What Are Options Contracts?
In the world of trading, there is an agreement called an options contract, which grants a trader the option to either buy or sell a specific asset at an agreed-upon price, either at a set date or before it. It should be noted that this type of contract differs from futures contracts, as traders who purchase options contracts are not required to settle their positions.
Options contracts are derivatives that can be based on a variety of underlying assets, such as stocks, cryptocurrencies, and even financial indexes. They are commonly used for hedging risks on existing positions and for speculative trading.
How Do Option Contracts Functionate?
When it comes to options contracts, there are two main types: calls and puts. Call options provide the owner with the right to purchase the underlying asset, while put options provide the right to sell. As such, traders generally enter into calls when they anticipate the asset's value to rise and puts when they expect it to fall. They may also use calls and puts and combinations of both to speculate on market volatility or stability.
An options contract comprises four essential components: size, expiration date, strike price, and premium. The order size refers to the number of contracts to be traded. The expiration date is the point after which the option can no longer be exercised. The strike price denotes the price at which the asset will be bought or sold if the option is exercised. Finally, the premium is the cost of the options contract, which varies as the expiration date approaches. Buyers purchase contracts from sellers based on the value of the premium.
If the strike price is below the market price, the trader may choose to buy the underlying asset at a discount and, after accounting for the premium, can exercise the option for a profit. On the other hand, if the strike price exceeds the market price, the holder has no reason to exercise the option, rendering the contract useless. If the contract is not exercised, the buyer only loses the premium paid upon entering the position.
It is important to recognize that while buyers have the freedom to choose whether or not to exercise their calls and puts, sellers are dependent on the buyers' decisions. If a call option buyer exercises their contract, the seller is required to sell the underlying asset. Similarly, if a put option holder exercises their contract, the seller is obligated to buy the underlying asset from the buyer. As a result, sellers face greater risks than buyers and may lose much more depending on the asset's market price.
American option contracts also allow traders to exercise their options at any point before the expiration date. European options contracts, in contrast, can only be exercised at the expiration date. It is worth noting that these designations are unrelated to geographical location.
The price of an option's premium is determined by several factors, such as the underlying asset's price, strike price, time until expiration, and market volatility. These elements impact the premium of call and put options differently.
When the asset's price rises, the premium for a call option increases and the premium for a put option decreases. On the other hand, if the strike price is higher, the premium for a call option decreases, and the premium for a put option increases. As the expiration date approaches, the premium for both call and put options decreases. Finally, a rise in volatility leads to an increase in the premium for both call and put options.
As the asset's price and strike price affect the premium of calls and puts inversely, lower time usually leads to lower premium prices for both types of options. This is because traders have a lower probability of success. Conversely, higher levels of volatility cause premium prices to increase. Therefore, the premium of an option contract is influenced by these and other forces that interact.
Instruments known as Options Greeks have been created to gauge the numerous factors that impact the price of an options contract. These statistical values are used to measure the risk of a specific contract based on different underlying variables. There are several primary Greeks, and a brief summary of what they measure is given below:
- Delta: This measures the change in the price of an options contract concerning the underlying asset's price. A Delta of 0.6 indicates that the premium price is likely to move $0.60 for every $1 move in the asset's price.
- Gamma: This measures the rate of change in Delta over time. A change from 0.6 to 0.45 in Delta would give an option's Gamma of 0.15.
- Theta: This measures the change in price concerning a one-day decrease in the time of the contract. It reflects how much the premium is expected to change as the options contract approaches expiration.
- Vega: This measures the rate of change in a contract price concerning a 1% change in the implied volatility of the underlying asset. An increase in Vega would generally lead to an increase in the price of both calls and puts.
- Rho: This measures the expected price change regarding fluctuations in interest rates. Calls generally increase, while puts decrease with an increase in interest rates. Therefore, the value of Rho is positive for call options and negative for put options.
Common Use Cases
Options contracts are used in various scenarios, including hedging and speculative trading. In hedging, traders purchase put options on stocks they already own to mitigate losses if the price falls. For example, Alice buys 100 shares of a stock at $50 and also buys put options with a $48 strike price for a $2 premium per share. If the market turns bearish, Alice can exercise her contract, selling each share for $48 instead of $35, mitigating her losses. In speculative trading, traders can buy call options if they believe that an asset's price is about to rise. When the asset's price exceeds the strike price, the trader can exercise the option and buy it at a discount. A contract is "in-the-Money" when the asset's price is above the strike price, "at-the-Money" at its breakeven point, and "out-of-the-Money" when it incurs a loss.
One can employ various strategies when trading options based on four basic positions. Buyers can purchase call options (the right to buy) or put options (the right to sell), while writers can sell call or put options contracts. Writers are obligated to buy or sell the assets if the contract holder decides to exercise it.
Strategies are based on the different possible combinations of call and put contracts. Protective puts, covered calls, straddle, and strangle are some basic examples.
A protective put involves buying a put option contract of an already-owned asset. This hedging strategy protects investors from a potential downtrend while still allowing them to maintain their exposure in case the asset's price increases. It is also known as portfolio insurance.
A covered call involves selling a call option of an already-owned asset. This strategy allows investors to generate additional income (options premium) from their holdings. If the contract is not exercised, they earn the premium while keeping their assets. However, if the contract is exercised due to increased market prices, they are obligated to sell their positions.
A straddle involves buying a call and a put on the same asset with identical strike prices and expiration dates. This strategy allows traders to profit if the asset moves far enough in either direction. Essentially, the trader is betting on market volatility.
A strangle involves buying both a call and a put that are "out-of-the-Money" (i.e., strike price above market price for call options and below for put options). A strangle is similar to a straddle but with lower costs for establishing a position. However, a strangle requires a higher level of volatility to be profitable.
Pros and Cons of Options Trading
Options trading provides several advantages, such as flexibility in speculative trading, various combinations of trading strategies with unique risk/reward patterns, and potential profit from all market trends, including bull, bear, and side-ways. Additionally, options can be used to reduce costs when entering positions and allow multiple trades to be performed simultaneously, making them suitable for hedging against market risks.
However, options trading also has some disadvantages. The working mechanisms and premium calculation are not always easy to understand, and options trading involves high risks, especially for contract writers (sellers). The trading strategies can be more complex than conventional alternatives, and options markets are often plagued with low levels of liquidity, making them less attractive for most traders. Furthermore, the premium value of options contracts is highly volatile and tends to decrease as the expiration date approaches.
Options vs. Futures
When it comes to derivative instruments, options and futures contracts share some similarities, but they also have a significant difference in the settlement mechanism. While futures contracts are always executed at the expiration date, meaning the underlying asset must be exchanged, options are only exercised at the discretion of the contract holder. This means that if a buyer exercises the option, the seller is obligated to trade the underlying asset, but otherwise the option remains inactive.
Investors can utilize options to buy or sell an asset in the future, independent of market price, making them flexible and versatile contracts that can serve many purposes. They're not just used for speculative trading but also for hedging strategies.
However, options trading is not without risks, like other derivatives. To use this type of contract successfully, traders must understand its mechanics and the potential risks involved in each strategy, including the various combinations of calls and puts. Risk management strategies, along with technical and fundamental analyses, should be employed to limit potential losses.