Basics of Options Trading

Options trading is an important topic for traders looking to explore different investment opportunities. In this article, we will learn the basics of options trading and how to execute it successfully.

Options Contracts

Options are traded in options markets, with the smallest trading unit being one contract. Options contracts define the trading parameters in the market, such as the type of option, expiration or exercise date, tick size, and tick value. For example, the contract specifications for the ZG Options Market (Gold 100 Ounce Troy) are as follows:

• Symbol: ZG
• Expiration: expires in the nearest month of the six-month contract cycle (February, April, June, August, October, December)
• Exchange: ICE Futures US
• Currency: USD
• Strike or exercise price intervals: $25 and $50 per ounce
• Exercise style: American
• Delivery: futures contract

The contract specifications are for one contract, so the value displayed above is the trading value of a single contract. If a transaction is made with more than one contract, the trading value increases accordingly. For example, if a trade is made in the ZG Options Market with three contracts, the equivalent trading value would be 3 × $10 = $30, meaning that for every $0.1 change in price, the profit or loss of the trade will change by $30.

Call and Put Options

Options are available either as call options or put options, depending on whether they grant the right to buy or sell. A call option gives its holder the right to buy the underlying asset, while a put option gives the right to sell the underlying asset. The right to buy or sell is exercised only when the option is exercised, which can occur on the expiration date (European options) or at any time until the expiration date (American options).

Like futures markets, options markets can be traded in both directions (upward or downward). If a trader believes the market will rise, they will buy a call option, and if they believe the market will fall, they will buy a put option.

Note: There are also options strategies that involve buying both a call and a put option, in which case it does not matter to the trader which direction the market moves.

Long and Short Positions

In options markets, long and short positions refer to buying and selling one or more contracts, but unlike futures markets, they do not indicate the direction of the trade. For example, if a trade is entered in the futures market by buying a contract, the trade is a long trade, and the trader wants the price to rise. However, with options, a trade can be entered by buying a put option, and it is still a long trade, even though the trader wants the price to fall. The following chart may help clarify this better:

Limited or Unlimited Risk

Basic options trades can be long or short and carry different risk-reward ratios. The risk-to-reward ratio for long and short options trades is as follows:

• Long Trade
  • Entry Type: Buy a call option or a put option
  • Potential Profit: Unlimited (call option) or the value of the underlying exercise price minus the premium paid (put option)
  • Potential Risk: Limited to the premium paid
• Short Trade
  • Entry Type: Sell a call option or a put option
  • Potential Profit: Limited to the premium received
  • Potential Risk:
  • Potential: Unlimited

As noted above, the long option trade carries the potential for unlimited profit and limited risk, while the short option trade carries limited profit potential and unlimited risk. However, this is not a comprehensive risk analysis, and in fact, short option trades carry greater risks due to the possibility of unlimited increases in the underlying security’s value.

Premiums

When a trader buys an option contract (whether a call option or a put option), they obtain the rights granted by the contract and pay a premium to the seller of the option contract. These fees are called premiums, and they vary from one options market to another, and also within the same options market, depending on the time of the premium calculation. The value of the premiums is calculated using three main criteria, which are as follows:

• In the money, at the money, or out of the money: If the option is in the money, the premiums will have additional value because the option is already profitable, and the profit will be immediately realized by the option buyer. If the option is at the money or out of the money, the premiums will have no additional value because the options have not yet been profitable.
• Time value: All options contracts have an expiration date, after which they become worthless. The more time an option has before its expiration date, the greater the time available for the option to reach profitability, so the premiums will have additional time value. The less time an option has until its expiration date, the less time there is available for the option to reach profitability, so the premiums will have less or no additional time value.
• Volatility: If the options market is highly volatile (i.e., if the daily price range is large), the premiums will be higher, as the option has the potential to generate more profits for the buyer. Conversely, if the options market is not volatile (i.e., if the daily price range is small), the premiums will be lower.

Note: The volatility of the options market is calculated using the long-term price range, the current price range, and the expected price range before the expiration date, using various volatility pricing models.

Entering and Exiting a Trade

A long option trade is entered by purchasing an option contract and paying the premiums to the seller of the option contract. If the market subsequently moves in the desired direction, the option contract will become profitable (in the money). There are two different methods for converting an in-the-money option into realized profit. The first method is to sell the contract (as is the case with futures contracts) and keep the difference between the buying and selling prices as profit. Selling an option contract to exit a long trade is safe because the sale is for a contract already owned.

The second method to exit the trade is to exercise the option and receive the underlying futures contract, which can then be sold for profit. The preferred method to exit the trade is to sell the contract, as this is easier than exercising the option, and theoretically, it is more profitable, since the option may have some remaining time value.

Ultimately, new traders in the options market must understand the basics and key concepts of options trading before starting actual trading. They should be familiar with contracts and premiums and know how to successfully enter and exit trades. By understanding these fundamentals, traders can achieve greater success in options trading and reach the desired profits.

Source: https://www.thebalancemoney.com/how-options-are-traded-1031302