Option Trading
The Options Market is one of the most robust and active markets accessible today. Options are contracts that give a buyer the right to buy or sell an asset at the stated price, the “strike price,” of the contract.
What is an Option?
Options are asset derivatives that derive their value from the price of the underlying asset. An option buyer has the right, but not the obligation, to buy or sell assets at the strike price stated on the option contract they purchased.
Options are used by traders and investors for various reasons. They enable traders to hold a leveraged position at a lower price than buying shares of the asset outright and they allow for hedging against the risk exposure of their portfolio. Option buyers’ risk is limited to the premiums they pay for the option contract; however, the upside potential is uncapped.
Options are also a good tool for investing in commodities where the price fluctuations can often be cyclical.
Options are also a good tool for investing in commodities where the price fluctuations can often be cyclical.
The Greeks
Delta
Delta measures the rate of change of the option’s price and a $1 price movement of the underlying asset
Theta
Theta is a measure of the option time decay. It is the rate of change of the option’s price and time based on the options expiration date.
Gamma
Gamma measures the rate of change between an options delta and the underlying asset’s price
Vega
Vega measures the rate of change between an option’s value and the underlying asset’s implied volatility
Rho
Rho measures the rate of change between an option’s value and a 1% change in the interest rate
Call Options
Buyers of call options have the right to purchase shares of the underlying asset at the strike price specified in the option contract for a set period of time, determined by the expiration date of the contract.
Sellers of call options have the obligation to sell shares of the underlying asset at the strike price specified in the option contract for a set period of time, determined by the expiration date of the contract. Sellers are only obligated to sell shares in the event that the option buyer exercises the option.
Put Options
Buyers of put options have the right to sell shares of the underlying asset at the strike price specified in the option contract for a set period of time, determined by the expiration date of the contract.
Sellers of put options have the obligation to buy shares of the underlying asset at the strike price specified in the option contract for a set period of time, determined by the expiration date of the contract. Sellers are only obligated to purchase shares in the event that the option buyer exercises the option.
Option Spread Strategy
An option spread is a strategy that combines both Calls and or Puts.
A vertical spread is an option strategy that involves buying/selling a call/put and simultaneously selling/buying another call/put at a different strike price, but both with the same expiration date. Vertical spreads limit risk, but also limit the potential for return.
A horizontal spread is an option strategy created with simultaneous call and put options on the same underlying asset and same strike price, but with different expiration dates.
Butterfly Strategies
A butterfly strategy is one that combines options with three different strike prices, which are equally apart. All three options are the same type (call or put) and have the same expiration. In a long butterfly, the middle strike is sold outside of the strikes and bought in a ratio of 1:2:1 (buy one, sell two, buy one). If this ratio does not hold, it is not a butterfly strategy. The outside strikes are commonly referred to as the wings of the butterfly, with the inside strike being the body. The value of a butterfly will never fall below zero.