What are options?
Options are a specific derivative instrument that gives buyers the right – though not the obligation – to purchase or sell a security at a predetermined price sometime in the future. For this right, buyers are charged an amount called a premium by sellers. Should the market prices become unfavourable for option holders, they can choose not to exercise this right and let the option expire worthlessly. On the other hand, if the market moves in a favourable direction, option holders can make use of the option.
Options are divided into two categories – put and call contracts. A put option is where the buyer has the right to sell the underlying asset in the future at a specified price. On the other hand, a call option is where the buyer has the right to buy the underlying asset in the future at a specified price. In this article, we take a look at key terms to know and how to begin options trading in Australia.
Key terms to know
Holders and writers: The holder is the buyer of an option, while the seller is the writer. Regarding a call option, the holder has the right to buy the underlying asset from the writer. Regarding a put option, the holder has the right to sell the underlying asset to the writer.
Strike price: The price at which the holder can either buy or sell the underlying asset.
Premium: The fee paid by the holder to the writer.
Expiration date/expiry: The date with which the options contract ends or terminates.
Out of the money: This is when the underlying asset’s price is above the strike (for a put option) or below the strike (for a call option). If an option is out of the money at the time of expiry, exercising the contract will incur a loss.
In the money: When the underlying asset’s price is below the strike (a put) or above the strike (for a call). This means that if the holder exercises this contract, they would be able to place a trade at a better price than the current market’s price.
All the money: This is when the underlying asset’s price is equal or very close to being equal to that of the strike price.
Break–even point: When the underlying market’s price is equal to an option’s strike minus premium (for a put) or plus premium (for a call).
Intrinsic and extrinsic value: Intrinsic value refers to the difference between an option’s strike price and the current price of the underlying asset. Extrinsic value refers to other factors that affect the premium, such as how long the option is good.
How to start options trading
Identify what makes up the price of an option
Traders need to know the factors that make up the price of an option. There are three main factors, and they work on the same principle. Basically, the more likely the underlying asset’s market price will be below (puts) or above (calls) an option’s strike price at the expiry date, the higher its value.
Time to expiry
The more time an option has to expiry the more time the underlying asset has to overtake the strike price. This means that an out of the money will tend to lose value when it nears its expiration date, so there is less chance of it potentially making a profit
The underlying market’s level
This will depend on the type of option a trader picks. If a call option’s strike is below the underlying asset, or a put option’s strike is higher above the underlying asset, the higher their premiums are likely to be. This is because these options are considered in the money, so there is more chance of them expiring with value.
The underlying market’s volatility
The more volatile the underlying asset of an option is, the more likely it is that it will pass the strike price. This volatility tends to increase with an option’s premium.
Understand the Greeks
The Greeks are measures of individual risks that are associated with options trading. As their name suggests, they are each named after a Greek symbol. It is important for traders to learn how they work in order to help them calculate the risk involved with the elements that affect the price of an option.
Gamma: This is a derivative of delta. Gamma focuses on measuring how much an Option’s delta moves for every point of movement in regard to the underlying asset.
Delta: Delta helps to measure how sensitive an option’s price is to the movements of the underlying asset. This means that assuming all variables stay the same, traders can use delta to estimate how much impact market movements will have on the value of their option.
Vega: An option’s Vega focuses on measuring its sensitivity to the underlying asset’s volatility. More specifically, it looks at how much the option’s value will change for every 1% change in volatility.
Theta: Theta measures how much the price of an option decays over time. A high theta indicates that the option is near its expiration date. This is because the closer the option is to its expiration, the quicker the time value decays.
Rho: Rho showcases how much interest rate changes are likely to move an option’s price. If the option’s price rises due to the result of interest rate changes, its rho will be positive. Vice versa, if the option’s price goes down, the rho will be negative.
Choose an options trading strategy
There are currently numerous options trading strategies that people can use to achieve various results when they are trading options. A few popular strategies are listed and explained below:
Buying call options
One of the simplest options trading strategies involves buying a call option when a trader expects the underlying asset to increase in price. If this does happen, traders can potentially profit by selling their options before the expiry date. Or, if a trader decides to hold their option until the expiry date and the underlying asset still remains above the option’s strike price, holders will still be able to exercise their right to buy at the strike price and potentially make a profit.
Buying put options
Another simple options trading strategy is to purchase a put option when a trader expects the underlying asset to fall in value. If this does happen, traders can potentially profit by selling their options before the expiry date. Traders also can hold the contract until expiry, and they would still be able to potentially profit if the underlying asset ended up below the strike price.
Overall, options trading can be complex, and it requires a solid understanding of the underlying asset, options strategies, and market dynamics. Those interested in options trading should conduct thorough research, seek guidance from reputable sources, and consider paper trading before committing to real funds. It is also recommended to consult with a financial advisor to ensure your trading strategies align with your investment goals and risk tolerance.