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US DOLLAR
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Options - Understanding the BasicsAn option is a contract that gives the owner the right, but not the obligation, to buy or sell a security at a particular price on or before a certain date. Investors buy and sell options just like stocks. There are two basic types of options: - The call option
- The put option
The Call Option The call option is the right to buy the underlying security at a certain price on or before a certain date. A call option is the right but not the obligation to buy an underlying futures contract. Purchasing a call means that you are expecting higher prices for the underlying commodity. Let’s assume you purchased a December Crude Oil $40 call option. You bought the right but not the obligation to buy 1000 barrels of December crude oil for $40 per barrel. The Put Option The put option is the right to sell the underlying security at a certain price on or before a certain date. A put option is the right but not the obligation to sell an underlying futures contract. Purchasing a put means that you are expecting lower prices for the underlying commodity. Let’s assume that you purchased a November Soybean $5 put option. You bought the right but not the obligation to sell 5000 bushels of November soybeans at $5 per bushel. What are the simple basics a beginning options trader must know? There are basically two types of options you might trade: Calls and Puts. LEAPS are simply long-term options. If a call or put option typically expires in 30 to 90 days, a LEAP might not expire for a year or two. By the way, options are traded on a number of exchanges: CBOE, American, Philadelphia and Pacific. You will get that information from the Options Chains and need to know that to place trades. And in case you weren't sure, a Call gives you to right to buy a particular stock, or index, and a Put is the opposite. With a Call you make money when the market rises. A Put makes you money only if the market or the underlying stock falls sharply in value. What is the value of an option? Unlike a stock, an option has more risk as it is a "wasting" asset. The initial value of an option declines as time passes until it expires completely worthless - if an option has a 30 day expiry, it will be worth about 1/30 less each day you hold it. Actually, a 3 month option decays at twice the rate of a 9 month option. And options lose time value faster within the last few weeks before expiry. But the important point is this: with time working against you, you must not only be right about the direction but you must also be correct about timing. Options are the very antithesis of a "buy and hold" stock. True, like a stock, an option is a security, but it is a derivative security. Stock splits and dividends may affect the option price but the holder of a call option does not receive dividends paid to stockholders. There are at least two components to the price of an option: one is intrinsic value, the amount by which the stock or index price exceeds the options price. The second is the premium. The premium is simply that value of time left until expiry plus any amount by which the option exceeds the intrinsic value. That can vary depending on investor sentiment and volatility. Deep in the money options may actually trade at a discount to the cheaper out of the money calls due to the percentage risk/reward ratio. You can minimize those risks and fluctuations by trading "near the money" or "in the money" options with near term expiries. And as we said earlier, get to know your one or two areas of expertise as we discussed earlier. Don't trade all over the board. Strike Price: Options generally have prices spaced 5 points apart for smaller cap stocks and 10 points for the large caps. Smaller stocks may have strikes 2 « points or less. Stock splits may leave the options with odd fractions or decimals. Strike prices are not set in stone and may be altered by exchange officials to improve liquidity. Strike prices close to the price of the stock or index are called "near the money" or "at the money." Strike prices with little chance to close "at the money" are called "out of the money" and have much more risk. The most important point to remember is that the options closest to the money trade the most often and generally have the lower risk. That said, they also have the highest price. Experienced traders like to trade options within a few point of the money and with 30 to 90 days expiry dates. The time premium is lower and the profit potential and liquidity is higher. The exception might be in preparation for a Y2K-like crash where the out of the money LEAPS might make sense. Expiry: Options have expiration dates on cycles: Jan/April/July/October or Feb/May/Aug/Nov or Mar/June/Sept/Dec. The longest term options typically expire in 9 months or less, except for LEAPS. Typically the last trading day for an option is the third Friday of the month at the close of trading. You must sell the option or exercise the right to buy the stock. For our purposes you only need to remember that if this is the first week of the month of October, and you buy the October calls or puts, you only have a couple of weeks before your option is worthless. If you buy the January 2001 LEAPS you have plenty of time but you will pay a high premium for time and your asset is wasting away every day you are wrong. Details of Option Trading: The sooner you sell an option the better. Place a limit order to sell as soon as you buy it. Options trades typically have a one day settlement so the trade settles the next day of business. Most brokers require that you pay in cash. Options are not marginable. Options are open for trading in rotation after the stocks open for trading. There may be volatility in the first hour of trading or a market panic where prices are severely distorted. Here is one time where knowing what the options are worth will save you overpaying by up to 300 percent. Open Interest and Volume: You can see how many options are currently held by looking down your Options Chain under Open Interest. The Volume column will tell you how many options are currently trading. It helps to keep track of both and check the calls against the puts to see where the buying and selling is. But don't assume the crowd is right. They often are not. You can also find high and low prices for the day and the last trade. Those will give you an idea what to bid and then what sell price you might expect depending on market swings and volatility. A put option is the right to sell a particular stock at a specified price for a limited period of time. This stock is called the underlying security. Put option is said to be exercised when the stock is sold. The strike is the price the holder of the option must pay to exercise it. Since the buyer (holder) of a put has a right to sell stock at the striking price, the seller (writer) of a put has no choice but to buy that stock. For assuming the obligation to buy stock at a pre-specified price, the writer of the put receives the put option premium. Maximum profit is equal to this premium if the put expires worthless. Each option is valid for only a limited time; thus, each option has an expiration date. An option contract has four specifications: - Type of option (put or call)
- Name of the underlying stock
- Expiration date
- Striking price
Example 1. One contract"ABC October 30 put" is an option to sell 100 shares of the underlying ABC stock for $30 per share, the contract expiring in July. The price of a listed option is quoted on a per-share basis, regardless of how many shares of stock can be bought with the option.
If the contract in this example is sold for 2 points, the maximum profit is $200. The loss is the difference between the strike price and stock price at expiration. However, no net loss will be realised if the stock price goes down to 28, because the premium of 2 points had been paid upfront. | ABC Stock Price at Expiration | Put Price at Expiration | Profit | | 24 | 6 | -$400 | | 23 | 5 | -$300 | | 26 | 4 | -$200 | | 27 | 3 | -$100 | | 28 | 2 | 0 | | 29 | 1 | $100 | | 30 | 0 | $200 | | 31 | 0 | $200 | | 32 | 0 | $200 |
A put option is out-of-the-money if the stock is selling above the striking price of the option.
A put option is in-the-money if the stock is selling below the strike. The intrinsic value of an in-the-money put is the amount by which the strike exceeds the stock price. The intrinsic value of an out-of-the money put option is zero. Option premium is the price an option sells for. Time value is the excess of the option premium over the intrinsic value of the option. Time value decreases as the expiration day approaches. Put option with a strike close to current price of the underlying security has the greatest time value. Such a put, other conditions being equal, is the most profitable put to sell. In this respect, a put writer is a seller of time value. We consider bull put option spreads, i.e. selling a put option with a certain strike and buying a protective put option with a lower strike. Both options have the same expiration date. The bull spread is profitable if the underlying stock goes up. As we have seen above, the profit is limited. Fortunately, the potential loss is also limited because we buy a protective put. Let us modify our previous example. Example 2. We establish a put option spread by buying one contract "ABC October 27 1/2 put" at 1/2 points and simultaneously selling one contract "ABC October 30 put" at 2 points. The credit is 1 1/2 point or $150 for one contract. The maximum profit (net credit) for this bull spread is $150. We already got it. Nevertheless, if the stock moves down our loss is limited by the difference between the strike prices minus net credit received. ABC Stock Price
at Expiration | October 30 Put Price
at Expiration | Profit | October 27 1/2 Put
at Expiration | Profit | Total
Profit | | 25 | 5 | -$500 | 2 1/2 | $250 | -$100 | | 26 | 4 | -$400 | 1 1/2 | $150 | -$100 | | 27 | 3 | -$300 | 1/2 | $50 | -$100 | | 28 | 2 | -$200 | 0 | 0 | -$50 | | 29 | 1 | -$100 | 0 | 0 | $50 | | 30 | 0 | 0 | 0 | 0 | $150 | | 31 | 0 | 0 | 0 | 0 | $150 | | 32 | 0 | 0 | 0 | 0 | $150 |
Unlike in the previous example, here we traded a fraction of our potential profit for a downside protection.
Profit/loss ratio is 1.5 = $150/$100.
Is it reasonable? Is it worth taking the risk? The answer depends on how bulish you are on the stock. If the stock is unlikely to go up, neither high credit nor high profit/loss ratio will look attractive. On the contrary, if you are very bullish on the stock, a certain risk level appears quite acceptable. Break-even stock price (when we have zero profit from our investment) is equal to the higher strike minus net credit. Collateral requirement for options spread is usually equal to $2000 for one contract. You have to keep that much equity on your margin account to establish a spread. You can enhance your portfolio, no matter what it is! You have a unique possibility to participate in upward stock price movements, with a little investment. Besides, you have a downside protection. Just compare to outright purchase of a stock - no downside protection and no leverage! It is better to select spreads with a short at-the-money put (strike is equal to the current price
of the underlying security). In this case you sell a maximum time value. If the stock goes substantially up, it is reasonable to roll the spread up - to buy back the short put at a lower price and to sell another one at a higher price. If the underlying stock drops, you can also undertake a protective action. You can buy back your short put at a loss and sell another one at a lower strike. It is better to sell the at-the-money put which contains more time value. Remember that the price of the protective put you bought goes up. Therefore, rolling your spread down you can reduce your losses even more. |
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Option Spread Trading A spread is merely a position consisting of two components transacted simultaneously or in close succession where each position would profit from opposite directional price moves in the market. Each part of the paired spread is entered into simultaneously in the hopes of either limiting risk or obtaining benefit from the change in price relationship between them. Spreads are of two types: - Directional & Volatility spreads. Directional Spreads A trader would use a Directional Spread when one is focusing on the underlying directional price movement (up or down). For this trader, the volatility in the market is of secondary importance, one rather wants to harness the bullish or bearish movement that one foresees happening. The first type of Directional Spread that is the 1:1 Vertical Spread. This simple combination gives a range of profitability with less risk than the outright purchase of a naked put or calls. The trader has put on a Vertical Spread when one has both purchased one option and sold another where both options are of the same type (call or put) and expiration (e.g. July) but have different strike prices. A Bull Spread is a strategy involving two or more options that will result in a profit from a rise in price of the underlying asset. A Bull Spread would be implemented by an investor who was bullish on the underlying asset but who is not bullish enough to buy a call option straight out. A Bear Spread is a strategy involving two or more options that will profit from a decrease in the price of the underlying asset. This investor is bearish about the underlying asset. One hopes to capitalize on what one foresees as a downward movement, but is somewhat more risk averse than the outright buyer of a put. Bull Spreads and Bear Spreads are of two types. Bull Spreads can be either Call Bull Spreads or Put Bull Spreads, and Bear Spreads can be either Call Bear Spreads or Put Bear Spreads. A Call Bull Spread consists of the purchase of one call option with a lower strike price and the sales of another call option with a higher strike price. A Put Bull Spread consists of the sale of one put option with a higher strike price and the purchase of another put option with a lower strike price. A Call Bear Spread consists of the sale of one call option with a lower strike price and the purchase of another call option with a higher strike price. A Put Bear Spread consists of the purchase of one put option with a higher strike price and the sale of another put option with a lower strike price. Volatility Spreads The trader who uses a volatility spread is chiefly interested in the degree of volatility of the underlying asset, and only secondarily in the directional movement of the underlying asset. Volatility can be defined as the measure of price fluctuation of the underlying asset. Now the Volatility Spreader may have a bullish or bearish perspective on the market, but unlike the Directional Spreader, one tries to take advantage of the fluctuation in market price of the underlying asset rather than bet on its direction. Volatility spreads are sensitive to a number of factors, including the price of the underlying asset, time until expiration, price volatility, and prevailing interest rates. Volatility spreads are based on moves like "Buy a Call & Buy a Put at different strike prices" or "Sell a Call and Sell a Put at different strike prices" or a combination of various strategies to take advantage of price volatility of the underlying asset. There are a large variety of volatility spreading strategies including Straddles, Strangles, Back Spreads, Time or "Calendar" Spreads, Ratio Vertical Spreads, Butterfly Spreads and several others. Option Strike Price In options, the strike price is the pre-determined price at which the option may be exercised. Strike price is also known as the exercise price. Strike is the price at which an option begins to have a settlement value at expiration. The strike price is set at the time the option contract originates. An option is "in-the-money" when the current market price of the underlying futures contract exceeds the strike price of a call or is below the strike price of a put. Similarly, an option is "out-of-the-money" when the current market price of the underlying futures contract exceeds the strike price of a put or is below the strike price of a call.
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Option Strike Price
In options, the strike price is the pre-determined price at which the option may be exercised. Strike price is also known as the exercise price. Strike is the price at which an option begins to have a settlement value at expiration. The strike price is set at the time the option contract originates. An option is "in-the-money" when the current market price of the underlying futures contract exceeds the strike price of a call or is below the strike price of a put. Similarly, an option is "out-of-the-money" when the current market price of the underlying futures contract exceeds the strike price of a put or is below the strike price of a call. Strike Price and Option Premium Call and put option premiums depend upon several factors, the most important of which is the strike price of the option relative to the market price of the underlying futures contract. A call option becomes more valuable, and hence its intrinsic value becomes greater, as the market price of the underlying futures contract rises above the option's strike price. A put option becomes more valuable, and hence the intrinsic value becomes greater, as the market price of the underlying futures contract falls below the option's strike price. The intrinsic value and time value together constitute the option premium. An option may or may not have intrinsic value, but it will almost always have time value. Any option may become valuable in the future and hence, a liability to the seller, so the time value exists to compensate option sellers appropriately. The major factors that influence the time value of an option are: Time to Expiration The longer the time to expiration of a call or put option, the larger the time value. This is because, with lots of time until expiration, the option has plenty of opportunity to acquire intrinsic value. On the flip side, as option approaches expiration, the time value, all else constant, will erode steadily to zero. Volatility As the underlying futures contract becomes more volatile, the time value of a call and a put option increase. This is because, as volatility rises, it becomes more likely that prices will move to the point where the option has intrinsic value.
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What is Delta? Delta is the amount by which the option changes compared to the underlying asset. It is a measure of the probability that an option will expire in the money. Call deltas can be interpreted as the probability that the option will finish in the money. Put deltas can be interpreted as -1 times the probability that the option will finish in the money. An at-the-money option, which has a delta of approximately 0.5, has roughly a 50/50 chance of ending up "in-the-money". For example, if an at-the-money wheat call option has a Delta of .5, and if wheat makes a 10-cent move higher, the premium on the option will increase approximately by 5 cents (.5 x 10 = 5), or $250 (each cent in premium is worth $50). The interpretation of Delta values is as under: - Call options: 0 to 1
- Put options: -1 to 0
- In-the-money options: Delta approaches 1 (call: +1, put: -1)
- At-the-money options: Delta is about 0.5 (call: +0.5, put: -0.5)
- Out-of-the-money options: Delta approaches 0
- Long Calls have a positive delta -You want the market to go up
- Short Calls have a negative delta -You want the market to go down
- Long Puts have a negative delta -You want the market to go down
- Short Puts have a positive delta -You want the market to go up
Delta is useful as a hedge ratio. A futures option with a delta of 0.5 means that the option price increases 0.5 for every 1 point increase in the futures price. For small changes in the futures price therefore, the option behaves like one-half of a futures contract. Constructing a delta hedge for a long position in 10 calls, each with a delta of 0.5 would require you to sell 5 futures contracts. As time passes, the delta of in-the-money options increases and the delta of out-of-the-money options decreases.
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EURO BANK NOTES
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What is Gamma? Gamma, measures the rate of change of Delta. When call options are deep out of the money, they generally have a small Delta. This is because changes in the underlying bring about only tiny changes in the price of the option. But as the call option gets closer to the money, resulting from a continued rise in the price of the underlying, the Delta gets larger. Gamma is the change in an option’s delta for unit change in the value of the underlying asset. The gamma of a long option position (both calls and puts) is always positive. At-the-money options have the largest gamma. The further an option goes "in-the-money" or, "out-of-the-money" the smaller is gamma. - If you are long gamma you expect the underlying to make large moves. Traders with long positions expect positive gamma
- If you are short gamma you expect the underlying to remain relatively inactive. Traders with short positions expect negative gamma
- Gamma is a useful indication of the risk associated with a futures position. A large gamma number, whether positive or negative indicates a high degree of risk and a low gamma number indicates a low degree of risk.
As time passes, the gamma of at-the-money options increases; the gamma of deep ‘in-the-money’ and deep out-of-the-money options decreases. What is Theta? Theta is defined as the change in the price of an option for a 1-day decrease in the time left for expiration. At-the-money options have the greatest time value and the greatest rate of time decay (theta). The further an option goes "in-the-money" or "out-of-the-money", the smaller is theta. As volatility falls, the time value declines and hence theta also declines. - Theta is the rate at which an option loses its value as each day passes.
- The inherent assumption is that the options are a "wasting asset."
- Long options have negative theta
- Short options have positive theta
As time passes, the theta of at-the-money options increases, the theta of deep in-the-money and out-of-the-money options decreases. Theta has the exact opposite characteristics of gamma. Thus the size of a gamma position correlates to the size of the theta position. A large positive gamma position goes in hand with a large negative theta position, while a large negative gamma position goes hand in hand with a large positive theta position. What this means is that every option position is a tradeoff between market movement and time decay. Theta is not used much by traders, but it is an important conceptual dimension. Theta measures the rate of decline of time-premium resulting from the passage of time. In other words, an option premium that is not intrinsic value will decline at an increasing rate as expiration nears.
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What is Vega? Vega is the change in the value of an option for a 1-percentage point increase in implied volatility of the underlying asset price. Implied volatility is measured as the annualized standard deviation of an asset’s daily price changes. The Vega of a long option position (both calls and puts) is always positive. At-the-money options have the greatest Vega. The further an option goes "in-the-money" or "out-of-the-money", the smaller is the Vega. As time passes, Vega decreases. Time amplifies the effect of volatility changes. As a result, Vega is greater for long-dated options than for short dated options. As volatility falls, Vega decreases for in-the-money and out-of-the-money options; Vega is unchanged for at-the-money options. - Vega is the option’s change in theoretical value with a change in volatility
- Most options have a positive Vega because they gain value with rising volatility and lose with falling volatility
- Vega of most options decline as time to expiration grows shorter
Vega tells us approximately how much an option price will increase or decrease given an increase or decrease in the level of implied volatility. Option sellers’ benefit from a fall in implied volatility, and it’s just the reverse for option buyers. Vega can increase or decrease even without price changes of the underlying because implied volatility is the level of expected volatility.
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JPY YEN
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Option Volatility Volatility can be a very important factor in deciding what kind of options to buy or sell. Volatility shows the investor the range that an assets’ price has fluctuated in a certain period. The official mathematical value of volatility is denoted as "the annualized standard deviation of a asset’s daily price changes." The historical volatility for an asset relates to a past period of time. Generally, when evaluating volatility, we look at several different periods. We may look at what the volatility has been for the past week, for the past month, for the past three months, for the past six months, and so forth. The longer time period will yield more of an average volatility. When evaluating the purchase of an option, it is the historical volatility of the underlying instrument that is generally evaluated. Since the options are based on futures contracts, by having price data for the underlying futures contract, one can calculate the historical volatility. The most commonly used model is the Black-Scholes, which is a part of most option pricing models today. By entering the futures price data, the model then calculates what the historical volatility is and can also then give you the fair market premium. In actual practice, usage of historical volatility in option pricing models such as Black-Scholes or other variations does not have predictive capability. Implied volatility is the calculated value of volatility that yields the option price in the relevant option-pricing model. The way to solve for this implied volatility is to use our option-pricing model in reverse. We know the price of the option and all the other variables except the volatility the marketplace is using. Therefore, instead of using the equation to solve for the option's price, we use the model to solve for the option's volatility. We insert the price into the model, leave out the volatility (which we are looking for), and keep the other variables the same. It is then that we will find out what volatility will yield the current market price. is the calculated value of volatility that yields the option price in the relevant option-pricing model. The way to solve for this implied volatility is to use our option-pricing model in reverse. We know the price of the option and all the other variables except the volatility the marketplace is using. Therefore, instead of using the equation to solve for the option's price, we use the model to solve for the option's volatility. We insert the price into the model, leave out the volatility (which we are looking for), and keep the other variables the same. It is then that we will find out what volatility will yield the current market price. Professional option traders find it important to be able to not only know what the current volatility is, but what it is likely to be in the future. Just as market analysts will project what prices we'll see in the next few days, weeks or months, so a professional options trader will try to determine what the volatility is likely to do in a variety of time periods. The more accurate a trader is able to make this forecast, the greater the likelihood that one can earn a profit. Forecast volatility is similar to projecting futures prices, in that one commonly looks back over the past to help determine what the future holds. And just like projecting the futures markets, projecting volatility is far from a pure science or purely mathematical. Ideally, what traders would like to know is what the future volatility is going to be. Professional option traders find it important to be able to not only know what the current volatility is, but what it is likely to be in the future. Just as market analysts will project what prices we'll see in the next few days, weeks or months, a professional options trader will try to determine what the volatility is likely to do in a variety of time periods. is similar to projecting futures prices, in that one commonly looks back over the past to help determine what the future holds. And just like projecting the futures markets, projecting volatility is far from a pure science or purely mathematical. Ideally, what traders would like to know is what the future volatility is going to be. Professional option traders find it important to be able to not only know what the current volatility is, but what it is likely to be in the future. Just as market analysts will project what prices we'll see in the next few days, weeks or months, a professional options trader will try to determine what the volatility is likely to do in a variety of time periods. The Future volatility is really more of an expression than a reality. The future volatility is simply what the volatility will be at a given point in the future as opposed to what it is forecast to be. Since we're dealing with a great deal of uncertainty and unknown anytime we project into the future, there can be no certainty to this classification. If a person actually knew without a doubt what the future volatility would be, it would be the equivalent of the person knowing exactly where the market would be on a given date in the future.
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