How do options contracts work?
There are two basic types of options, known as puts and calls. Call options give contract owners the right to buy the underlying asset, while put options confer the right to sell. As such, traders usually enter into calls when they expect the price of the underlying asset to increase, and puts when they expect the price to decrease. They may also use calls and puts hoping for prices to remain stable - or even a combination of the two types - to bet in favor or against market volatility.
An options contract consists of at least four components: size, expiration date, strike price, and premium. First, the size of the order refers to the number of contracts to be traded. Second, the expiration date is the date after which a trader can no longer exercise the option. Third, the strike price is the price at which the asset will be bought or sold (in case the contract buyer decides to exercise the option). Finally, the premium is the trading price of the options contract. It indicates the amount an investor must pay to obtain the power of choice. So buyers acquire contracts from writers (sellers) according to the value of the premium, which is constantly changing, as the expiration date gets closer.
Basically speaking, if the strike price is lower than the market price, the trader can buy the underlying asset at a discount and, after including the premium into the equation, they may choose to exercise the contract to make a profit. But if the strike price is higher than the market price, the holder has no reason to exercise the option, and the contract is deemed useless. When the contract is not exercised, the buyer only loses the premium paid when entering the position.
It is important to note that although the buyers are able to choose between exercising or not their calls and puts, the writers (sellers) are dependent on the buyers’ decision. So if a call option buyer decides to exercise his contract, the seller is obligated to sell the underlying asset. Similarly, if a trader buys a put option and decides to exercise it, the seller is obligated to buy the underlying asset from the contract holder. This means that writers are exposed to higher risks than buyers. While buyers have their losses limited to the premium paid for the contract, writers can lose much more depending on the asset’s market price.
Some contracts give traders the right to exercise their option anytime before the expiration date. These are usually referred to as American option contracts. In contrast, the European options contracts can only be exercised at the expiration date. It is worth noting, however, that these denominations have nothing to do with their geographical location.
The value of the premium is affected by multiple factors. To simplify, we may assume that the premium of an option is dependent on at least four elements: the underlying asset’s price, the strike price, the time left until the expiration date, and the volatility of the corresponding market (or index). These four components present different effects on the premium of calls and put options, as illustrated in the following table.
Call options premium
Put options premium
Rising asset’s price
Higher strike price
Naturally, the asset’s price and strike price influence the premium of calls and puts in an opposing way. In contrast, less time usually means lower premium prices for both types of options. The main reason for that is because traders would have a lower probability of those contracts turning in their favor. On the other hand, increased levels of volatility usually cause premium prices to rise. As such, the option contract premium is a result of those and other forces combined.
Options Greeks are instruments designed to measure some of the multiple factors that affect the price of a contract. Specifically, they are statistical values used to measure the risk of a particular contract based on different underlying variables. Following are some of the primary Greeks and a brief description of what they measure:
Delta: measures how much the price of an options contract will change in relation to the underlying asset’s price. For instance, a Delta of 0.6 suggests that the premium price will likely move $0.60 for every $1 move in the asset’s price.
Gamma: measures the rate of change in Delta over time. So if Delta changes from 0.6 to 0.45, the option’s Gamma would be 0.15.
Theta: measures price change in relation to a one-day decrease in the contract’s time. It suggests how much the premium is expected to change as the options contract gets closer to expiration.
Vega: measures the rate of change in a contract price in relation to a 1% change in the implied volatility of the underlying asset. An increase in Vega would normally reflect an increase in the price of both calls and puts.
Rho: measures expected price change in relation to fluctuations in interest rates. Increased interest rates generally cause an increase in calls and a decrease in puts. As such, the value of Rho is positive for call options and negative for put options.
Common use cases
Options contracts are widely used as hedging instruments. A very basic example of a hedging strategy is for traders to buy put options on stocks they already hold. If the overall value is lost in their main holdings due to price declines, exercising the put option can help them mitigate losses.
For example, imagine that Alice bought 100 shares of a stock at $50, hoping for the market price to increase. However, to hedge against the possibility of stock prices falling, she decided to buy put options with a strike price of $48, paying a $2 premium per share. If the market turns bearish and the stock declines to $35, Alice can exercise her contract to mitigate losses, selling each share for $48 instead of $35. But if the market turns bullish, she doesn’t need to exercise the contract and would only lose the premium paid ($2 per share).
Options are also widely used for speculative trading. For instance, a trader who believes that an asset's price is about to go up can buy a call option. If the price of the asset moves above the strike price, the trader can then exercise the option and buy it at a discount. When an asset's price is above or below the strike price in a way that makes the contract profitable, the option is said to be "in-the-Money." Likewise, a contract is said to be "at-the-Money" if on its breakeven point, or "out-of-the-Money" if in a loss.
When trading options, traders can employ a wide range of strategies, which are based on four basic positions. As a buyer, one can buy a call option (right to buy) or put option (right to sell). As a writer, one can sell call or put options contracts. As mentioned, writers are obligated to buy or sell the assets if the contract holder decides to exercise it.
The different options trading strategies are based on the various possible combinations of call and put contracts. Protective puts, covered calls, straddle, and strangle are some basic examples of such strategies.
Protective put: involves buying a put option contract of an asset that is already owned. This is the hedging strategy used by Alice in the previous example. It is also known as portfolio insurance as it protects the investor from a potential downtrend, while also maintaining their exposure in case the asset’s price increases.
Covered call: involves selling a call option of an asset that is already owned. This strategy is used by investors to generate additional income (options premium) from their holdings. If the contract is not exercised, they earn the premium while keeping their assets. However, if the contract is exercised due to an increase in the market price, they are obligated to sell their positions.
- Straddle: involves buying a call and a put on the same asset with identical strike prices and expiration dates. It allows the trader to profit as long as the asset moves far enough in either direction. Simply put, the trader is betting on market volatility.
Strangle: involves buying both a call and a put that are “out-of-the-Money” (i.e., strike price above market price for call options and below for put options). Basically, a strangle is like a straddle, but with lower costs for establishing a position. However, a strangle requires a higher level of volatility to be profitable.
Suitable for hedging against market risks.
More flexibility in speculative trading.
Allow for several combinations and trading strategies, with unique risk/reward patterns.
Potential to profit from all the bull, bear, and side-way market trends.
May be used for reducing costs when entering positions.
Allow multiple trades to be performed simultaneously.
Working mechanisms and premium calculation not always easy to understand.
Involves high risks, especially for contract writers (sellers)
More complex trading strategies when compared to conventional alternatives.
Options markets are often plagued with low levels of liquidity, making them less attractive for most traders.
The premium value of options contracts is highly volatile and tends to decrease as the expiration date gets closer.
Options vs. futures
Options and futures contracts are both derivative instruments and, as such, present some common use cases. But despite their similarities, there is a major difference in the settlement mechanism between the two.
As the name suggests, options give an investor the choice to buy or sell an asset in the future, regardless of the market price. These type of contracts are very versatile and can be used in various scenarios - not only for speculative trading but also for performing hedging strategies.