The Options Market
Whilst once the domain of professional traders, options are an increasingly popular trading choice for small traders. Options offer leverage (multiplication of gains or losses) and the prospect of trading gains. What are options, what do you need to be aware of, and how should you trade them?
The options market is quite closely linked to the stock market in most countries, although it is also possible to buy and sell options over futures contracts. There are two types of options – put options and call options. A put option is the right (but not the obligation) to sell a certain quantity of stock or a futures contract at a set price by a given date. A call option is the right (but not the obligation) to buy a certain quantity of stock or a futures contract at a set price by a given date.
You are not restricted to buying put options or call options – you can also sell them. Most traders tend to overlook this possibility. If you sell put or call options, you earn a premium in exchange for the obligation to either buy the stock or contract (put option) or sell the stock or futures contract (call option). You sell an option in the hope that it will not be exercised. The majority of options expire without being exercised (that is, the seller of the option being obliged to buy or sell the underlying stock or futures contract).
This highlights an important factor in options – the value of an option tends to decay over time, all other things being equal. Why is this? It is because as time progresses, there are less opportunities to exercise the option. Once the option expires, the value goes to zero because then there is no opportunity for it to be exercised.
The value of an option depends on several factors, which are represented by Greek letters, and are therefore known as Greeks. They are theta, which represents time. We have discussed this.
There is vega, which represents volatility. The higher the volatility (variance in price from one time to another), the higher the price of the option, because it is more likely to be exercised. There is delta, which is the amount by which the value of an option is affected by the change in value of the underlying share or contract. This is the price sensitivity.
Rho represents the sensitivity to interest rate changes. This is because interest rates represent a risk free return. If the risk free return goes up, then the option’s return must also go up, or there would be no point in holding it. Gamma is the final Greek, and this represents the relationship between the rate of change of the delta against the value of the underlying asset.
You really don’t need to understand the mathematical details as a trader, except you need to remember that an option will decrease in value over time, increase in value as volatility increases, decrease in value as interest rates increase. A put will increase in value as the value of the asset declines, while a call will increase in value as the value of the asset increases.
One other concept is “out of the money” and “in the money”. An out of the money option is one where the exercise price is away from the current underlying price. In the money means that it is within the exercise price.
I generally don’t recommend option trading for most beginners. The time decay of options means that the odds of you being right decline over time, and as mentioned, most options expire without being exercised (the figures that I have seen indicate that around 90% of options expire without being exercised). Apart from that, the essential skills of options trading are similar to those in other trading – you need to find an entry point, decide whether you are right or wrong, and close the position accordingly.
One area that does offer opportunities is writing options, particularly over stocks you already own. You can write an out of the money call option over your shares and pick up a premium. If the stocks go up to the exercise price, you have both the gain and the price of the option. This is a good way to transition from being purely an investor to a trader.
Tags: options, Options Trading