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INTRODUCTION

Several newbie traders across the world find it intriguing to explore the possibility of making money from the convenience of one’s home.

All you need is a working computer system and an internet connection.

Trading as a whole is an exciting field for many around the world.

It is risky yet most people consider it an easy way to be successful – we must understand that this is a huge misconception.

There are several elements within stock market trading that is learnt through years of practice.

This report attempts to elucidate to our readers about the definition and various uses of option contracts.

For beginners in trading, understanding option contracts can be a little daunting while for the seasoned traders, this report could furnish information which could amplify the worth of their trading strategies in hand.

For most of us the most common rule of the stock market as we understand it would be “Buy low, sell high”.

Nevertheless, it goes without saying that the stock market cannot be that easily deconstructed.

Just like in case of options, there are several elements within the stock market which need to be analyzed and understood.

To understand options, we must look at it as a machine which has several components within itself – thus, making it difficult to be understood.

This report attempts to break down the idea of options for the readers – along with all the minute components and their functionalities.

Do not be advisable about the vast extent of each element – but take in the knowledge about each one through small steps.

One of the worst disadvantages faced by investors and traders new to the stock market is the inability to possess a clear understanding of how the market works.

We overcome this disadvantage with a clear understanding of the market we would be participating in, with a foundational knowledge of how each part of the financial market works.

With reference to the case in question, this foundation begins with the understanding of what are options, how they work and whether you can implement options into your chosen trading techniques.

As part of every trading technique, one needs to first have a well thought of trading strategy in mind.

This trading strategy could guide you through every rough patch you might face within the stock market and help you understand where you are going wrong.

This way you can limit the mistakes you might make in your future trades.

This report would guide you through the measures required to understand how financial options can be understood, how to work with these measures and how they might help you to succeed in stock trading.

What Are Options?

What Are the Different Types of Options?

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An option would also mean that a buyer (also known as the “optionee” or “beneficiary”) has certain rights but not an obligation.

According to a definitive statement available online, options “Provide a great way for traders and investors to realize the gain on equity movements without purchasing the underlying securities, yet only a small fraction of people utilize options in their own portfolios.

Instead, many traders and investors discount them as extremely complicated and risky, when in many cases they can provide a superior risk/reward ratio over simply purchasing the underlying equity.”

Furthermore, an option contract can be defined as an agreement which meets the requirements for the formation of a contract on options, which would act like a binding contract between two parties.

The contract comes bearing an expiration date as well.

There are two types of options contracts – Call and Put.

Call Options – Definition & Overview

Call options provide an investor the permission to buy a stock, bond or other underlying security at a specific purchase price within a specified time frame.

“Call options give the buyer a guarantee that the person, who sold the option, will sell those shares at a predetermined price.”

How does this work?

The predetermined price is called the “strike price”.

‘Strike Price’ can be defined as the guaranteed price at which the owner of the option can purchase a security from the writer of the call.

Here, the strike price being “bullish” would mean that an investor hopes for the stock price to increase over time as investors who purchase call options are bullish on underlying stocks.

At the same time, “bearish” would mean that an investor hopes that the stock will decrease in value.

Conversely, “bearish” indicates that an investor believes that the stock will decrease in value.

A call option is a bet that the stock is going to increase in value.

A call option investor can generate profit from “strike price” when it is lower than the market price of the security in question.

For instance, if person A predicted that Apple’s stock was on the verge of rising, he/she would buy a call option.

The higher Apple’s stock climbs, the more the call option spurts.

According to an example provided on a write-up on options, “The risk with options is that the option could expire worthless.

If Apple’s stock were hovering at $500 and one bought a $510 call, it would expire worthless and the premium paid would be lost by that unfortunate investor.

What that seller managed to do is called “writing an option.”

If a stock were going to go lower, one could sell those options to a third party who believes it will go higher.

That is called “writing premium,” or “collecting premium”.

Writing call options is among the riskiest of trade strategies.

A particularly unfortunate scenario was illustrated when one individual sold hundreds of a $50 call option for approximately one dollar; when the stock price was $48.

The call ended up expiring worthless, but that person had initially thought he would make $25,000 on the trade.

The next day he received the news that the stock was up over $50 a share, as it was being bought out.

The money he had invested was unable to be recovered.

That is the risk associated with writing call options.”

When one purchases a call option, it offers the right to buy a given asset at a fixed price, also known as the strike price.

If a call option is priced at Rs. 15 and the underlying security increases in value, the call will increase in value as well.

At any time before the specified expiration date, the option writer or the person who created the purchased option has a legal obligation to sell the security at the strike price.

Call options that have a stroke price ranging below the current market price of the underlying security are known to bring in the most amount of money.

Apart from this, it is important to remember that an option price consists of the intrinsic as well as the time value.

While the intrinsic value can be defined as the amount that the option is in the money, the latter (time or extrinsic value) contains several variables that create the given currency value.

Buying a call option is the least amount of risk that one could take.

Selling a naked call option, on the other hand, is the riskiest endeavor.

The downside is essentially unlimited.

However, this should not indicate that buying will offer a constant stream of income; if one purchases the wrong stock option, no money shall be made.

For instance, if a stock trades at $520 and there are options available at a strike price of $570, this would indicate a tidy profit if the stock were to rise in price.

However, the stock could trade sideways, which would leave the trader with nothing as the option expires worthless.

As an example, if Tata Steel’s March Rs.515 call option was priced Rs.23.10, the option buyer had the right to purchase 100 shares of Tata Steel’s stock at a strike price of Rs.515 per share any time prior to the expiration date.

If Tata Steel was priced at Rs.520 and one bought the Rs.515 call option, and the price might rise to Rs.550.

Then, there is a chance for an instant profit to be made because the stock is would be trading at Rs.550.

However, there is still the option of buying the stock at the price of Rs.515.

Keeping this in mind; we must know that several trading experts are not keen on purchasing stocks that are not that well known.

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Put Options – Definition & Overview

Moving on from call options, let’s look at the next form of options we would be dealing with in this write-up: Put options.

Put options are often considered to be the opposite of call options.

Nevertheless, one can buy or sell a put option in the similar ways as put forth in case of call options.

If ITC’s stock were going to go down, one would buy a put option because as that stock descends, the put option will definitely increase in value.

These options give you the right to sell shares at a given strike price.

Put option can be defined as a situation where an option contract gives the owner the right, but not the obligation, to sell a specified amount of a financial asset at a given price within a specified time.

The buyer of a put option estimates that the price of the financial asset will drop below the exercise price before the expiration date.

Another popular trading strategy is to look for a situation where the stock tends to trend positively, enabling investors to sell put options.

If the stock keeps rallying and the put options expire worthless, the premium received could be kept as income.

Let us look at certain pointers which can help us understand Put Options a little better:

If put options have a strike price above the current market value of the asset in question, those would be considered to be in the money.

If the strike price were below the current market value, those would be out of the money.

It has been noticed that purchasing put contracts gives the buyer a bearish outlook on the market.

This would mean that they hope the intended value will actually go down.

Therefore, we buy puts when we expect the market to descend and buy calls when we expect it to ascend.

Instead of purchasing put options, one can also sell them for profit. Put option writers, also known as sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums.

Another popular trading strategy is to look for a situation where the stock tends to trend positively, enabling investors to sell put options.

If the stock keeps rallying and the put options expire worthless, the premium received could be kept as income.

Further on, a few pointers on Put Options can help us understand these factors better:

If put options have a strike price above the current market value of the asset in question, those would be considered to be in the money.

If the strike price were below the current market value, those would be out of the money.

It has been noticed that purchasing put contracts gives the buyer a bearish outlook on the market.

This would mean that they hope the intended value will actually go down.

Therefore, we buy puts when we expect the market to descend and buy calls when we expect it to ascend.

Buying Put Options

In trading, the two terms we deal with everyday are buying and selling.

Put buying is one of the easiest ways to trade with put options.

When the options trader is bearish on particular security, he can purchase put options to profit from a slide in financial asset price.

The price of the financial asset must move significantly below the strike price of the put options before the option expiration date for this strategy to be profitable.

Selling Put Options

As discussed before, in trading the other term we deal with every day is selling.

In case of put options, apart from purchasing or buying them we can also write them off or sell them for a profit.

Put Option Sellers or Writers sell put options in the hope that they would expire worthless in order to gain control of the premiums.

Put writing or selling puts is believed to be quite a risky activity which requires a lot of precision and practice.

Nevertheless, amongst seasoned option traders, this has been found to be quite a profitable strategy.

Leverage and Pricing an Option

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The idea of leverage can be better understood by imagining the use of a pulley system to lift a heavy object, or using a crow bar to open a jammed door.

Leverage equips the use of a small amount of work to create a larger force.

The leverage of options can help in building a powerful portfolio.

It is highly important to maintain different accounts to work with.

It has been noticed that traders maintain multiple trading accounts for different kinds of trading: short-term, long-term, day trading futures, swing trading options, etc.

Moving on, let us look at how pricing in options work.

To understand this better, we will have to begin by looking at the two determinants for option value.

Variables Relating to Underlying Asset

• Value of Underlying Asset; as this value increases, the right to buy at a fixed price (calls) will become more valuable and the right to sell at a fixed price (puts) will become less valuable.

• Variance in that value; as the variance increases, both calls and puts will become more valuable because all options have limited downside and depend upon price volatility for upside.

• Expected dividends on the asset, which are likely to reduce the price appreciation component of the asset, reducing the value of calls and increasing the value of puts.

Variables Relating to Option

• Strike Price of Options; the right to buy (or sell) at a fixed price becomes more (or less) valuable at a lower price.

• Life of the Option; both calls and puts benefit from a longer life.

Level of Interest Rates – As rates increase, the right to buy (or sell) at a fixed price in the future becomes more (or less) valuable.

It is important to remember that in Trading and Finance, there is an amount of money paid (known as premium) during the purchase or selling of options. This price contains two components:

  • Intrinsic Value
  • Time Value

Intrinsic Value

Intrinsic Value of an option can often be defined as the authentic value of a company or a financial asset based on an underlying perception of its true value including all aspects of the business, keeping in mind all the tangible and intangible factors.

This true value may or may not be the same as the current market value.

Value investors use a variety of analytical techniques in order to estimate the intrinsic value of securities in hopes of finding investments where the true value of the investment exceeds its current market value.

In case of call options, an intrinsic value is the difference between the underlying stock’s price and the strike price.

For put options, it is the difference between the strike price and the underlying stock’s price.

In the case of both puts and calls, if the respective difference value is negative, the intrinsic value is given as zero.

Formulas to calculate Intrinsic Value are:-

Call Option Intrinsic Value = Underlying Stock’s Current Price – Call Strike Price

Put Option Intrinsic Value = Put Strike Price – Underlying Stock’s Current Price

Time Value

Time Value can be defined as the amount the option trader is paying for a contract above its intrinsic value, with the belief that prior to expiration the contract value will increase because of a favorable change in the price of the underlying asset.

An option’s time value is equal to its premium (or the cost of the option) minus its intrinsic value and it has been often noted that the longer the length of time until the expiry of the contract, the greater the time value.

In other words, the more time it remains until expiration, the time value of the option becomes greater.

This is because investors are willing to pay a higher premium for more time since the contract will have longer to become profitable due to a favorable move in the underlying.

Formula for calculating time value is:-

Time value = Option Premium – Intrinsic value

Hence as a conclusion we can state that, Time Value can be defined as the additional premium that is priced into an option, which in turn represents the amount of time left until expiration.

The price of time is influenced by various factors, like the time left until expiration, stock price, strike price and interest rates, but none of these are considered as important as implied volatility.

In the next chapter, we will look at what implied volatility is and how it works.

Implied Volatility

Implied Volatility is one of the difficult market terminologies that have been elaborately discussed by investors and traders around the world.

It could be defined as an enormous factor which could provide an edge in options trading.

This is a computed value that has to do with the option itself rather than the underlying financial security.

This in turn means that the intrinsic portion of an option would continue to remain the same.

However, you must remember that the premium portion of that option could exceedingly change depending on possible market conditions.

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An article which aimed at a valuable example to understand Implied Volatility states that, “If the stock is right before earnings, there might be an extra $20 of premium since the implied volatility jumps up 100%.”

The statement is a possibility because some traders have trouble in comprehending prior to earnings, which is an options strategy that has the investing holding a position with both call as well as put options, with the same expiration date and strike price.

One of the initial ways to interpret this idea better is by looking at a clear comparison between this and basic implied volatility.

This indicator can be found on most trading platforms.

Implied volatility represents the expected volatility of a stock over the life of the given option.

Option premiums react differently with the change in the market expectations.

Implied volatility is directly influenced by the flow of supply and demand of the underlying options and by the market expectation with reference to the direction of the share price.

As expectations associated with the option rises, or in other words when the demand for an option increases, implied volatility will also rise.

Options that have high levels of implied volatility will result in high-priced option premiums.

At the same time, when the market expectations decrease or the demand for an option dwindles, implied volatility will also decrease.

Options containing lower levels of implied volatility will result in cheaper option prices.

This is important because the rise and fall of implied volatility will determine how expensive or cheap time value is to the option.

One of the effective ways to analyze implied volatility is to examine a chart.

Many charting platforms provide ways to chart an underlying option’s average implied volatility, in which multiple implied volatility values are computed up and the average calculated.

Like other charting techniques, Implied Volatility also moves in cycles.

It has been noted how high volatility periods are often followed by low volatility periods, and vice versa.

Using relative implied volatility ranges, along with prescribed forecasting techniques, helps investors select the best possible trade.

When determining a suitable strategy, these concepts are critical in finding a high probability of success, helping traders maximize returns and minimize risk.

Certain pointers to be kept in mind while dealing with how implied volatility affects options, one must remember that the success of an option’s trade can be significantly enhanced by being on the right side of implied volatility changes.

Each stock has a unique implied volatility range and these values should not be compared to another stock’s volatility range.

Why is this?

It is important to remember that Implied Volatility should be analyzed on a relative basis.

In other words, each measure of implied volatility may differ from company to company.

Therefore, once the implied volatility for an option is calculated, it would be advisable to not compare it against another one.

This mostly produces an incorrect measurement.

CONCLUSION

Like all other trading approaches, trading with the use of options also bears its own set of risks.

It has been noted how those who trade with options mostly lose money.

This is mostly because they only focus on purchasing options as part of their trading strategy – ignoring all other factors at play.

There needs to be other optional strategies in place, and traders need to remember that 80% to 90% of options expire worthless.

Often it has been noticed how people outside the purview of the stock market generally buy options without paying much heed to the fair value of the option and the related implied volatility.

This results in more harm than good.

It leads to buying overpriced options and in turn, losing more money.

There are several rookie mistakes that can trap the unsuspecting beginners in trading.

One of them is to not include the use of diverse strategies and not chasing out of the money options.

As seen in case of all other trading techniques and approaches available to us in the market, trading with options is also a technique which requires a bit of time, patience and practice to be able to absorb the best out of it.

This fundamental logic will increase your monetary returns and decrease your stress, giving you the ability to sketch out an almost flawless trading plan.

Each element has a different role to play when it comes to trading with options.

It is important for a trader to look at each of these elements separately and then analyze their role, with relation to each other.

Focusing just on the purchase of options would not result in financial success.

There are several factors discussed at length in this report which outlines the various buying and selling techniques associated with the two types of Options.

Though risk associated, options’ trading is found to be quite an interesting trading strategy for those who wish to learn more about the stock market.

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So, trade safely and limit your losses as you amass more profits through time!