Option

An option, in the sphere of trading, is a type of derivative contract with the value based on a financial instrument, which might be an asset, a commodity, a currency, etc. It provides the owner with the ability to sell or purchase a security for a particular amount of money stated in the contract during a given limited period of time while the contract is valid. There are two main kinds of options — call options and put options, with the key difference being that a call grants a right to buy, while a put gives a right to sell a certain security.

The important notion is that it suggests no obligation for its owner to exercise the option if there’s no benefit for the owner, so an option might expire without anything being purchased or sold. Options themselves might be traded more than once, but this type of financial activity requires experience in trading and the good understanding of the market.

Buying and selling options, as well as exercising or not exercising them, give the market participants a wide range of possibilities, as it is a way to gain profit with little investment, or hedge one’s securities, or diverse one’s investment strategy. At the same time, despite all the available ways to gain and attractive prospects, there are certain risks involved with options trading, so all advantages and disadvantages of these financial instruments must be thoroughly studied before entering the trade.

Option main features

To fully grasp what an option is, it’s necessary to clear out the related terminology. 

The following terms are essential and intricately linked to the concept of an option:

• A strike price. As an option grants the right to buy or sell a security at a specified price, this price is crucially important. It’s one of the key points of the whole contract, it’s clearly stated and cannot be changed, regardless of the price changes that might happen to an underlying security. A strike price is a unique feature of options that serves as a basis for speculating and hedging, as it gives the possibility to buy or sell securities at the prices lower or higher than actual market prices.
• A premium. When a buyer purchases an option, a sum paid for it is called a premium. This sum is based by some degree on the strike price stated in the contract, but is also affected by many external circumstances, which are important to consider before making a purchase to choose the best time. A premium is usually stated in a dollar amount per share, and an option contract is usually written for 100 shares. So, to understand the full price of an option contract, it’s necessary to multiply the premium by 100.
• An expiration date. Option contracts are limited by time, and the date at which the contract expires (i.e. becomes invalid) is also fixed and clearly stated. Depending on the circumstances and the option type, the approach of an expiration date might affect the option price and an overall result differently, but in any case it has a direct influence on the option’s value. It’s also important to note that for American options, it’s possible to exercise a contract before an expiration date, while European options are allowed to be exercised precisely at the date of expiration.

Besides the abovementioned features of options, it’s worth studying the participants to get a better understanding of how a process of writing and exercising an option is organized.

There are always two parties involved — a writer (or a seller of an option) and a holder (or a buyer of an option). A seller is an individual or an entity who creates the contract, i.e. writes it, thus being called a writer. According to the contract, the one who agrees to pay a certain fee, called a premium, is granted a right to buy or sell a security to the writer under stated conditions. After the second participant buys the option, he or she becomes the holder. While an option gives its holder a right and charges no obligation, the writer has to fulfil the commitments of the contract if the holder decides to exercise the option.

Main types of Options

As it has been already stated, there are two types of option contracts:

• Call options. This kind of option represents a possibility (without necessity) to buy a certain security at a certain time at a specific price. Call options are usually bought when a buyer is sure that there will be an increase in market price of the underlying security. In this case, after the price rises above the strike price, the buyer can buy the security at a lower price stated in the contract, and immediately sell it, gaining the difference in prices as a profit. If the price doesn’t grow up, the buyer doesn’t have to buy the security, so the call option expires, and the buyer’s loss is limited to a premium paid for the option. Selling call options is considered more risky than buying, as the writer is obliged to sell the security on the owner’s demand, which usually happens when its price rises above strike, and an increase might be unpredictably high, thus causing the option writer significant losses of possible profits, while the buyer’s possible loss can’t be larger than the premium.
• Put options. This kind of option gives the buyers a right to sell their security at a strike price in the stated period of time, again with no obligation charged. In this case, if the market price of the security lowers below strike, it’s possible for the buyer to gain profits by selling the security at a higher price stated in the contract. Put options might be as risky as call options, and again the seller must be more aware of possible outcomes, as the seller’s risks are unlimited by a premium amount. So, if the security market price significantly drops and the put holder exercises his right to sell the security at the strike price, the put option writer has to buy securities for a higher price, incurring a loss. Put options are also used as a hedging instrument against price decrease.

So, both types of options has its own advantages and disadvantages, at the same time providing a possibility for an experienced trader to maneuver among constant price changes and get profits from it. There are plenty of strategies of trading, allowing the market participants to reach specific goals. Such strategies of trading both options types are called spreads, often with an additional name for each strategy. Those strategies imply a simultaneous process of buying and selling calls and puts, finding a way to maximize the profit and eliminate risks.

Buying options is attractive to brokers and investors, as this way of trading securities hold fewer risks than buying securities themselves by limiting the possible losses to an amount of a premium in case the security doesn’t perform too well. One more important advantage of trading options lies in the fact that participants don’t have to actually operate securities, i.e. transfer it from one place to another or spend resources on storing it. This feature is especially important when commodities are traded, as unlike currencies, bonds or stocks, commodities might actually take time and resources to be physically managed.

As a strike price of an option is rarely the same as the current market price of the security, there’s also a differentiation of options based on this factor. There are three kinds of options in the market, which are defined by the relation of the strike price of the underlying security and that security’s actual market price. 

Those options are the following:

• In the money options, or ITM, with strike prices beneficial for an option holder (for a call, the strike is lower than the market price, and for a put, the strike is higher than the market price);
• At the money options, or ATM, with strike prices equal or nearly equal to current market prices of the underlying security;
• Out of the money options, or OTM, with strike prices providing no gain for the holder being higher or lower than the market prices (such options are usually not exercised, and they have no intrinsic value, but they still have some time value, as it’s possible that something might change in the market).

An option isn’t fixed to be ITM or OTM for all period of time stated in the contract, and it’s possible to change over time due to the market conditions, so it’s important for an option holder to constantly monitor the state of his or her option to choose the right moment to act. Option chains providing all the available data on options trading often allow sorting the options by this parameter.

Option trading risks and what affects them

Trading options is not the same as trading securities. In fact, when a trader buys or sells options in huge amount, he or she faces a risk, as it’s strongly connected with forecasting future performance of the underlying security, options market situation, the market situation in general, and the price changes over time, as an option contract is always limited by time. So, there are many variables that need to be considered, and predicting all those changeable circumstances might be tricky, and many assumptions made might turn out to be wrong. Another factor of risk is that many participants in the options market are skilled traders with rich experience in that field, often equipped with specifically designed programs and software, calculating possible profits and risks considering as much data as possible.

So, in options trading, it’s crucial to estimate risks properly. To do that, a set of metrics called the Greeks has been developed. It is aimed at calculating a range of rates and relationships between different indicators and numbers of a particular options class and the market in general. It’s called the Greeks because most of those metrics are represented by Greek letters. There are main Greeks, which are used more often, and also some additional ones called the minor Greeks, representing secondary and tertiary relationships between the main Greeks and options market indicators.

The most commonly used Greeks are the following:

• Delta, which measures the rate of change in price between the price of an option and the price of its underlying security, or, to put it another way, the reaction of the option price to the change of the security price. There isn’t always a direct correlation between those prices, so delta might be positive or negative.
• Gamma, which measures the relation of price change of an underlying security and delta of an option for the security, representing price sensitivity of the second order.
• Theta, which measures the effect of time passing on an option’s price;
• Vega (not actually a Greek letter, but the name was established exactly like this), which measures the relationship between the price change of an option and volatility changes of the market.

There are also minor Greeks, which are getting more and more popular with the spread of informational technologies, simplifying their calculation.

By considering and calculating all possible and available metrics of an option, it’s possible for a sophisticated trader to predict the highest possible risks and, by doing so, be able to minimize it. Forecasting the highest risks, as well as the highest and lowest possible profit, also aids in decision-making, providing a basis for choosing the needed action in an ambiguous situation. For instance, if a broker analyzes an option’s metrics and gets the result showing that risks are significantly higher than the greatest possible profit, the broker likely won’t engage into action in this case.

Besides the abovementioned metrics, there are other important indicators affecting the price changes and the risks, accordingly. One of those indicators is the implied volatility of the underlying asset. If it’s implied that there is a strong probability of significant price changes of the asset, options prices usually increase, and vice versa, a decrease in implied volatility often indicates a decrease in options prices.

Open interest is another measure which is worth considering when buying or selling options. It reflects the interest of market participants, and is measured by the total number of outstanding contracts for a certain strike price.