Options Market - Finance Expression (2024)

Introduction:
How options are priced:
The formula:
Types of options:
For buyers:
Call option:
Put option:
Further classification of option contracts:
For sellers:
Options Greeks:
Advantages of trading options:
Risks of Trading Options:
Conclusion:

Introduction:

The word “option” means choice, alternatives; this is exactly the case with the “options market” in the derivatives world; it gives a trader many options to capitalize on the price movement; he can make money when the price is going up by buying a “call option”, when the price is going downward by buying a “put option” or when the price is not going anywhere by using the concept of “time delay.”, Will try to cover all the aspects of options in this article.

How options are priced:

The price of any option contract, called the premium, is the sum of two things: the intrinsic value and the time value.

The formula:

Option premium = intrinsic value + time value

Let’s say that Google is trading at $100 right now, and if it’s $100 call, it’s trading at $5, and if it’s $100 put, it’s trading at $5.

The price of the premium for the call:

Types of options:

For buyers:

Options buyers are traders who buy options at a particular strike price. After doing their analysis and believing that the price of the security will either go up or down, their risk is limited to the premium they are paying to buy this security, meaning that no matter how much the price goes against them, they will only lose the premium amount.

Call option:

Call options are bought when you expect the price of the underlying security to go up. A call option gives the buyer the right to buy the underlying asset at a specified price on or before a specified date. It means that if you buy a call option of a particular security at a price, you have locked in the price of that security at the strike price, meaning you will have the right to buy that security at the given price. If the price goes above your strike price, you can probably make money (I said probably, as there are other factors, like implied volatility, also added to it).

Try to understand it by an example, let’s say that the price of Google’s stock is $100 per share, you did your own analysis and believe that the price of Google stock will go up in the next month, so you bought a call option with a strike price of $100 and an expiration date of one month from now, if the price goes above $100 per share in the next month, you can exercise your call option and buy 100 shares (depending on lot size) of Google stock for $100 per share, even if the price of stock is higher than $100 per share, you will bank the increase in price, on the other hand, if the price of Google stock goes down below $100 per share before the expiration date, your call option will expire and you will lose the premium that you paid for the option. The price at which the option can be exercised is called the strike price. The date on which the option expires is called the expiration date.

Put option:

Put options are bought when you expect the price of the underlying security to go up. A put option gives the buyer the right to sell the underlying asset at a specified price on or before a specified date. It means that if you buy a put option on a particular security at a price, you have locked in the price of that security at the strike price, meaning you will have the right to sell that security at the given price. If the price goes below your strike price, you can probably make money (I said probably, as there are other factors, like implied volatility, also added to it).

Try to understand it by an example, let’s say that the price of Google’s stock is $100 per share, you did your own analysis and believe that the price of Google stock will go down in the next month, so you bought a put option with a strike price of $100 and an expiration date of one month from now, if the price goes below $100 per share in the next month, you can exercise your put option and sell 100 shares (depending on lot size) of Google stock for $100 per share, even if the price of stock is lower than $100 per share, you will bank the decrease in price, on the other hand, if the price of Google stock goes up more than $100 per share before the expiration date, your put option will expire and you will lose the premium that you paid for the option.

Further classification of option contracts:

In the money: When the price of security is less than the stike price in the case of the call option and higher than the stike price in the case of the put option, the contract is called the In the Money (or ITM) option. The deeper the in-the-money contract is, the less it is risky, as the intrinsic value is higher.
At The Money: When the price of security is equal to the strike price in both cases of the call and put option, the contract is called the At the Money (or ATM) option.
Out the Money: When the price of security is higher than the stike price in the case of the call option and less than the stike price in the case of the put option, the contract is called the Out the Money (or OTM) option. The deeper the Out of Money contract is, the more riskier it is, as it has zero intrinsic value and only a time value.

For sellers:

An options seller or options writer is a person who opens the options position with the aim of collecting a premium from the buyer. He can make money from the premimum decay or time decay if the price of the security does not move in any direction. The risk for the options seller is unlimited, as the price can theoretically reach any point in no time, and if the premium can increase multifold, the writer has to cover the difference between the price he sold the premium for and the current premium price.

Options Greeks:

Options Greeks are a set of mathematical ways of measuring the price movement of an option’s price with respect to changes in the underlying asset price, implied volatility, time to expiration, and interest rates.

The four main options for Greeks are:

Delta: The change in an option’s price with respect to every $1 change in the underlying asset price change is called Delta.

Gamma: The change in delta with respect to every $1 change in the underlying asset price, is called Gamma.

Vega: The change in an option’s price with respect to every 1% change in implied volatility, is called Vega.

Theta: It measures the time decay of an option’s price, as the day of expiration comes closer.

Advantages of trading options:

Leverage: Options contacts gives traders to hold large positions with relatively small capital.
Limited risk (for buyers only): The maximum loss on an options trade for a buyer is only the premium that the trader paid.
Flexibility: Their are a variety of trading strategies, which gives traders flexibility.
Directional benefits: Options traders can leverage the movement of prices in both directions; they can buy calls or puts.
Time decay benefits: Options writers can not only take advantage of the change in the price of security; they can even take advantage of time decay, as the time value will keep going as the expiration date gets closer.

Risks of Trading Options:

The buyer of an option can lose the entire premium if the option expires unexercised. Unlimited risk, The seller of a naked call option has unlimited risk, meaning that they could lose more money than the premium that they received for the option if the underlying asset price moves significantly against them, also options trading is very complex and difficult to understand in the start.

Conclusion:

Trading options contracts is a complex business, though it may appears simple and profitable in the surface, theoretically, it’s easier to say that buyers have limited risk, but if the buyer puts all his money in one contract and the contact closes out the money, he will lose all his capital. The same is the case with options writers; if the security starts trending against them, if it gaps against them, they can lose more money than they have in their account and can even go bankrupt. Hence, both ways of buying and selling are extremely risky. One has to consider risk appetite, position appetite, and position sizing and should always be careful in both cases.