What are options?
An Option is a financial
derivative instrument which gives the right but not the obligation to the
option holder to either sell or buy an underlying Stock at a per-specified date
i.e. expiry date and at a per-specific price or the strike price.
Options are exactly as their name suggests that they provide the purchaser with
an option to buy or sell an underlying financial Stock. Options are wonderful
tools that can provide both the Buyer of the option and the Seller of the
option with the ability to protect or hedge current stock positions and reduce
their market risk. It will give an additional income to option traders.
Options
can be issued over a range of financial securities, including stocks, indices
and foreign currency. In order to simplify the discussion, for the most part we
will refer to options issued over stocks. However, the same concepts generally
apply to options issued over other underlying financial Securities. An option
is defined by a contract between the seller of the option and the buyer of the
option. The contract gives the buyer of the option the right (or option) to buy
or sell a set amount of stock at a specific price on or before an Expiry date.
The buyer pays the seller a premium in order to acquire this right .When an
option buyer exercises their option, they are taking action to buy or sell the stock
as specified in the option contract.
It is
important to note that the buyer of an option pays a premium to have the choice
to exercise their right to buy or sell a stock. They are not obligated to
exercise this right. Thus, in purchasing an option they have purchased the option
to buy or sell the underlying stock.
Option is one of the most versatile trading methods. There
are various option strategies exist to provide to traders with different risk,
type of personalities and amount of capital or time available. Many new Stock option
traders are being attracted to buying option. However sell the option is also a
good trading method.
To have better profit trades, should we buy or sell options?
The quick answer is that sometime there are advantages to buy options and
sometime selling options has its benefit. Which option strategies will be applied
is depend on your goals, your view on the underlying stocks and general market.
Ideally, we should develop strategies for both buying and selling of the options.
Learning the basics of options
involves three steps:
1. Understand the rights and obligations of long and short options.
2. Learn to calculate profit and loss at expiration.
3. Master the mechanics of
exercise and assignment
Before entering into an option trading we have to looking for
the underlying stock that we are going to invest our money. And we need to
identify whether the underlying stock is bullish, bearish or sideway move. As
you know option has a fixed expiration date, you will also need to know when
that move is possibly going to happen and how far the underlying stock might
move. Therefore the option trading strategies based on our judgement on the
underlying stock’s direction, timing of movement and how volatile the movement for
the underlying stock.
Let’s look at the various options strategies that can be
applied to the general market direction
Bullish Strategies:
4. Bull Call Spread
5. Bull Put Spread
Bearish Strategies
1. Long Put
2. Short (Naked) Call
3. Covered Put
4. Bear Put Spread
5. Bear Call Spread
Volatility Strategies
1. Long Straddle
2. Long Strangle
3. Short Call Butterfly
4. Short Call Condor
5. Short Iron Butterfly
6. Short Iron Condor
Sideway Strategies
1. Short Straddle
2. Short Strangle
3. Long Call Butterfly
4. Long Call Condor
5. Long Iron Butterfly
6. Long Iron Condor
TERMS AND DEFINITIONS:
Call Option:
An option contract that gives the holder the right to
buy the underlying security at a specified price for a certain, fixed period of
time.
Put Option:
An option contract that gives the holder the right to
sell the underlying security at a specified price for a certain, fixed period
of time.
Break-Even Point (BEP):
The stock price at which an
option strategy results in neither a profit nor loss.
In-the-money:
A call option is in-the-money if the strike
price is less than the market price of the underlying security. A put option is
in-the-money if the strike price is greater than the market
price of the underlying security.
Long position:
A position wherein an investor is a net
holder in a particular options series.
Out-of-the-money: A call option is out-of-the-money if the
strike price is greater than the market price of the underlying security. A put
option is out-of-the-money if the strike price is less than the market price of
the underlying security.
Premium:
The price a put or call buyer must pay to a put or
call seller (writer) for an option contract. Market supply and demand forces
determine the premium.
Short position:
A position wherein the investor is a seller(Writer) of a particular options series.
Strike price or exercise price: The stated price per share
for which the underlying security may be purchased (in the case of a call) or
sold (in the case of a put) by the option holder upon exercise of the
option contract.
Synthetic position:
A strategy involving two or more
instruments that has the same risk/reward profile as a strategy involving only one
instrument.
Volatility:
A measure of the fluctuation in the market price
of the underlying Stock. Mathematically, volatility is the annualized standard
deviation of returns.
I will briefly explain the option trading strategies in next post. Feel free to leave comment if you need
any further clarification.
