Introduction to Options

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:

1. Long Call

2. Short (Naked) Put

3. Covered Calls

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.