Essential Option Trading Guide

Options trading can seem overwhelming. But they are easy to understand if you know a few key points.An investor’s portfolio is usually built with multiple asset classes, these can be stocks, bonds, ETFs, and even mutual funds.Options are other asset classes, and When used correctly, it offers many advantages that trading stocks and ETFs alone cannot provide.

Options are contracts that give rights to the holder. But it is not an obligation to buy or sell certain underlying assets at a predetermined price at or before the contract expires.Options can be bought like most other assets with a brokerage investment account.

Options are effective because they can improve an individual’s portfolio, they do this through increasing income, protection and even leverage, depending on the situation there is usually an option situation that is appropriate for the investor’s goals. The popular stock market options are used as an effective hedge against falling stock markets to limit losses. such as betting on the direction of stocks

There are no free lunches with stocks and bonds, options are no different, options trading has risks that investors need to be aware of before trading, this is why when trading options with a broker you will often see a disclaimer. Similar to the following:

Options belong to a large group of securities known as futures contracts, where the price of a derivative depends on or comes from the price of something else, for example wine is a derivative of ketchup, grapes are a tomato derivative and stock options are. An option is a derivative of a financial security, its value depends on the price of another asset, examples of futures contracts include calls, futures, forwards, exchanges, and mortgage securities, among others.

Call and put options

An option is a type of derivative security, an option is a derivative because its price is linked to the price of something else, if you buy an option contract it gives you the right. but not the obligation to buy or sell the underlying asset at a specified price on or before a specified date.

Call options give the option holder a chance to buy shares, and put options allow the option holder to think of a call option as a down payment for future purposes.

Example call options

As potential homeowners see new developments increase, the person may want the right to purchase a home in the future. But will want to exercise that right as soon as something develops around the area.

Will potential homebuyers benefit from the buy-in option Imagine if they could buy a call option from a developer to purchase a home for $400,000 over the next three years? Knowing that it is a non-refundable deposit, in nature the developer will not grant such an option for free, potential homebuyers must contribute a down payment to lock in that privilege.

With respect to options this cost is known as the premium, it is the price of the option contract, in our house example the deposit might be $20,000 that the buyer pays the developer, assuming it passes. It’s been two years and now that the development has been built and the zoning has been approved, the home buyer exercises the option and buys the house for $400,000 because that’s the contract it buys.

That home’s market value could double to $800,000, but since the down payment is locked in at a predetermined price, the buyer pays $400,000. Fourth, this is a year ago, the option expired, now the homebuyer will have to pay the market price because the contract expires, in any case the developer will keep the original $20,000.

insert sample options

Now think of the option put as an insurance policy. If you are a homeowner, you may be familiar with purchasing homeowners insurance. A homeowner buys a homeowner’s policy to protect their home from damage. They pay a certain amount, called Premium for one year, the policy has face value and provides insurance coverage in case of home damage.

If it’s not your home, your asset is investing in stocks or indexes Similarly, if investors want to insure their S&P 500 index portfolio, they can buy put options, investors may be afraid that a bear market is imminent. comingIf the S&P 500 is trading at $2500, he/she can purchase a put option which gives the right to sell the index at $2250, i.e. at what time? in the next two years

If during a six month market crash of 20% (500 points off the index) he or she has made 250 points being able to sell the index at $2250 when it was trading at $2000 – a total loss of only 10%. In fact, even if the market drops to zero, the loss will be only 10% if this put option is suspended. Again, buying the option costs (premium) and if the market does not. Lower during that period, the option’s maximum loss is simply the premium spent.

Buy Sell Calls / Puts

There are four things you can do with options:

1. Buy a cable
2. Sell cables
3. Buy, make
4. Sell makes

Buying a stock gives you a long position Buying a call option gives you a buy position in the underlying stock Short selling gives you a short position Selling an undisclosed or exposed call will Allows you to take a short position on the underlying stock.

Buying put options gives you a short position in the underlying stock, selling naked or unmarried puts gives you a potential position in the underlying stock, making these four situations important.

The person who buys an option is called the holder and the person who sells the option is called the option author. Here are the key differences between the holder and the writer:

1. Call holders and holders (purchasers) do not have to buy or sell, they have the option to exercise their rights, this limits the risk of the option buyer for using the premium only.
2. However, call writers and writers (sellers) are obligated to buy or sell if the option expires in the money. (more on that below) This means that the seller may be required to fulfill their contract to buy or sell, it also means that the option seller carries more risk, and in some cases, no risk. Limited, which means writers can lose more than the price of premium options.

speculative

Speculation is a bet on the future price direction. A speculator may think that the price of a stock will rise, possibly based on fundamental or technical analysis. A speculator may buy a stock or buy a call option on a stock. Speculation with trading options. Calls – rather than buying stocks outright – are attractive to some traders, after-hours call options can cost just a few dollars or even cents compared to the full $100 of the stock.

Hedging

Options are invented for hedging, options hedging are meant to reduce risk at a reasonable cost, here we can think of using options such as insurance policies, just as you would insure. A house or car option can be used to insure your investment against downturns.

Imagine you want to buy a technology stock but you want to limit your losses, by using put options you can limit your downside risk and enjoy all the upside in a cost-effective way. That can be used to limit losses if inaccurate, especially during a short squeeze.

How options work

In terms of valuation of OOP contractsThat is why it is important to consider the probability of a future price event, the more that happens, the more expensive the option is to profit from that event, for example, the call value increases as the stock (quote). higher. This is the key to understanding the relative values of options.

The less time there is until expiration, the fewer options there are, this is because the chance of price movement in the underlying stock decreases as we approach expiration, this is why options are a wasted asset if you buy them. A one-month option with no money and stocks does not move, the option becomes less valuable with each passing day, because time is the price component of the option, a one-month option is less valuable than a three-month option, because it has more time. The probability that the price moves in your favor will increase and vice versa.

Thus, the same strike option expiring in one year will cost more than the same strike for a month, this feature, the loss of the option resulting from time decay, the same option will It is less valuable tomorrow than today if the stock price does not move.

Volatility also increases the price of an option, this is because uncertainty pushes the odds of an outcome higher, if the volatility of the underlying asset increases then the larger price swings increase the likelihood of an upward movement. Up and down, more price swings increase the likelihood of that happening, so the greater the volatility, the greater the price of the option, options trading and volatility are inherently linked to each other in this way.

On most US exchanges, the stock option contract is an option to buy or sell 100 shares; that’s why you’ll need to multiply the contract by 100 to get the total you’ll need to buy the call.

Most of the time the holder chooses to take their profit by trading out (closing) their position, which means the option holder sells the option in the market and the writer buys back their position. Close Only 10% of options are active, 60% are traded (closed) and 30% expire worthless.

Option price volatility can be explained by value and extrinsic value, which is also known as time value, option premium is the combination of intrinsic value and time value, intrinsic value is the contract amount. An option which is a call option is an amount higher than the price at which the security is traded Time value is the added value that the investor pays for the option above its intrinsic value This is an external or time value, therefore The price of an option in our example can be thought of as follows:

In real life, options are often traded to some extent higher than their intrinsic value because the probability of an event never comes to zero, even though it is unlikely.high

American and European options

American options can be exercised at any time between the purchase date and the expiration date European options differ from American options in that they can only be exercised at the end of their life on the expiration date The difference between options American and European have nothing to do with geography. But only when exercising first Many options in stock indices are European type due to exercise rights. Early workouts have some value, American options usually have a higher premium than similar European options, this is because early fitness features are desirable and pre-commanded. premium

There are also exotic options which are novel because they can either change in their yield profile from a plain vanilla option or they can turn into a completely different product altogether with embedded “options”. Binary options, for example, have simple payout structures that dictate that payout events occur regardless of level. Other types of exotic options include knock-out knock-in barrier options. Lookback time options, Asian options and Bermudan options again are generally exotic options for professional derivatives traders.

Option expiry and liquidity

Options can be categorized by duration Short-term options are options that generally expire within one year Long-term options with an expiry of more than a year are categorized as long-term forward-looking securities, or LEAPs. They generally last longer.

Options can also vary by when their expiration date falls, options packs expire weekly, on Fridays, at the end of the month, or even daily, index and ETF options sometimes have quarterly expiration.

More and more traders are searching for option information through online resources (for related reading, see “Best Online Stock Brokers for Options Trading 2019”) While each source has its own format for presenting information, the main components generally include the following variables:

• Volume (VLM) simply tells you how many contracts of a particular option were traded during the last session.
• The “bid” price is the latest price level at which a market participant intends to purchase a particular option.
• The “ask” price is the latest price offered by market participants to sell a specific option.
• Imlicit bid volatility (Iml BID VOL) can be regarded as the future uncertainty of price direction and velocity, this value is calculated by option pricing models, such as the model. Black-Scholes and represents the degree of future volatility expected based on the option’s current price.
• Amount of open interest (OPTN OP) indicates the total number of contracts of a particular option that have been opened, fixed interest decreases when closed trades are opened
• Delta can be seen as a probability, for example a 30 delta option has about a 30% chance of expiration in the money
• Gamma (GMM) is the speed at which options move in or out of money, gamma can also be thought of as a delta movement
• Vega is a Greek value indicating the amount an option’s price is expected to change based on a single point change in implied volatility.
• Theta is a Greek value indicating how much the option will be worth after one day.
• “Strike price” is the price at which an option buyer can buy or sell the underlying security if he/she chooses to exercise.

The simplest option position is a long call (or put) on its own. This position is profitable if the price of the rise (fall) and your drawback is limited to the loss of the premium option. If you buy a call and put an option with the same strike and expiry, you have created a straddle.

This position pays off if the underlying price rises or falls dramatically; however, if the price remains stable you lose the premium on both calls and bets, you will enter this strategy if you expect a move. big time in stock but not sure which direction

Essentially you need a stock to move out of range, a similar strategy is to bet on moving securities when you expect high volatility. The tradeoff (uncertainty) is buying a call and buying a series with different strikes and the same expiry – known as a strangulation. Stranging requires a larger price movement in a particular direction to make a profit. But it is also less expensive than a straddle. On the other hand, shorting either a straddle or a strangle (selling both options) profits from a market that hasn’t moved much.

Spreads take positions of at least two options of the same class, they combine market sentiment. Spreads are often limited upside opportunities as well, but these strategies are still preferred as they tend to be less expensive compared to single options. A vertical spread involves selling one option to buy another, the second option is typically of the same type and at the same expiration. But there are different strikes.

A bull call spread or vertical call spread is created by buying a call and selling another call simultaneously with a higher price and the same expiry. The price of the underlying asset increases. But the margin is limited due to the short call stop. The benefit is that selling a high call costs lowers the cost of buying a lower call. Selling second staff with lower strike and same expiration If you buy and sell options with different expiry periods, it is known as calendar spread or time spread.

A combination is a trade built with call and put, there is a special type of combination known as “synthetic”, the point of synthesis is to create an option position that behaves like an underlying asset. There may be some legal or regulatory reasons why you cannot own it, but you may be allowed to create a synthetic position using options.

Butterfly

Butterfly consists of picks where three strikes are evenly spaced where all picks are of the same type. In long butterfly, the middle strike option is sold and the outside strike is bought at a 1:2:1 ratio ( Buy one, sell two, buy one)

If this ratio does not hold, it is not a butterfly, the outer strike is often referred to as the butterfly’s wing, and the internal strike is the body, the butterfly’s value cannot be lower than zero, the butterfly’s close relationship is perch. Dor – The difference is that the middle option is not at the same strike price.

Risk Options

Because price options can be mathematically modeled with models such as Black-Scholes Many of the risks associated with options are therefore modeled and understood, their characteristics making options less risky than other types of assets.Few allowed the risks involved in the choice to be understood and evaluated, individual risk was assigned a Greek letter name and sometimes simply referred to as “Greeks”.

Below are some very basic ways to start thinking about Greek concepts:

Options don’t have to be difficult to understand once you understand the basic concepts, they can provide opportunities when used correctly and can be dangerous when used incorrectly (for related reading see “Should investors hold or use options?”)

Article Source – Investopedia.com