noted that these two types of options have nothing to do with geographical location.
Option premiums
Premium value is affected by many different factors. To simplify, we can assume that an option premium depends on at least four elements: the price of the underlying asset, the strike price, time to expiration, and market volatility (or index). These four elements create different effects on the premiums of call and put options, as shown in the table below.
Naturally, the price of the asset and the strike price adversely affect the call and put premiums. Conversely, decreasing time means lower premium price for both types of options. The main reason for this is that traders are less likely to turn options to their advantage. On the other hand, increased volatility levels often lead to higher premium prices. As a result, option contract premiums are affected by a combination of these factors and other forces.
Option Parameters
Option Parameters are tools designed to measure some of the factors that affect the price of a contract. They are statistical values used to measure the risk of a particular contract depending on different variables. Below are some basic parameters and briefly what they measure:
Delta: measures how much the price of an option contract will change depending on the price of the underlying asset. For example, a Delta of 0.6 indicates that for every $1 change in the asset price, the premium price is likely to change by $0.60.
Gamma: Shows the rate of change in Delta over time. So if Delta drops from 0.6 to 0.45, the option's Gamma becomes 0.15.
Theta: Measures the price change due to a one-day decrease in the contract duration. It estimates how much the premium will change as the maturity of the option contract approaches.
Vega: Measures the rate of change in the contract price due to a 1% change in the implied volatility of the underlying asset. A rise in Vega indicates an increase in both buying and selling prices.
Rho: Measures estimated price changes due to changes in interest rates. Rising interest rates generally lead to an increase in purchases and a decrease in sales. Therefore, the Rho value is positive for calls and negative for puts.
Common uses
to hedge
Option contracts are commonly used as hedging instruments. A very basic example of a hedging strategy is when traders buy options on stocks they hold. If the overall value of their portfolio decreases due to a price drop, they can avoid losses by exercising the put option.
For example, let's imagine that Alice buys 100 shares at $50 in the hope of a rise in the market price. However, to hedge against a decline in stock prices, he decides to buy a put option with a strike price of $48, paying a premium of $2 per share. If the market declines and shares fall to $35, Alice may decide to use her contract to cut her losses and sell each share at $48 instead of $35. But if the market goes up, he doesn't need to execute the contract and just loses the premium he paid ($2 per share).
In such a scenario, Alice could break even at $52 ($50 + $2 per share) and her losses would be limited to -$400 ($200 for the premium and another $200 if she sold each share at $48).
speculative trading
Options are often used for speculative trading. For example, a trader who believes that the price of the asset is about to rise may purchase a call option. If the asset price rises above the strike price, the trader can purchase the asset at a discount by exercising the option. If the price of the asset is above or below the strike price, making the contract profitable, the option is considered to be "in the money". Similarly, if the contract is at break-even, it is considered "at-the-money" and if it is at a loss, it is considered "out-of-the-money".
Basic strategies
When trading options, traders can employ a wide range of strategies, which are based on four basic positions. As a buyer, one can buy a call option (right to buy) or put option (right to sell). As a writer, one can sell call or put options contracts. As mentioned, writers are obligated to buy or sell the assets if the contract holder decides to exercise it.
Traders can apply many different strategies when buying and selling options based on four basic positions. As a buyer, you can purchase a call option (right to buy) or a put option (right to sell). As a printer, a call or put option contract can be sold. As previously mentioned, printers are obligated to buy or sell the assets if the contract owner decides to enforce its contract.
Different options trading strategies are based on various possible combinations of call and put contracts. Protected selling, protected buying, compass and bowl are the most basic examples of these strategies.
Hedged put: Buying a put option contract for an asset that is already owned. This is the hedging strategy used by Alice in the previous example. This strategy is also known as portfolio insurance because it protects the investor from a potential downtrend while maintaining the position in case the price of the asset rises.
Hedge call: Selling a call option contract for an asset that is already owned. This strategy is used by investors who want to earn extra income (option premium) from their portfolio. If the contract is not implemented, they earn a bonus while keeping their assets. However, if the contract is exercised due to an increase in the market price, they must sell their position.
Compass: It refers to purchasing a call and a put option for an asset with the same strike price and maturity. It allows the trader to make a profit if the asset moves far enough in either direction. In simpler form, the trader bets on market volatility.
Bowl: Involves buying a call or put option that is “out of the money” (i.e., the strike price is above the market price for a call option and below the market price for a put option). Essentially, the bowl strategy is similar to the caliper, but it is less costly to establish a position in the bowl. However, in order to profit in the bowl strategy, the volatility level must be higher.
Advantages
Useful for hedging against market risks.
It provides greater flexibility in speculative trading.
It allows different combinations and trading strategies with unique risk/reward structures.
There is the potential to profit from all bearish, bullish or sideways market trends.
It can be used to reduce expenses when entering positions.
It allows multiple trades to be made simultaneously.
Disadvantages
It is not always easy to understand the working mechanisms and premium calculations.
It poses a high risk, especially for printers (sellers).
They are more complex trading strategies compared to traditional alternatives.
Options markets often suffer from low liquidity, making them less interesting for most traders.
The premium values of option contracts are highly volatile and premiums tend to decrease as maturity approaches.
Option and Futures Contract Comparison
Options and futures contracts are both derivative instruments and therefore have some common uses. But despite their similarities, there is a fundamental difference between the implementation mechanisms of the two.
Unlike options, futures contracts are always exercised when the maturity date is reached. That is, contract holders are legally obliged to buy or sell the underlying asset (or pay the equivalent amount of cash). On the contrary, the exercise of options depends on the decision of the contract owner. If a contract owner (buyer) exercises the option, the contract writer (seller) is obligated to buy or sell the underlying asset.
latest ideas
As the name suggests, option contracts offer investors the option to buy or sell an asset in the future, regardless of its market price. These types of contracts are versatile and can be used not only for speculative trading but also for various scenarios such as hedging strategies.
However, it is worth noting that trading options involves as much risk as other derivatives. Therefore, before you start using these types of contracts, it is important to have an in-depth understanding of how they work. It is also important to be knowledgeable about different buying and selling combinations and the potential risks to each strategy. Additionally, risk management strategies should be used along with technical and fundamental analysis to limit potential losses.
