Trading Options

Introduction to Option

An option is a financial derivative instrument that represent a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right (not the obligation) to buy (CALL) or to sell (PUT) a security (underlying stock) or other assets at an agreed price (Strike Price) for a certain period of time.

Strike Price

Strike Price is the agreed upon price which the assets can be purchased or has to be sold. It is like striking a deal, a promise that the deal can be transacted at the agreed-upon price.

Option Example

Watch a video explaination here -> https://www.youtube.com/watch?v=EfmTWu2yn5Q

A buyer wanted to buy a house as an investment. He visited a house which has an attractive price of $300K, and has the intention to buy. However, there are rumours that the neighbour will have development work which can make his investment worthless. He is not able to confirm the purchase immediately. He is worried that if he buy the house now, it may become worthless in weeks to come.

The buyer has a stronger interest to buy, but at the same time, he is worried about the future influence. Wanting to strike a deal, the house seller offer the buyer with a contract (option) to have the option to buy the house at the agreed price of $300K (strike price) before a specific date (expiry date). For this special privilege (option), the buyer has to pay $5K (premium) to the seller. The buyer is willing to pay for the premium because the seller is willing to hold the deal price (strike) for a period of time. The seller writes the contract (option writer) and sell it to the buyer (option holder). With this contract the buyer has the right to buy the house, and the seller is obligated to sell the house with a limited time period.

An option can be seen as a means of buying an insurance of $5K, just to have the option of buying the asset at a later date before the contract expires. If the assets really turns out to be bad, the buyer can choose not to exercise his right to purchase the asset. As a result, his lost will be the $5K premium that he paid. If after some time, the asset looks fine or has rise in value, the buyer can choose to excise his right to buy over the house at the strike price of $300K before the option expires.

The seller will get the $5K premium for accepting the contract. If the buyer decides not to buy the house, the seller will still keep that $5K in his pocket. If the buyer decides to buy the house from the seller at $100K, the overall value that the seller gets is actually $305K.

The buyer’s loses will be limited. If the house is worth much much less a few weeks later, the maximum lose the buyer incurred will be the $5K premium that he has paid for. The seller’s risk is also reduced, because although the house is worth lesser, but the premium income that he had collected helps him to cover his loses.

The example above is known as a CALL option. CALL options gives buyer the right to buy an asset at the agreed strike price. The seller has the obligation to sell the asset.

The value of an Option Contract will lose its value over time

An option contract helps to retain (freeze) the value of the asset for the buyer as well as the seller. However the price of the option which is honouring the retained value of the asset gets lower and lower every day.

The value of the option contract which is the premium will lose its value over time. If an option contract’s premium is worth $5K for a period of 3 months, its worth maybe only $1K after a period of 2 months, leaving only 1 month time before the contract expire. This is assuming that the price of the asset remains at $300K. This is because the contract period is shorter, and less people are willing to pay more for the reduce in privilege.

The value of an Option Contract can increase

The value of the option can increase if the market price of the underlying asset increases. For example, if the neighbour houses suddenly increases by about 50% a few weeks later, this will result in a valuation of the house from the original $300K to a new valuation of $450K. The option contract with a premium of $5K having already strike the deal at $300K now looks attractive. Those who wants to buy the house now is will to buy over the option contract at a higher value than the paid premium because it allows them to own the same asset at a lower price than the current market valuation price.

The buyer (option holder) who owns this option contract can easily sell it off at $100K and still there will be people willing to buy it.

As the price of the underlying increases, so will the value of the option that you are holding on hand.

The value of an Option Contract can decrease

On the other hand if the market price of the underlying asset decreases, so will the option contract. No one will want to buy your option contract when the actual house on the market is cheaper than the strike price stated on the contract.

In order to attractive people willingness to take over the contract, the option contract can be sold at a lower price. For example, the premium was $5K at a strike price of $300K. After a few days the valuation of the house drop by $3K, to $297K. In order for option contract to look as attractive as before, the premium has to be lowered to $2K.

As the price of the underlying decreases, so will the value of the option that you are holding on hand.

CALL and PUT

A CALL option gives the buyer the rights to purchase the underlying stock at the contract’s strike price by its expiration date.

A PUT option on the other hand gives the buyer the rights to sell the underlying stock at the contract’s strike price by its expiration date. The buyer can push (or put) the underlying asset to the seller.

Premium

Premium is the price you are paying to buy the option. A premium of $1 means that you are paying $1 for a share. An option contract consist of 100 shares, meaning that each contract the premium is $100.

Premium price can be analysis down into two components, the intrinsic value and the time value.

Premium = Intrinsic value + Time value (volatility+days to expiry)

Intrinsic value is the gain in value when your option is in-the-money. If the option is at-the-money or out-of-the-money, the intrinsic value is $0.

The time value (also known as extrinsic value) is the value of the option from the time now to its expiration date. This time value will decreases over time and is influence by a number of factors. The factors are, volatility, the number of days left to expiration.

Intrinsic value = ITM(Stock Price – Strike Price)

ITM is in the money.

Premium general increase if the option has intrinsic value (into-the-money) and decreases as it is out-of-the-money.

Profit and Loss Diagram

Also known as Payoff Diagram, or Risk Graph. These graph shows what the profit/loss are like at expiration time.

Buy Stock

  • Buying a stock price at $50.
  • Break even at $50.
  • Maximum loss is $50
  • Maximum gain is $infinity.

Option Value

  • Call option at strike price $50.
  • Call option value below strike price is $0.
  • Call option value above strike price = stock price – strike price.

Buy Call (for Low Volatility Bull), Option price goes UP

  • Buying call option at a strike price of $50.
  • Premium paid $10.
  • Break even at $60.
  • Maximum loss is $10 (premium).
  • Maximum gain is $infinity.

 

 

Buying call option is safer as it has a flat limited loss. The same goes to the buying of a put option which is a mirror image of a buy call.

Buying option has a flat limited loss. Suitable for low volatility underlying price.

The bend corner is the strike price. The point line where it cross the $0 profit line is the breakeven point.

The loss is limited to the premium paid. This is also the same for a buy put option.

 

Sell Call (for High Volatility Bear), Option price goes DOWN

  • Selling call option at a strike price of $50.
  • Premium received $10.
  • Break even at $60.
  • Maximum loss is $infinity.
  • Maximum gain is $10 (premium).

 

 

Selling call option has the opposite risk compare to buying a call option. It has a mirror image along the profit/lost line.

Option favours the seller. There is a decay time component. The value of the option will go down even when the underlying stock price remains the same.

Sell strategy is better to apply when the underlying volatility is high.

Buy Put (for Low Volatility Bear), Option price goes UP

  • Buying put option at a strike price of $50.
  • Premium paid $10.
  • Break even at $40.
  • Maximum loss is $10 (premium).
  • Maximum gain is $40 (strike price – premium).

 

 

Sell Put (for High Volatility Bull), Option price goes DOWN

  • Selling put option at a strike price of $50.
  • Premium received $10.
  • Break even at $40.
  • Maximum loss is $40 (strike price – premium).
  • Maximum gain is $10 (premium).

 

 

The high volatility of the increasing underlying stock price, is an easier opportunity to sell a put option, and there is a less chance for the put option to be exercise.

pictures taken from the following website, https://www2.poems.in.th/home/derivatives/en/options04.htm

Factors affecting Option price

  • Underlying price (intrinsic value)
  • Strike price (intrinsic value)
  • Time until expiration (probability of a profitable move)
  • Volatility (probability of a profitable move)
  • Dividends (share price adjustment)
  • Interest rates (cost of money)

Rewrite this section

Assuming a call option, all parameter remains, except…

Underlying price increase -> option price increase.

Strike price increase -> option price decrease.

Volatility increase -> option price increase.

Interest rate rise -> option price increase.

Dividends issued -> option price decrease.

Options Expiration Cycle

(Best explanation on weekly, monthly quarterly) http://www.optionsuniversity.com/blog/options-universitys-options-101-part-38/

http://www.investopedia.com/articles/optioninvestor/03/090303.asp

http://www.investopedia.com/terms/o/optioncycle.asp

Explain on 5 Greeks (Delta, Gamma, Vega, Theta, Rho)

Greeks are a set of indicators (computed base on current market situation) which helps reflect the current market rate of the options’ premium.

Good and simple explanation on greeks. http://www.optionsplaybook.com/options-introduction/option-greeks/

  • Delta- (premium price with relation to the stock price) an indication of the probability of an Option to be ITM at expiration. Delta is about 0.5 when option is ATM. Approaching 1.0 when it is ITM, and approaching 0.0 when OTM. Delta 1.0 is an ideal case where the options rise a dollar to dollar with the stock price (pure intrinsic value).
  • Gamma- (premium price with relation to the delta) an indication of the number of strike that the options which is in ATM will take, to approach ITM a delta of 1.0.
    Gamma risk increases a lot when less than 10 days to expiration (options’ price fluctuate a lot). It is good to take the position off two weeks from expiration.
    delta_gamma
  • Vega- (*most important greek. premium price with relation to the volatility of the stock) high implied volatility (projected volatility) increase the premium price.
  • Theta- (premium price with relative to the expiration date) premium price decrease as it gets nearer and nearer to the options’ expiration date.

The chance of getting assignment increase with gamma

Type of Options (Weekly, Quarterly)

http://www.investopedia.com/articles/active-trading/040814/give-yourself-more-options-weekly-and-quarterly-options.asp

Weekly options simply means the expiry date falls on a Friday.

Quarterly options simply means the expiry date falls on the last day of a quarter (example last day of Mar, Jun, Sep, Dec).

Monthly (Regular) options simply means the expiry date falls on the 3rd Friday of the month.

2016-08-19 Options Perspective

Selling or Buying options.

Always Sell options at a high premium price.

Always Buy options at a low premium price.

Premium is high when options is ITM. As a seller, we want to sell as high as possible but we should not aim to sell an ITM options because the chance of it expiring ITM is high (delta > 0.5).

Premium is high when volatility is high. We would want to sell options when volatility is high. For example, selling options just before the earnings announcement, or when there are uncertainty in the market.

Premium is high when the time to expiry is long. But if the time to expiration is too long, there is a higher chance that the options will be ITM at expiration. Selling an options about 30-45 days to expiration will be just nice.

Premium may become high when Gamma is high. The slight change in the underlying stock price can move the options premium price a lot. Gamma becomes high when options is ATM and near expiration day. Don’t hold the short options when it is at ATM near the expiration. It is good to close the shorted position about a week before expiration. Low gamma is good for seller.

Premium is low when options is OTM. As a buyer, we want to buy as low as possible but we should not aim to buy an options too far OTM (delta < 0.1 or 0.0), because the chance of the options going into the ITM will be slim.

Premium is low when the implied volatility is low. As a buyer we want to buy as low as possible. For example, after earnings announce or the market expectation is known (stable).

Premium is low when the options is near its expiration day. We do not want to buy it too near expiration as the time decay is large. The probability of it going into the money is low.

2016-08-23 Options Volatility

Volatility is the most important factor (no.1) we need to pay attention to when dealing with options.
When volatility is at its low, we don’t short options, when volatility is at its high, we don’t long options.

However can use Vertical Spread strategy which tends to cancel away the effect of volatility.

Options Trading MCQ Questions

http://wps.prenhall.com/ema_uk_he_levy_fundinvest_1/6/1721/440738.cw/index.html

Question – > “You trade in the direction of volatility first and foremost.

Time value ->

In-The-Money

At-The-Money

Out-Of-The-Money

Get assigned

Put

Delta

Gamma

Theta

Vega

Rho

Call Spread

Vertical Spread

Time Spread

Butterfly

Get assigned

writer