In ancient Greece, Thales from Miletus (600 BC) is considered the first who made this kind of risk mitigation, and Wikipedia describes the story as…
The first reputed option buyer was the ancient Greek mathematician and philosopher Thales of Miletus. On a certain occasion, it was predicted that the season’s olive harvest would be larger than usual, and during the off-season, he acquired the right to use a number of olive presses the following spring. When spring came and the olive harvest was larger than expected he exercised his options and then rented the presses out at a much higher price than he paid for his ‘option’.
Before 1848, option contracts were traded outside an exchange. That year this whole market changed because the Chicago board of trade (CBOT) was established. The market, as we know it today, came to be in the 70s with the standardization of the product, price, and the offering on the put options. In 2005 the first weekly options were created.
Investopedia describes option contracts as…
An options contract is an agreement between two parties to facilitate a potential transaction on the underlying security at a preset price, referred to as the strike price, prior to the expiration date.
That simply means that we lock, with a contract between two parties, the today’s price of a financial product by paying a premium, in order for us to be able to have “the option” to buy it in the future, before its expiration date, at the present/locked price.
Options as securities are categorized as derivatives. Derivatives derive from another financial asset, which is called the ‘underlying asset’. There are many kinds of option contracts. There are the stock options, that are options contracts that derive from stocks, forex options, etc. Since a stock option derives from a stock, its price is intrinsically linked to it.
Since an options contract is an agreement between two parties, an options contract has an expiration date. Quarterly options expire on the last day of the quarterly month (January, March, June, September). Monthly options, which are the most liquid, expire every third Friday of each month. Weekly options expire on the Friday of each week. Every platform will have a ‘days before expiration’ section.
As we saw above, options contracts are used by traders to hedge their portfolio/trades. Another use is to generate additional income on an investment portfolio. In that case, the investor can earn dividends on his stock portfolio, plus earn additional income through option premiums. Finally, an investor can use options to buy the underlying asset at a discount. For speculators, options are a way to leverage their positions since 1 option contract controls 100 stocks.
A great example of options usage comes from the legendary investor Warren Buffet. He used options to buy a big chunk, if not all, of his portfolio. Let us take an example here, let’s assume that a single coca-cola stock costs $100. Warren Buffet wants to buy coca-cola stocks, either way, so he goes and sells put options at $90. He collects the option premium. If coca-cola stocks go down to $90, the price that he always wanted to buy on, then he is obligated, by his option sell, to buy the stock. In the process, he earned premiums which also reduce the cost of the stock.
All the above terminology will be explained further below.
A call stock option gives the owner the right to buy a stock (go long) and a put stock option gives the owner the right to sell a stock (go short). From the seller’s perspective, selling a call stock option gives him the obligation to go long on the stock, and selling a put stock gives him the obligation to go short on this particular stock. Since an options contract has a limited and predetermined lifetime, the above right is just for this timeframe.
With this in mind, we can use these choices to do four different kinds of trades with options.
- We can buy a call — We have the right to go long at the strike price.
- We can sell a call —We have the obligation to go long at the strike price.
- We can buy a put — We have the right to go short at the strike price.
- We can sell a put — We have the obligation to go short at the strike price.
As we can see above, the seller has the obligation to take action if the buyer makes use of his right on his contract, and the buyers have the right, or the choice, to make use of his contract.
A general rule of thumb is that, when the underlying asset gains value, the put options losing value, and the call options gain value. On the contrary, when the underlying asset loses value, the put options gain value, and the call options losing value. Of course, option valuation is a completely different and complicated subject.
When we trade an option a sentence like this will appear.
ACM AUGUST 29 PUT @ (AT) $10
This basically means that we trade the stock with the symbol ACM, with expiration date August (or AUG19 — August 2019 for example), on strike price 29, that is a put option, and finally, that has a $10 premium (as a seller we receive, $10 as a buyer we pay $10).
In this particular example, and since an options contract is a ‘packet’ of 100 stocks, a speculator would spend ($10 x 100) $1.000 in total.
Any option contract is been traded through the option chain.
This is a screenshot from AAPL’s option chain on the TWS platform, by Interactive Brokers.
The whole table consists of the ‘CALLS’, the ‘STRIKE’, and the ‘PUTS’ sections. The columns inside those sections is subject to the user’s preferences and can be changed at any time. The most commonly used columns are:
Investopedia gives us this definition of the strike price as follows…
A strike price is the price at which a derivative contract can be bought or sold (exercised). The term is mostly used to describe stock and index options. For call options, the strike price is where the security can be bought by the option buyer up till the expiration date. For put options, the strike price is the price at which the security can be sold by the option buyer up till the expiration date.
Bid and Ask
Investopedia describes the bid and ask terms as…
The bid price represents the maximum price that a buyer is willing to pay for a security. The ask price represents the minimum price that a seller is willing to receive.
If at the calls section, we click at the ask price then we sell a call option. If we click on the bid price then we buy a call option. The same is true for the puts section.
The difference between the bid and ask price is called the spread. Generally speaking the smaller the spread the bigger the liquidity of an option contract.
At the Money, In the Money and Out of the Money
In the ‘calls’ section of an option chain, the option contract that has a strike price equal, or at the closest, with the current price of the underlying asset is ‘at the money’. The option contracts that have a strike price lesser than the price of the underlying asset are inside the ‘in the money’ section and the ones with a price greater than the price of the underlying asset are in the ‘out of the money’ section.
In the ‘puts’ section, the opposite is true. When the option’s strike price is equal, or at the closest, with the price of the underlying asset, the option contract is ‘at the money’ when it’s lesser, they are ‘out of the money,’ and when it’s greater, they are ‘in the money.’
Volume and Open Interest
The trading volume in an option chain gives us an indication of the most favorable contract throughout the speculators and investors, as it would in a plain stock, and it shows the number of contracts traded in a given period. Investopedia writes..
Trading volume is the number of shares or contracts traded in a given period. When looking at the option’s underlying stock, that volume can give you insight into the strength of the current price movement. Trading volume in options, just like in stocks, is an indicator of current interest. However, trading volume is relative. It needs to be compared to the average daily volume of the underlying stock. A significant change in price accompanied by higher-than-normal volume is a solid indication of market sentiment in the direction of the change. But, a big increase in price accompanied by low trading volume does not necessarily signify strength. In fact, that combination may well indicate that a price reversal is coming soon.
The open interest column shows us the total number of option contracts that are open and currently active. It changes before the next day starts and adjusts itself once the trades are totaled.
It is much time overlooked, but when we combine this indicator with volume, bid and ask prices, as well as the implied volatility, we can predict many unforeseen consequences.
Unlike historical volatility, implied volatility shows us how big of a move the price will make, upward or downward, in the future. If, for example, implied volatility is 4, then the market participators believe that the price will go either +4 or -4 in the future.
Investopedia describes it as follows…
… Implied volatility is the market’s forecast of a likely movement in a security’s price. It is a metric used by investors to estimate future fluctuations (volatility) of a security’s price based on certain predictive factors. Implied volatility, denoted by the symbol σ (sigma), can often be thought to be a proxy of market risk. It is commonly expressed using percentages and standard deviations over a specified time horizon. Implied volatility does not predict the direction in which the price change will proceed. For example, high volatility means a large price swing, but the price could swing upward — very high — downward — very low — or fluctuate between the two directions. Low volatility means that the price likely won’t make broad, unpredictable changes.
The big takeaways from here are that the higher IV in an option, the stronger the sentiment of the market for future price fluctuations, and the pricier the option contracts. Increased volatility generally increases in bearish markets and decreases in bullish markets.
The greeks are indicators that constantly change and they show us the sensitivity of an option contract on changes in price, time, and volatility. They are called greek because they are represented with letters from the Greek alphabet. We use greeks to check the possible profitability of a trade we are about to take. Greeks are also heavily used in portfolio management.
(Δ) Delta — Stock Price Effect on Option Price (Price Risk)
Delta represents the rate of change of the option price for every $1 movement in the underline asset. A call option can take delta values between 0 and 1, and a put option has a range between 0 and -1. If the price of an underline asset to a call option moves up $1, and the delta is 0,80, then the price of the option will also increase by 80 cents. In other words, an option with delta of 0.5 men that the option has a 50% chance of ending in-the-money and a 50% chance that will end up out-of-the-money. Note that, the delta values in the put side are just the opposite on the call side. Delta is usually the main risk in selling options.
(Γ) Gamma — Change in Delta
Delta measures the rate of change between the delta of an option and the price of an underline asset. Delta is the second derivative of the price sensitivity and the first derivative of delta. When gamma has a value of 0.50, that means for every $1 movement in the price of an underline asset, the delta will also make a 50% move. In other words, we can think of gamma as the acceleration of the speed of delta. Unlike delta, gamma has always a positive value. Gamma increases exponentially the closer to expiration.
(Θ) Theta — Time Decay (TIme Risk)
Theta indicates the time decay of an option, also known as “time sensitivity”. As time passes, the price of an option will decay according to a rate indicated by theta per day. The greater the theta, the lower the gamma. Theta also increases as the option moves towards its expiration date. Theta is a negative number that is increased on higher volatility, and move towards zero as the volatility decreases.
Theta works against option buyers and in favour of option sellers. More on that on “The four fundamental single-legged option trades and their risk profile”.
(v) Vega — Volatility Affect (Volatility Risk)
Vega shows the sensitivity of the option price as a result of changes in the implied volatility of the option. It indicates the change in the option price gives a 1% change in the implied volatility. Is one of the most important greeks but also one of the most underrated. Vega has a greater value the further out of the expiration date, because the more time an options contract has left, the more susceptible is to implied volatility fluctuations. More expensive options have greater vega.
A detail that we should remember is that we need to buy options when volatility is low, and sell options when volatility is high.
Minor Greeks — (Good to know but not in general use)
In the following section, I will post the definition of each Greek taken from Investopedia — (https://www.investopedia.com/terms/g/greeks.asp)
(Ρ) Rho — Interest Rate
Rho (p) represents the rate of change between an option’s value and a 1% change in the interest rate. This measures sensitivity to the interest rate. For example, assume a call option has a rho of 0.05 and a price of $1.25. If interest rates rise by 1%, the value of the call option would increase to $1.30, all else being equal. The opposite is true for put options. Rho is greatest for at-the-money options with long times until expiration.
(Λ) lambda, (Ε) epsilon, vomma, vera, speed, zomma, color, and ultima.
These Greeks are second- or third-derivatives of the pricing model and affect things such as the change in delta with a change in volatility and so on. They are increasingly used in options trading strategies as computer software can quickly compute and account for these complex and sometimes esoteric risk factors.
1 Option Contract on a US Stock/ETF/or index = 100 Stocks
1 Option Contract on a UK Stock = 1.000 Stocks
1 Option Contract on Crude Oil = 1.000 Barrels
1 Option Contract on Natural Gas = 10.000 MMBTU
1 Option Contract on Gold = 100 Ounces of Gold
1 Option Contract on S&P500 Futures = 50 Futures
1 Option Contract on Euro (EUR) = 125.000 EUR
1 Option Contract on Australian Dollar (AUD) = 100.000 AUD
1 Option Contract on Great Britain Pound (GBP) = 62.500 GBP
1 Option Contract on United States Dollar (USD) = 1.000 USD
First of all, as we saw, we can categorize an option contract into put or call.
Another categorization we could do is according to the underlying asset. There are equity options (also known as stock options), bond options, options on futures, index options and ETF options, commodity options, and forex or currency options.
Next, there are various options styles. There are the American options contracts that can be exercised at any point and there are the European options contracts that can be exercised only on expiry. The American and European options are also known as vanilla options.
There are also some less traded options contracts. The Bermudan options can only be exercised on specified dates. An Asian option is an options contract whose payoff is determined by the average underlying price over some preset time period. The Barrier options contract needs the underlying asset’s price to surpass a certain ‘barrier’ at its price to be exercised. Inside the exotic options contracts are all other more complex and more specific options contracts.
The binary options are as Wikipedia writes..
An all-or-nothing option that pays the full amount if the underlying security meets the defined condition on expiration otherwise it expires.
- American Stock Exchange (AMEX)
- Chicago Board of Trade (CBOT)
- Boston Options Exchange (BOX)
- Chicago Mercantile Exchange (CME)
- Boston Options Exchange (BOX)
- Chicago Board Options Exchange (CBOE)
- International Stock Exchange (ISE)
- New York Stock Exchange (NYSE/ARCA)
- Pacific Stock Exchange (PSE)
- Montreal Stock Exchange (MSE)
- Eurex Exchange