Options are financial instruments referred to as derivatives trading the value of underlying security such as a stock. An option gives the holder the right but not the obligation to exercise the option depending on the type of contract they hold.
There are two types of options calls and puts.
Call options give the holder the right but not the obligation to buy the underlying asset at a specific price within a specific period of time.
Put options give the holder the right but not the obligation to sell the underlying asset at a specific price within a specific period of time.
The options need to be exercised on or before the date of expiration, if the holder chooses to do so. The specified price on an option is called the strike price and is usually bought or sold through online or retail brokers.
Firstly, you need to understand that an option contract always involves a buyer and a seller in order to form one contract. Someone needs to be there and buy the option when the other participant is selling in order for the transaction to be completed and vice versa.
The holder of the contract pays an option’s premium in exchange for the rights granted by the contract. Call options have a bullish buyer and a bearish seller whereas put options have a bearish buyer and bullish seller.
Options contracts consist of 100 shares of the underlying asset and the buyer pays the premium fee according to the number of contracts he purchases/hold. For example, if an option has a premium fee of $1 per contract, buying one option will cost $100 ( $1 x 100 ).
The expiration date indicates the day the option contract must be used however the underlying asset will determine the use-by date. For stocks, it is mostly the third Friday of the contract’s month.
Options can be used for several reason, such as arbitrage, speculation and hedge.
Arbitrage opportunities have decreased with the advent of automated trading strategies. However, an arbitrage opportunity is when a trader performs “conversions” when an option is overpriced by purchasing stock and selling the equivalent options position. In this scenario, they short a call option, long a put option and long the underlying asset. This results in a delta-neutral portfolio. On the other hand, when options are underpriced traders will do “reversals”. In this scenario, you long a call option, short a put option and short the underlying asset resulting again in a delta neutral portfolio.
Delta (Δ) represents the rate of change between the option’s price and a $1 change in the underlying asset’s price. This can also be described as the price sensitivity of the option relative to the underlying. Delta of a call option has a range between zero and one while a put option has a range between zero and a negative one.
For instance, an investor is long on a call option with a delta of 0.80, therefore, if the underlying stock increases by $1 the option’s price would theoretically increase by 80 cents.
Delta is also used for hedging purposes that are explained below.
Investors will use options to minimize their risk exposure and hedge their portfolio. Assume you hold 1000 shares of NIO that are currently trading at $30 giving you a total exposure of $30,000. You believe that something will happen, and the stock will drop so you decide to buy a put option on NIO. The strike price is $27 which means that NIO shares have to fall below $27 before the option is in profit. To open your position, you will pay a premium fee of $30 and a commission of $10.
You were right and NIO stock fell to $25 your shares would have made you a loss of $5,000. However, your put option could be exercised and make you a profit of $2,000 (27-25 x 1000) giving you a profit of $1,660 (Including fees u paid).
Speculation by definition is when a trader takes a position in the market, betting if the price of a security will increase or decrease. Options provide leverage since they can be cheaper than the actual stock. This gives the trader a larger position in options compared with owning the underlying asset. For example, a trader has $2,000 to invest in Apple and each stock costs $50. The call option has a strike price of $70 and expires in one month, the cost of a contract is $0.20. The premium is $2 (0.20 x 100) per contract since each contract has 100 shares of stock.
In a scenario when the trader buys only the underlying stock, he would have 40 shares ($2,000/ $50) whereas if he chooses to hold only options, he would control 1,000 shares ($2,000/$2). Let’s say that the stock has dropped $1 to $49, in the case when the trader holds the underlying stock, he would end up with a loss of $40 or a position worth $1960. However, In the options scenario, the total value would be zero at expiration since the options would expire worthless because nobody would agree to buy shares at a price that is greater than the current market value.
In the opposite scenario when the trader is speculating that the price of an asset will go down, he can hold a put option.
Read more option-related terms such as Open Interest!!!