Options are a highly versatile type of financial derivative that offers investors a plethora of alternatives in different applications and market conditions, involving a high level of leverage and allowing exposure to different levels of risk.
This type of instrument has been present in exchange markets since the 19th century and was used to secure the prices of raw materials, especially in the city of Chicago, which gave rise to the Chicago Board of Options in 1973 (CBOE).
Options allow traders and investors to choose between being the seller or the buyer of contracts, allowing them to tailor the operation and quantify the probabilities of success. An options seller limits their maximum returns but increases their chances of success.
There are different types of options: jumbo, which control 1000 shares per contract; standard, which control 100 shares per contract; mini, which control 10 shares per contract. Standard options are the most common and will be used throughout this article and any other of our explanations.
Types of Option Contracts
Calls: give the owner or buyer of the contract the right to purchase 100 shares of the underlying asset at the agreed price (Strike) in an agreed upon time period (expiration). These contracts revalue when the price of the underlying asset increases.
Puts: give the owner or buyer of the contract the right to sell 100 shares of the underlying asset at the agreed price (Strike) in an agreed upon time period (expiration). These contracts revalue when the price of the underlying asset decreases.
Option Characteristics
To understand the concept of options contracts, it is important to know their characteristics:
Expiration date: all options have an expiration date, which indicates the moment in which the option loses its value to be traded. This can be weekly, monthly or more. The frequency of expiration dates varies depending on the underlying asset.
Agreed price (Strike): the Strike price is the price specified in the option contract to close the transaction.
Intrinsic value and extrinsic value: intrinsic value refers to the difference between the strike price and the value of the asset. Extrinsic value refers to the temporal or subjective value of the option contract, its value is determined primarily by three fundamental elements: Contract's time of validity, implicit volatility of the asset and the interest or demand of the contract.
ITM, OTM, ATM: the terms ITM, OTM, and ATM refer to the position of the strike price in relation to the current price of the underlying asset and will define part of the value of the option and its ability to exercise.
ITM or in the money (ITM) is what is referred to when a financial option begins to acquire intrinsic value, meaning that the valuation of the contract begins to have a relationship with its execution value.
ATM or at the money (ATM) refers to those option contracts whose strike price is the same as the quotation price of the asset.
OTM or out of the money (OTM) refers to those option contracts whose strike price is not the same as the quotation price of the asset and does not have intrinsic value.
Multiplier of the contract: Normally, an options contract has the ability to control 100 shares of the underlying asset and for this reason we use 100 as the multiplier. Brokers show the price in contracts in cost per share, therefore, it will have to be multiplied by 100 to know the price to be paid. For example, if the price of a contract is $0.65, the cost of the option will be $65 plus commissions.
Nomenclature: There is a standard nomenclature for naming options and it is composed of the ticker or symbol that identifies the underlying asset, the expiration date, the type of contract, and the strike price.
Options Chain: The options chain is specific to each asset and is displayed by the broker. It shows the different expiration dates and strike prices, both for Call and Put options. In the example, the options chain for Meta Platforms Inc. (NASDAQ: META) is shown. On the left are the different available expiration dates and on the right, you can see that by expanding a particular date, you can find the different strike prices for Call and Put options.
a - Volatility values
b - Implied volatility curve
c - Call options section
d - Expiration date
e - Put options section
Note: Values highlighted in purple are strikes that are in-the-money (ITM), white are out-of-the-money (OTM)
Price calculation and Greek variables
Trading options is more complex than simply trading stocks, as this type of instrument involves different variables that affect its price, but knowledge of these variables will benefit the investor in the long run. The price of options contracts is calculated using the Black-Scholes mathematical model and the main variables that influence the price of a contract are:
Delta: variation due to movement in the price of the underlying asset;
Vega: variation due to change in implied volatility;
Theta: depreciation due to the passage of time;
Rho: variation due to changes in interest rates.
Options strategies
Options contracts can be traded just like stocks, without having to fulfill the exercise rights (purchase or sale of shares) that they carry. Trading with this type of instrument can be very profitable if the trader is certain of the market movement, generating returns that can exceed hundreds or thousands of percent in low-capital transactions.
However, there are many variables that work against this type of operation and small movements against the operation can generate large losses in the investment. That is why those who trade options combine different contracts to produce more sophisticated strategies with higher chances of success.
Options can be used for different purposes (speculation, portfolio protection, periodic income, and others). Among the most popular options strategies are:
Covered Call;
Synthetic Covered Call;
Vertical Spreads;
Iron Condors.
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