Key Takeaways
Options trading offers traders and investors the choice, but not the obligation, to buy or sell assets like cryptocurrencies and stocks at a fixed price.
In options trading, most trading activity and profits come from buying and selling options contracts rather than exercising them to trade the underlying asset.
American options can be exercised at any point before they expire, whereas European options can only be exercised on their expiration or exercise date.
Understanding calls, puts, premiums, expiration dates, and strike prices is key to making informed decisions in options trading.
Introduction
Options trading gives you the choice to buy or sell an underlying asset at a fixed price by a specific date. The term choice is essential here because what makes options trading unique is that you are not obligated to buy or sell that asset. You simply have the right to do so if you wish.
To make this clearer, let's imagine reading a choose-your-own-adventure book. At a point, you might reach a fork in the story, and you must make an important decision: Choose option A or B. Rather than choosing immediately, place a bookmark on the page. You then read ahead, see how the story unfolds, and return later to make the call.
This is similar to the concept behind options trading. Traders do not have to buy or sell an asset immediately. Instead, they can purchase an option, which you can think of as a financial bookmark, giving them the right, but not the obligation, to buy or sell the asset later before the expiration date. To do this, they have to pay a premium, which you can think of as the cost of the bookmark.
Just as you might sell your bookmark to another reader, you can also sell your option contract to another trader before the expiration date. This allows you to potentially profit from changes in the options value, without buying or selling the underlying asset.
Like those choose-your-own-adventure books with unexpected twists, options trading involves risk. So, it is important to understand how options contracts work before starting.
What Is Options Trading?
Options trading is the act of buying and selling options contracts. To really grasp how it works in practice, let's explore its key building blocks:
What are options?
Options are contracts that give you the right, but not the obligation, to buy or sell an asset at a fixed price, the strike price, on or before a specified date, the expiration date.
Imagine you’re interested in a home but not committed to buying it yet. Instead, you negotiate an option with the seller, giving you the right to buy the home at an agreed-upon price within a specified timeframe. You must pay a small holding fee, the premium, to gain this right.
If the home's market value rises, you can exercise your contract to buy the home at the lower, agreed-upon price. If the market value falls, you can simply decide to walk away, losing only the holding fee.
While the strike price may be fixed, the value of the option itself is not. It can fluctuate based on factors like the home’s market price, time remaining until expiration, and market demand. If the home’s market price has risen, the value of your option could increase, allowing you to sell it for a profit without buying the home.
What are call options?
A call option gives you the right to buy an underlying asset at the strike price on or before the expiration date.
The more the market value for the asset increases, the more profit you make. Thus, you might buy a call option if you think the price of a particular asset will go up. If it does, you can buy the asset at the strike price and sell it at the higher market price, making you a profit.
If the call option's value increases before expiration, you can also sell it, allowing you to profit without exercising it. In this way, you are trading the contract itself and not the asset.
What are put options?
A put option gives you the right to sell an underlying asset at the strike price on or before the expiration date.
You might want to buy a put option if you believe the market price for an asset will go down. If the price does fall below the strike price, you can sell your asset at the higher strike price. The more the price falls, the more profit you could make. This would also allow you to buy back the asset at a lower market price.
Like call options, put options can be sold before expiration if their value increases. This allows you to make a profit without exercising them. This is how both call and put options are most typically traded.
Underlying assets
We have discussed underlying assets and how options are contracts that give you the right to buy or sell them without being obligated to do so. In our analogy, the underlying asset is a home. But in financial markets, these assets typically include:
Cryptocurrencies: You can buy options on crypto like bitcoin (BTC), ether (ETH), BNB, and Tether (USDT).
Stocks: You can buy options on company stocks like Apple (AAPL), Microsoft (MSFT), and Amazon (AMZN).
Indexes: You can buy options on stock market indexes like S&P 500 and Nasdaq 100.
Commodities: You can buy options on gold, oil, and other commodities.
Trading before expiration
It is important to note that waiting until expiration to see a return on investment is not necessary. It is the options contracts themselves that are actively traded.
The value of an options contract changes constantly depending on factors like market conditions and time until expiration. This means there is the potential to buy an options contract and then sell it later for a profit or loss. The majority of options trades happen in this way, where you are not necessarily trading the asset itself but trading the right to buy or sell the asset.
Options Contracts
Now that we are familiar with options trading, let's examine the components of the actual options contract.
Expiration date
The expiration date is a specific date on which the option contract will expire. Once this date passes, the option contract will no longer be valid and cannot be exercised. Options can have different expiration dates, ranging from weeks to years.
In the analogy where we discussed your interest in a home, imagine you bought an option for one month from the purchase date. This means you would have a month-long timeframe to decide whether you want to use your right to buy the home at the strike price.
Strike price
The strike price is the predetermined price at which you will have the right to buy (for call options) or sell (for put options) an underlying asset.
So when negotiating with the seller of the home, if you came to an agreed-upon number of $300,000 for the strike price, that is the price you would have to buy the home for if you decided to exercise the option. No matter what the current market price is, you would have the right to purchase the home at that fixed price as long as it is within the specified timeframe.
The relationship between the strike price and the current market price of the underlying asset determines the value of an option contract.
Premium
The premium is the price paid for an options contract. It is the cost of having the right but not the obligation to buy or sell an underlying asset.
Earlier, we compared this to a holding fee. Imagine that you pay the seller a $5,000 non-refundable holding fee to buy an option for the home. This premium ensures that you can buy the home for $300,000, regardless of the current market price, as long as it's within the predefined timeframe. If you decide not to buy, you lose the $5,000 premium.
Some key components that can influence the price of the premium include:
The current market price for the underlying asset.
The volatility of the underlying asset’s price.
The strike price.
The time until expiration.
Contract size
Usually, an options contract for stocks covers 100 shares of the underlying asset. However, for other types of options, like those tied to indices or cryptocurrencies, the contract size can be different. That’s why it’s important to thoroughly check the contract details before trading, so you know exactly how much of the underlying asset you’re dealing with.
Important Terminology
When dealing with options trading, there are some important concepts you should be familiar with.
Profitability terms
Terms like in the money (ITM), at the money (ATM), and on the money (OTM) describe the relationship between the strike price and the current market price of the underlying asset. These terms are important because they not only inform whether you might want to exercise the option but, more importantly, how much the options contract itself is worth.
The Greeks
In options trading, the Greeks are risk measures that help traders understand how various factors affect an option’s price.
Each Greek represents a different sensitivity, allowing traders to assess potential risks and make more informed decisions. The five key Greeks are Delta, Gamma, Theta, Vega, and Rho.
American vs. European Options
It is important to note that throughout this article, we have discussed options trading as it primarily exists in American markets, where American-style options are used. But depending on the market, you may also find European options. The key difference between these two types of options is when they can be exercised:
American options: can be exercised at any time before their expiration date, giving the holder more flexibility.
European options: These options can only be exercised on their expiration date.
Are Binance Options American or European?
On the Binance trading platform, you will only find the European-style options. This means that when you trade options on Binance, you will only be able to exercise them on expiration. However, as most options trading involves buying and selling contracts rather than exercising them, this distinction mainly affects how and when the contract can be settled.
Options on Binance exercise automatically. This means that if your option is ITM when it expires, you will receive your pay-off regardless of whether you exercise the option yourself.
These option contracts are also cash-settled, meaning that when an option is exercised, instead of delivering the underlying asset, the parties exchange the cash value. This can simplify the process and avoid the complexities of asset delivery.
Closing Thoughts
Options trading, particularly American-style options, gives traders and investors the choice to buy or sell an underlying asset at a fixed price before the expiration date. By removing immediate commitment from the equation, you can have more flexibility when engaging with financial markets.
However, you can trade option contracts themselves without ever having to exercise them, allowing for profit from changes in the contract's value. While it offers profit potential, it is important to understand the key concepts behind options contracts before trading.
Further Reading
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