An option is a financial instrument, a form of derivative based on the value of underlying securities. Such contracts give the buyer the opportunity to buy or sell some basic resource. However, this possibility may not be realized if it is not profitable.
There are two types of options:
- A “call” that allows you to buy assets within a given time at a predetermined price.
- “Put”, allowing to sell.
Each such contract indicates its validity period, as well as the total cost of the underlying asset, which must be paid by that time, the strike price. Usually, operations are making using a variety of brokers.
How it works?
This is a universal financial instrument. The contract is concluded by two parties - the buyer and seller. Moreover, the first party is obliged to pay the second option premium - the very cost of concluding the contract. If we are talking about the “call option”, then the buyer acts on a bullish tactic, and the seller - on a bearish one. If about "put options", then - on the contrary.
By default, option contracts imply a basic package of 100 shares, and the buyer must pay a premium for each. This award is based on several factors, including the strike price, due date and other parameters that the parties can agree on.
Traders and investors have their own reasons to participate in such trading. The main one is speculation, because using borrowed funds, you can hold a borrowed position in resources much more efficiently than simply acquiring these resources. A second use case is to hedge in order to reduce the risk exposure of your stock portfolio. There are also alternative options - earning income from a premium when selling or creating a new application.
In addition, there are two main categories: “American”, in which the purchase/sale can be done at any time before the end of the validity period, and “European”, in which actions can be done only on the due date.
Risk Metrics: Greeks
Or, in translation - "Greeks". This term is used in markets to describe various aspects of risk associated with the adoption of an option position, either in each case or in the whole portfolio. It is named so because the letters of the Greek alphabet are used to designate different metrics. At its core, each such variable is the result of an incomplete offer or the relationship of an option with another underlying variable.
The price sensitivity of the option relative to the underlying asset. The ratio between the rate of change of the option price and the price of the underlying asset is $ 1. For a “call” it lies between 0 and 1, for a “put” it lies between 0 and -1. An example - if the delta is 0.5, then with an increase in the price of the stock by $ 1, the size of the contract will increase by 50 cents.
Sensitivity to time or “decay of option time”. The rate at which the option price changes relative to its expiration date. That means - the closer to the time of expiration, the lower the cost. A simple example is if the investor has a “call” with a theta of -0.5 dollars, then every day, if nothing else changes, the value of the option will fall by 50 cents. For 3 days, for example, it will decrease by $ 1.5. Long (by time and not by ownership of assets) theta contracts are usually negative, regardless of the direction of purchase or sale. And if the value of the underlying asset does not change over time, then the theta will be zero.
Second-order price sensitivity (second derivative). Or - the rate of change between the option delta and the price of the underlying asset. Simply put, the gamma will show how the delta changes when the value of the underlying asset changes by 1 dollar. For example, there is an option with a delta of 0.5 and a gamma of 0.1. If the stock price changes by $ 1, the delta, accordingly, will change by 10 cents.
The gamma as a whole determines the overall stability of the delta option. The higher it is, the less stable the cost and strong changes when the prices of the underlying asset fluctuate. It increases as the completion date approaches.
The sensitivity of the option to volatility. Or, the rate of change between the value of the option and the implied volatility of the underlying asset. That means - how much the value of the option will change when the volatility changes by 1 percent. So, for example, a position with Vega 0.1 means that when volatility changes by 1 percent, the price will change by 10 cents.
Increased volatility implies a significant increase in the value of the option, and lower volatility - exact opposite.
Interest rate sensitivity. Or the rate of change between the option price and the interest rate of 1%. For example, if there is a “call option” of $ 1.25 and Rho of 0.05, then with an increase in interest rates, the new cost will be $ 1.3. For the “put option” the situation is the opposite - 1.2.
There are other Greeks - lambda, epsilon, vomma, vera, speed, zomma, color, ultima. But they are secondary and even tertiary. But in practice, they are also used, since computer simulation allows you to calculate all these parameters in real time.
Risks and profits when buying a “call”
This option variant allows the holder to buy securities at the stated strike price by the time the term expires. However, if the owner does not want to do this, he is not obliged. So the risk is limited to paying a premium, and fluctuations in the price of the underlying asset do not affect profit in any way.
"Calls" is usually bought by bulls, playing on the increase in the value of shares above the price of the strike until the end. If the forecast is confirmed, then the investor can apply his right to buy, and then immediately sell the purchased, but at market value.
Profit here is the difference between the market price and the strike price, minus the premium and brokerage commission. Separately for each of the 100 shares.
If the price of shares does not rise above the strike, then the buyer of the option call won't sell it, and the premium will be lost in any case.
Risks and profit on the sale of “call”
Such a sale is known as “contract writing.” The author receives a premium fee if someone buys this option from him. An investor usually follows a bearish tactic and believes that the price of the underlying asset will fall or remain within the stated strike price throughout the term.
If the buyer does not apply his right to purchase, since the price of the assets will not change much, or the strike price will be lower, the seller will retain the premium in any case.
But a situation is possible when the market price of an asset increases markedly - then the seller must either sell his asset or, if he doesn’t, buy shares at market value in order to resell the “call option” to the buyer. Losses are the difference in price between the underlying asset and the declared strike price plus brokerage rent minus a premium.
It can be concluded that the authors of the option call risk are much stronger than the buyers - that is why they receive the “risk premium”.
Risk and profit when buying a put
The buyer believes that the price of the underlying asset will fall below the strike price before the completion date. As for the owner of the main resource, he may not sell it if something does not suit him. The value of the option increases as the value of the underlying asset decreases.
The profit on such a transaction is the difference between the strike price and the current market value, minus the premium and brokerage expenses. The result is multiplied by the number of options and by 100, since we are usually talking about 1 share. Risk is only a loss of premium.
Risks and profits from the sale of "put"
It’s also “contract writing”. The author uses bullish tactics and calculates that the price of the stock will not change or increase. And the buyer is doing the opposite. And the buyer can force the seller to buy the asset at the stated strike price by the time the contract is executed.
If the value of the assets at the time of expiration is higher than the declared value, the contract will not be implemented - it is not beneficial to the buyer. However, the seller, in any case, will receive a premium.
If the price falls below the stated strike price, the contract author is obliged to sell the assets to the buyer, or if the asset is not in possession, first buy it at the market price and then resell it. The risk is quite high, so the author is entitled to a premium that at least slightly compensates for possible losses.