Updated Mar 20, 2022

What are options?

What are the options?

You can purchase or sell stocks, ETFs, and other securities at a fixed price for a set period using online trading options. This technique of online trading also allows customers the option of not purchasing the securities at the specified price or on the specified date.

Although options trading is more complicated than stock trading, it can provide significant upside potential with minimal negative risk, which is limited to the premium you pay when purchasing the option. Similarly, selling options reduces your losses if the price of the security falls, which is known as hedging.

What is Options Trading?

Options trading allow you to buy or sell stocks at a set price and for a set length of time. Buyers of options have the option and flexibility of not acquiring the securities at the set price before the expiration time in options trading.

The principle of options trading is a little more sophisticated than stock trading, but you can make more money with options if the stock price rises. You don't have to pay the whole price for security when trading options. Hedging is a term used to describe how options trading can protect you from losses if the price of the investment falls.

Basics of Options

Depending on the form of the option, it gives the holder the right to purchase or sell an underlying asset or financial instrument at a specific strike price on or before a certain date. The strike price can be determined at a discount or a premium to the spot price (market price) of the underlying security or commodity on the day the option is issued. If the holder "exercises" the option, the issuer is obligated to complete the transaction (to sell or buy). A call is an option that gives the holder the right to buy at a specific price, while a put is an option that gives the holder the right to sell at a specific price.

The issuer may provide a buyer with an option as part of another transaction (such as a stock offering or an employee incentive plan), or the buyer may pay a premium to the issuer for the option. A call option is often used when the strike price is below the market value of the underlying asset, whereas a put option is typically used when the strike price is above the market value. When an option is exercised, the cost to the option holder is the asset's strike price plus any premium paid to the issuer, if any. The option expires if it is not exercised by the expiration date, and the holder forfeits the premium paid to the issuer. The premium is typically a capital loss for the option holder, but it represents income for the issuer.

Depending on the option, the holder of the option can sell it to a third party in the secondary market, either over-the-counter or on an options exchange. The gap between the stock's market price and the option's strike price is what determines how closely an American-style option's market price tracks that of the underlying stock. The actual market price of the option may vary depending on a variety of factors, such as a large option holder needing to sell the option due to the expiration date approaching and not having the financial resources to exercise the option, or a market buyer looking to accumulate a large option holding. The holder of an option does not usually have any rights to the underlying asset, such as voting rights, or any income from the underlying asset, such as dividends. 

Advantages of Options

Options have been accessible for more than four decades, but they are only now receiving the attention they deserve. Many investors have avoided options because they believe they are complicated to understand. Many more people have had negative experiences with options because they and their brokers were not properly educated on how to use them. Misuse of options, like misuse of any sophisticated technology, can lead to serious consequences.

Finally, terms like "risky" and "hazardous" have been incorrectly connected with options by the financial media and several well-known market personalities. Individual investors, on the other hand, should get both sides of the story before deciding on an option's value.

There are 4 major advantages that options provide to an investor:

• They have the potential to boost cost-effectiveness.
• They could be less hazardous than stocks.
• They have a high possibility of delivering huge percentage returns.
• They provide several strategic options.

Risk Metrics for Options: The Greeks

Greeks are a phrase used in the options market to express the various aspects of risk associated with taking an options position, whether it's in a single option or a portfolio. Since they are often linked with Greek symbols, these variables are referred to as Greeks. Each risk variable is the outcome of a flaw in the option's assumption or link to another underlying variable. Different Greek values are used by traders to gauge option risk and manage option portfolios.

Delta

The rate of change between the option's price and a $1 change in the underlying asset's price is represented by the delta. Call option’s delta is spanned from 0 to 1, while a put option’s delta span from 0 to negative 1.  

Theta

Theta is the rate of change between the option price and time, often known as time sensitivity or options time decay. Theta signifies what amount of option’s price decreases at the time of expiration falls, all other elements remain equal. 

Gamma

The rate of change between the delta of an option and the price of the underlying asset is represented by gamma. The gamma value reflects how much the delta would vary if the underlying security moved $1.

The gamma coefficient is used to determine the delta stability of an option. Higher gamma values imply that delta could alter drastically in response to even minor price changes in the underlying. Gamma is higher for at-the-money options and lowers for in- and out-of-the-money options, and it increases in magnitude as expiration approaches.

Vega

The rate of change between the value of an option and the implied volatility of the underlying asset is represented by Vega. This is the sensitivity of the volatility option. The Vega indicator shows how much an option's price changes in response to a 1% change in implied volatility.

Rho

The rate of change in the value of an option versus a 1% change in the interest rate is represented by Rho. This is a metric for interest rate sensitivity. Rho is best for at-the-money options with long expiration durations.

Minor Greeks

These Greeks are second or third-order derivatives of the pricing model, affecting factors like the change in delta when volatility changes. These complicated and even esoteric danger concerns are becoming more common in options trading techniques because computer software can swiftly calculate and adjust for them.

Conclusion

Options may appear to be complex derivative instruments, but they may be very beneficial financial instruments, providing you with risk mitigation or leverage while also shielding you from any adverse risk. There are advanced trading methods in India, like a straddle, strangle, butterfly, and collar, that can be employed to optimize profits if you're well-versed in online trading options.