Options
Introduction
Definition:
An purchased option gives you the right, but not the obligation to buy a certain number, of a certain asset, by a certain date, for a certain date, and if you don’t use this right by the certain date, the option expires, becomes worthless and you forfeit the money paid for the option.
Types of option
Body
Two main types
- Call Option: an option giving the buyer the right to buy a certain underlying asset. Remember it is the right, but not the obligation to buy a certain number, of a certain asset, by a certain date, for a certain date, and if you don’t use this right by the certain date, it expires.
- Put Option: an option giving the buyer the right to sell a certain underlying. Remember it is the right, but not the obligation to sell a certain number, of a certain asset, by a certain date, for a certain date, and if you don’t use this right by the certain date, it expires.
Terms - Strike Price: the price the Option purchaser has agreed to pay for the underlying asset.
- Premium: the amount in dollars per share that the purchaser is paying for the option.
- Expiration Date: the day, at 5:PM, that the option expires and becomes worthless.
- Exercise: the option buyer decides to buy the underlying asset, according to the details of the purchased option.
- Days to Expiration: the number of days on the date of purchase, until the option expires and becomes. Worthless.
Types of Options trades
Buy Options
- This type of strategy involves buying an option, and hoping its value goes up before the expiration, so it can be sold at a profit.
Sell Options
This type of strategy involves selling an option, and hoping its value goes down before the expiration, so it can be bought back for less then you sold it for, so you earn a profit.
Spreads
- This type of strategy involves either buying and selling either two call options, or buying and selling two put options, and in each case Strike prices are different, but number of contracts and expiration dates are the same. In this strategy you are hoping the price stays inbetween the two purchased or Sold Strike prices an option, so they expire worthless or drop in value enough you can buy them back and still make a profit.
Profit and Loss, and Probability of Success
- One of the advantages of trading options is that you can choose either defined profit and loss to trade defined profit and loss combinations, where you know exactly how much profit you can earn, and how much loss you can take.
- You can also choose to trade undefined loss strategies, where both your profit and your losses are not limited.
- Lastly, a big advantage of trading options is that you can determine your probability of success when you place a trade, by using the probability of a strike price being reached within the lifetime of the option your buying. The math behind this won a Nobel Prize in Mathematics for the Mathematicians who figured it out.
Summary
Options trading is an alternative to trading stocks, and is a type of derivative, where you don’t trade the underlying asset, you trade contracts controlling the underlying asset. It is heavily dependent on understanding probabilities and basic math, like addition, subtraction, multiplication, division and percentiles. It also requires an understanding of statistical probabilities, but not their calculation. Used incorrectly, options are like lottery tickets; with few winners and many losers. But used correctly they can become a steady source of income.
