INVESTMENTS
OPTIONS & DERIVATIVES
WHAT'S OPTIONS ?
A financial instrument based on the value of underlying securities such as stocks, indices, and exchange traded funds (ETFs) is referred to as an option. An options contract gives the buyer the choice to purchase or sell the underlying asset,
depending on the kind of contract. Unlike futures, the holder is not obligated to acquire or sell the item if they choose not to.
Each options contract will have an expiration date by which the option holder must exercise their option. The striking price is the stated price of an option. Option contracts are often purchased and sold through online or retail brokers.
KEY KNOWLEDGE
Understanding Options
Options are flexible financial instruments. These contracts involve a buyer and a seller, with the buyer paying a premium for the contract's rights. Call options allow the holder to purchase an asset at a specified price and period. Put options,
on the other hand, allow the holder to sell the asset at a certain price within a predetermined time frame. Each call option has a bullish buyer and a bearish seller, whereas each put option has a bullish buyer and a bearish seller.
Traders and investors purchase and sell options for a variety of reasons. Options speculation enables a trader to retain a leveraged position in an asset at a lesser cost than purchasing the asset's shares. Investors utilise options to hedge
or lower their portfolio's risk exposure.
In some circumstances, the option holder can earn money by purchasing call options or becoming an options writer. Option contracts are also one of the simplest methods to invest in oil. The daily trading volume and open interest of an option
are the two crucial statistics to follow for options traders in order to make the best educated investing decisions.
Options and its types:
Calls
A call option grants the holder the right, but not the responsibility, to purchase the underlying securities at the strike price on or before the option's expiration date. As the underlying security's price rises, a call option becomes more
valuable (calls have a positive delta).
A long call can be used to bet on the underlying's price growing because it has infinite upside potential, but the maximum loss is the option's premium (price).
Puts
A put option, as contrast to a call option, offers the holder the right, but not the responsibility, to sell the underlying stock at the strike price on or before expiration. A long put is thus a short position in the underlying securities,
because the put increases in value as the underlying declines in price (they have a negative delta). Protective puts are a type of insurance that provides a price floor for investors to hedge their positions.
American vs. European Options
Between the date of purchase and the expiration date, American options can be exercised at any time. European options vary from American options in that they can only be exercised when they reach their expiration date.
The difference between American and European possibilities has little to do with location and everything to do with early exercise. Many stock index options are of the European variety. Because the ability to exercise early has some monetary
value, an American option is often worth more than an otherwise similar European option. This is due to the fact that early exercise is preferred and demands a price.
Special Considerations
Typically, an option contract represents 100 shares of the underlying securities. For each contract, the buyer pays a premium cost.
The expiration date is also a component in the premium pricing. The expiration date, like the date on the carton of milk in the refrigerator, specifies when the option contract must be exercised. The use-by date is determined by the underlying
asset. It is normally the third Friday of the contract month for stocks.
Options Risk Metrics: The Greeks
The word "Greeks" is used in the options market to represent the many aspects of risk associated in taking an options position, either in a specific option or a portfolio. These variables are referred to as Greeks since they are often connected
with Greek symbols.
Each risk variable is the outcome of a flawed assumption or connection between the option and another underlying variable. Different Greek values are used by traders to gauge options risk and manage option portfolios.
Delta
Delta is the rate of change between the option's price and a $1 change in the price of the underlying asset. In other words, the option's price sensitivity to the underlying. The delta of a call option is between zero and one, whereas the
delta of a put option is between zero and negative one.
The current likelihood that an option will expire in-the-money is a less common application of its delta. For example, a 0.40 delta call option today has a 40% chance of ending in the money.
Gamma
Gamma is the rate of change between the delta of an option and the price of the underlying asset. Second-order (second-derivative) price sensitivity is what it is. Gamma represents how much the delta would vary if the underlying security moved
by $1.
Gamma values often decrease as one gets closer to the expiry date. This indicates that longer-term options are less susceptible to delta fluctuations. Gamma values often increase as expiry approaches, as price swings have a greater influence
on gamma.
Options traders may choose to hedge not just delta but also gamma in order to be delta-gamma neutral, which means that the delta will remain close to zero while the underlying price fluctuates.
Vega
The rate of change between an option's value and the implied volatility of the underlying asset is represented by Vega (V). This is the volatility sensitivity of the option. Vega is the amount an option's price changes in response to a 1%
change in implied volatility.
Those familiar with the Greek language will point out that there is no actual Greek letter named vega. There are various theories about how this symbol, which resembles the Greek letter nu, found its way into stock-trading lingo.
Rho
The rate of change between the value of an option and a 1% change in the interest rate is represented by Rho (p). This metric evaluates interest rate sensitivity. Assume a call option with a rho of 0.05 and a price of $1.25. If interest rates
climb by 1%, the call option's value rises to $1.30, all else being equal. Put options are the inverse of call options. Rho works best for at-the-money options with extended expiry dates.
Advantages and Disadvantages of Options
Buying Call Options
As previously stated, call options allow the holder to purchase an underlying security at the given strike price by the expiry date. If the holder does not choose to acquire the asset, they are under no duty to do so. The buyer's risk is limited
to the premium paid. The underlying stock's fluctuations have no bearing.
Buyers expect a stock's share price will climb over the strike price before the option expires. If the investor's optimistic forecast comes true and the price rises over the strike price, the investor may exercise the option, buy the shares at the strike
price, and immediately sell the stock for a profit at the current market price.
The market share price less the strike share price plus the option expense—the premium and any brokerage cost to execute the orders—is their profit on this trade. The result is multiplied by the number of option contracts acquired, then by
100 (assuming each contract represents 100 shares).
The option expires worthless if the underlying stock price does not rise above the strike price by the expiration date. The holder is not compelled to acquire the shares, but the premium paid for the call is forfeited.
Selling Call Options
Writing a contract is the process of selling call options. The premium money is paid to the writer. In other words, a buyer pays the premium to the option writer (or seller). The premium obtained while selling the option is the maximum profit.
A pessimistic investor who sells a call option anticipates the underlying stock's price will decline or remain reasonably close to the option's strike price over the option's term.
If the current market share price is at or below the strike price by expiry, the call buyer's option expires worthless. The premium is pocketed by the option seller as profit. The option is not exercised because the buyer would not purchase
the shares at the strike price that is greater than or equal to the current market price.
As you can see, the risk exposure of call writers is significantly bigger than that of call purchasers. Only the premium is lost by the call buyer. The writer faces an unlimited risk because the stock price might continue to grow, considerably
increasing losses.
Buying Put Options
Put options are investments in which the buyer expects the underlying stock's market price to fall below the strike price on or before the option's expiration date. Again, the holder has the option to sell shares without being obligated to
do so at the indicated strike per share price by the stated date.
Because put option purchasers desire the stock price to fall, the put option is lucrative when the underlying stock's price is lower than the strike price. The investor can execute the put if the current market price is less than the strike price at expiry.
They will sell shares at the higher strike price of the option. If they want to replace their holdings of these shares, they can do so on the open market.
The profit on this trade is equal to the strike price minus the current market price, plus expenditures (the premium and any brokerage charge for placing the orders). The result would be multiplied by the number of option contracts acquired,
then by 100 (assuming each contract represented 100 shares).
The value of a put option increases as the underlying stock price falls. The value of the put option, on the other hand, decreases when the stock price rises. When purchasing put options, the risk is limited to the loss of the premium if the option expires
worthless.
Selling Put Options
Selling put options is also known as contract writing. A put option writer expects the underlying company's price will remain stable or rise over the option's term, making them bullish on the stock. On expiry, the option buyer has the power
to force the seller to purchase shares of the underlying asset at the strike price.
The put option expires worthless if the underlying stock's price closes above the strike price by the expiration date. The premium is the writer's maximum profit. Because the option buyer would not sell the shares at the lower strike share
price when the market price is higher, the option is not exercised.
How Do Options Work?
Options are a sort of derivative instrument that allows investors to bet on or hedge against an underlying stock's volatility. Options are classified as call options, which enable buyers to benefit if the stock price rises, and put options,
which allow buyers to profit if the stock price falls. Investors can also sell options to other investors to go short. Shorting (or selling) a call option means benefiting if the underlying stock falls in value, whereas selling a put option
means profiting if the stock rises in value.
What Are the Main Disadvantages of Options?
The biggest downside of options contracts is their complexity and difficulty in pricing. As a result, options are regarded as a security best suited to experienced professional investors. They have grown in popularity among ordinary investors
in recent years. Because of the potential for exorbitant gains or losses, investors should ensure that they completely grasp the ramifications before getting into any options positions. Failure to do so can result in catastrophic losses.
How Do Options Differ From Futures?
Options and futures are both derivatives transactions based on an underlying asset or security. The major distinction is that options contracts provide the right to purchase or sell the underlying in the future but not the obligation to do
so. This responsibility exists in futures contracts.
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