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Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price, known as the strike price, on or before a specific date, known as the expiration date.

Options are versatile financial instruments that can be used for speculation, hedging, and income generation. They are often used by investors to manage risk and enhance returns.

This guide is designed to provide a comprehensive introduction to options and how they work, including the different types of options, how they are bought and sold, and how they can be used in various strategies.

Whether you are a beginner or an experienced investor, this guide will help you understand the basics of options and how to use them effectively in your investment portfolio.

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What Are Options?

At their core, options are contracts that give the holder the right to buy or sell an underlying asset at a specific price (known as the strike price) on or before a particular date (known as the expiration date). The purchaser of the option is known as the buyer, while the seller is known as the writer.

Options can be bought and sold in two ways: over-the-counter (OTC) or via a public exchange, such as the Chicago Board Options Exchange (CBOE). OTC options are usually more expensive than exchange-traded options because they are less regulated and more customized.

Options vs. Stock Options

It's important to note that options are not the same as stock options. Stock options allow the holder to purchase or sell a specified number of company shares at a specified price. On the other hand, options are derivatives that give the holder the right to buy or sell an underlying asset at a set price.

Types of Options

There are two types of options: calls and puts.

  • A call option gives the buyer the right to buy an underlying asset at a specified price.
  • A put option gives the buyer the right to sell an underlying asset at a specific price.

A call option is considered "in-the-money" if the current market price of the underlying asset is above the strike price. Conversely, a put option is considered "in-the-money" if the current market price of the underlying asset is below the strike price.

Options can also be classified as either American or European. American options can be exercised anytime before the expiration date, while European options can only be exercised on the expiration date.

Importance of Options in Financial Markets

Options are versatile financial instruments that can be used to hedge risk, speculate on the direction of markets, and generate income.

For example, investors can use options to hedge against risks associated with stock investments, such as declines in the value of stocks due to market volatility. By purchasing a put option, investors can protect themselves against losses if the stock price falls.

Options can also be used to speculate on the direction of markets. By purchasing a call option, investors can benefit from upward price movements in the underlying asset.

Finally, options can be used to generate income. Investors can sell options, known as writing options, and collect the premium. This is called a covered call strategy, in which an investor sells a call option against a stock they already own.

What Is Options Trading?

Options trading is the buying and selling of options contracts. When you trade options, you are essentially betting on the direction of an underlying asset. You can buy or sell call and put options depending on your outlook for the market.

Options trading is not suitable for all investors as it involves significant risk. Be sure to understand the risks associated with options trading and consult a financial professional before entering into any trades.

What Is an Options Trader?

An options trader is a person who trades options contracts. Options traders can be categorized as speculators or hedgers, depending on their trading strategy.

Speculators buy and sell options with the goal of making a profit from price movements in the underlying asset. Hedgers use options to reduce the risk of their existing investments.

Options traders use a variety of strategies to manage risk and generate profits, such as writing covered calls, selling puts, and spread trading.

How Do Options Work?

Options are bought and sold in contracts, with each contract representing the right to buy or sell 100 shares of an underlying asset.

When buying or selling an option, the investor pays a premium that is determined by several factors, such as the current price of the underlying asset, the strike price of the option, and the length of time until expiration. The premium is paid to the seller up front when the option is purchased.

The option will expire worthless if the strike price is not reached before the expiration date. If the stock does reach the strike price, the option will be worth the difference between the strike price and the current market price.

The Options Contract

An options contract is a legally binding agreement between two parties, the buyer and the seller. The buyer has the right but not the obligation to buy or sell a specified number of shares of an underlying asset at a set price (the strike price) on or before a specific date (the expiration date).

The seller is obligated to fulfill the terms of the contract should the buyer exercise the option. In return for this obligation, the seller receives a premium from the buyer.

Options contracts are available on a wide range of underlying assets, including stocks and commodities. They can be used to speculate on the direction of a market or as part of a hedging strategy.

The Strike Price

The strike price is the specified price at which the buyer has the right to buy or sell an underlying asset. If the option expires in-the-money, the buyer will receive a payment equal to the difference between the strike price and the current market price of the underlying asset.

For example, if an investor buys a call option with a strike price of $50 and the underlying asset is trading at $60, the option will be worth $10 ($60 - $50).

However, if the underlying asset is trading at or below the strike price, the option will expire worthless.

The Expiration Date

The expiration date is the day on which the option will expire. If an option holder chooses to exercise their right, they must do so before the expiration date.

American options can be exercised at any time before the expiration date, while European options can only be exercised on the expiration date.

The Time Value of Options

Options have an element of time value known as theta, which is the rate at which an option's value declines with each passing day. Theta is a major factor in determining the price of options, as it affects the amount of time that an option will remain in-the-money.

The expiration date is also important, as it determines when the option will expire. Options with longer expirations will generally have higher theta values, as they are more likely to remain in-the-money.

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Call Options

How Can Call Options Be Used to Speculate on a Stock's Price Increase?

Call options provide the buyer with the right, but not the obligation, to buy a certain number of shares of an underlying asset at a specified price (the strike price) on or before the expiration date.

Call options can be used to speculate on a stock's price increase. Suppose the stock price rises above the strike price before the expiration date. In that case, the option will be in-the-money, and the investor will receive a payment equal to the difference between the strike price and the current market price of the underlying asset.

How Can Call Options Be Used to Hedge Against a Stock's Price Decrease?

Call options can also be used to hedge against a stock's price decrease. By buying a call option with a strike price higher than the underlying asset's current market price, an investor can limit their losses if the stock price falls.

The cost of the option will limit any potential gains, but it also provides a certain level of protection against losses.

Put Options

How Can Put Options Be Used to Hedge Against a Stock's Price Increase?

Put options can also be used to hedge against a stock's price increase. By buying a put option with a strike price lower than the underlying asset's current market price, an investor can limit their losses if the stock price rises.

The cost of the option will limit any potential gains, but it also provides a certain level of protection against losses.

How Can Put Options Be Used to Speculate on a Stock's Price Decrease?

Put options provide the buyer with the right, but not the obligation, to sell a certain number of shares of an underlying asset at a specified price (the strike price) on or before the expiration date.

Put options can be used to speculate on a stock's price decrease. Suppose the stock price falls below the strike price before the expiration date. In that case, the option will be in-the-money, and the investor will receive a payment equal to the difference between the strike price and the current market price of the underlying asset.

Option Pricing

The Black-Scholes Model

The Black-Scholes Model is the most widely used model for pricing options. The model uses five variables to calculate the price of an option:

  • Underlying asset's price
  • Strike price
  • Time to expiration
  • Volatility of the underlying asset
  • Risk-free interest rate

The model takes into account all of the variables to calculate an option's fair market value at any given time. This is useful for traders who want to consider all the factors that affect an option's price.

How Is the Black-Scholes Model Used to Determine Options Prices?

Using the Black-Scholes Model, the fair market value of an option can be determined at any given time. The model takes into account the five inputs discussed above to calculate an option's value.

The resulting price is the fair market value of the option and can be used as a means of comparison with the current market price.

  • If the current market price is higher than the fair market value, it may be a good time to buy the option.
  • If the current market price is lower than the fair market value, it may be a good time to sell the option.

Greeks

The Greeks are a set of option-pricing models that use mathematical equations to calculate the sensitivity of an option's price to various factors. The most commonly used Greeks are Delta, Gamma, Theta, and Vega.

What Is Delta in Options?

Delta measures the rate of change in an option's price relative to the underlying asset's price.

What Is Gamma in Options?

Gamma measures the rate of change in an option's delta relative to the underlying asset's price.

What Is Theta in Options?

Theta measures the rate of time decay in an option's value as it approaches expiration.

What Is Vega in Options?

Vega measures the sensitivity of an option's price relative to changes in the underlying asset's implied volatility.

The Greeks can be used to measure an option's sensitivity to various factors, which can be useful for traders who want to analyze how an option's price will react in different scenarios.

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How to Trade Options?

Options can be traded either directly with a broker or on an exchange such as the Chicago Board Options Exchange (CBOE).

When trading options, traders must decide whether to buy or sell a call or put option. Traders can also use strategies such as spreads and straddles to manage risk and improve their chances of making a profit.

Options can be a powerful tool for investors, but they can also be risky. It is crucial for traders to understand the risks associated with options trading and develop a sound strategy before entering any trades.

How to Buy Options?

When buying an option, the investor must first decide whether they want to buy a call or a put option.

The investor then must decide the underlying asset they want to trade and the option's strike price. The investor must also specify when the option will expire, which can range from days to years for certain types of options.

The investor must then decide if they want to buy the option "at market", which means buying the option at the current market price, or "at limit", which means setting a specific price for the option.

Once the investor has made their selections, they can place an order with a broker or on an exchange. The investor will then need to wait until the option expires to see if they have made a profit or loss on their trade.

How to Sell Options?

When selling an option, the investor must first decide whether they want to sell a call or a put option.

The investor then must decide the underlying asset they want to trade and the strike price of the option. The investor must also specify when the option will expire, which can range from days to years for certain types of options.

The investor must then decide if they want to sell the option "at market", which means selling the option at the current market price, or "at limit", which means setting a specific price for the option.

What Is an Options Trading Tool?

An options trading tool is any software or service used to help traders analyze and trade options. Various tools are available, from simple calculators to sophisticated trading platforms. Options traders can use these tools to analyze and trade options and manage their risk.

Strategies for Trading Options

Options can be used in a variety of strategies for trading. Some popular methods and techniques include buying calls, selling puts, covered calls, long straddles, and long strangles.

Buying calls allows traders to speculate on an underlying asset's price increase. Selling puts allows traders to generate income on an underlying asset that they are willing to purchase at a certain price. Covered calls allow traders to generate income while also having some downside protection. Long straddles and long strangles allow traders to speculate on a wide range of price movements in an underlying asset without having to predict the direction of the move.

What Is a Strangle in Options?

A strangle is a type of options strategy that involves the purchase or sale of both a put and a call option with different strike prices but with the same expiration date. By buying both a put and a call option, an investor can benefit from price movements in either direction.

The goal of a strangle is to profit from the difference between the premiums received when selling the options and the cost of purchasing them. This strategy can be used by investors who believe a security will move but do not know in which direction.

Options Trading Examples

When trading options, it is vital to understand the different strategies that can be used and how they work in various market conditions. For example, if a trader believes that the price of gold will increase in the near future, they might buy a call option on gold. If the price of gold rises, the call option will increase in value, and the trader can realize a profit. However, if the price of gold drops, the call option will decrease in value, and the trader could suffer a loss.

Another example of trading options is selling a put option on an underlying asset. If a trader believes that the price of an asset is going to stay flat or go up, they might sell a put option. If the price of the underlying asset rises, the put option will decrease in value, and the trader can realize a profit. However, if the price of the underlying asset drops, the put option will increase in value, and the trader will suffer a loss.

Options Trading Risks and Considerations

Options trading comes with some risks and considerations that traders should be aware of before they begin trading. Options are leveraged instruments, which means that the gains or losses can be magnified. Options also have limited lifespans, so traders need to be aware of when their options are due to expire and plan accordingly.

Additionally, options can be illiquid in certain markets, and pricing can be difficult to obtain. Lastly, it's essential to understand the concepts of implied volatility, delta, and the other Greeks before beginning to trade options.

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Frequently Asked Questions

What Is Binary Options Trading?

Binary options trading is a type of options trading that allows traders to make a profit based on the direction of the market within a set period of time. They are called binary options because there can only be two possible outcomes: either the trader makes a profit, or they lose their entire investment. Binary options trading is becoming increasingly popular among investors due to its simplicity and potential for large profits.

What Are Open Interest Options?

Open interest options is a term used to describe the number of open contracts on a particular option at any given time. Open interest is an important metric to monitor when trading options because it reflects the amount of liquidity in a particular option.

Generally, higher open interest indicates more liquidity and better trading opportunities. Lower open interest may indicate a lack of liquidity and, therefore, fewer trading opportunities.

How Are Options Taxed?

Options are taxed differently depending on the type of option and whether it is held until expiration or sold before expiration. Generally, profits from trading options are taxed as either short-term or long-term capital gains.

Short-term capital gains are taxed as ordinary income, and long-term capital gains are taxed at a lower rate. It is important to consult with a tax professional prior to trading options in order to understand the applicable tax implications.

What Is Implied Volatility?

Implied volatility is a measure of the expected price movement of an underlying asset as implied by the price of its options. Implied volatility is important for traders because it can be used to gauge market sentiment and as an additional factor when determining which option to trade. Generally, options with higher implied volatility are more expensive than those with lower implied volatility.

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Conclusion

Trading options come with many risks and considerations that traders should be aware of. It's important to understand the different strategies involved in options trading and the tax implications and volatility levels. With the proper knowledge and preparation, options trading can be a lucrative endeavor for traders of all levels.

This comprehensive guide to options is designed to help traders make informed decisions about their options trades. With a clear understanding of the important topics related to options, traders can be better prepared to take on the market and succeed.

This post is not intended as investment advice. All trading involves risk, and individual results may vary. It is crucial to consult with a licensed professional before making any investment decisions.

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Hady ElHady
Hady is Content Lead at Layer.

Hady has a passion for tech, marketing, and spreadsheets. Besides his Computer Science degree, he has vast experience in developing, launching, and scaling content marketing processes at SaaS startups.

Originally published Jan 18 2023