What are my options?
It’s very mainstream to talk options when referring to retail trading and meme culture. As much I love laughing about the massive loss some guy took on Wall Street Bets after being on the wrong end of TSLA puts, I want to introduce some basic fundamentals that I think are important when understanding options contracts and trading.
I’m going to start with vocab getting the basics down will help you two and two together and expand on each topic as I am only addressing the broader concepts.
So, let’s start with a commonly asked question… What is an option?
Option — A contract that gives you the right but not the obligation to either buy or sell an amount of some underlying asset at a predetermined price or before the contract expires.
a. Options DO NOT represent ownership of the company like a stock. In retail trading, think of it as borrowing the underlying asset from the brokerage for a certain period of time, or in investment banking, the trader borrows it from the bank.
b. Most people tend to associate options with hedging against a declining stock to either limit downside loss or create a giant gain based on how the direction of the stock performance is predicted.
So, let’s get to the question we have all been waiting for…what are my options? I listed out the five broad types of options with a basic description to help you understand on a high level what each concept means.
1. Call Options — Allow you to buy shares at a specific time
2. Put Options — Allow selling of shares at a specific time
3. Futures — Similar to regular options it allows the buying or selling of shares on a specific future date, and they are traded on a daily basis with fixed maturity dates
4. Forwards — The ability to buy or sell an underlying asset at a certain future time typically OTC (over the counter) and settled just once at the end of the contract
5. Swaps — (swaption) An option to enter an interest rate swap or another type of swap on a specified future date
Ok so now we know the different categories of options so how do I measure their performance through risk? I’m listing a very broad explanation of risk metrics this topic can get very complicated with each metric’s calculations. (Rho is also used as a metric but not something I used as often)
1. Delta — Represents the change in the value of the option in relation to the movement in the market of the underlying asset. The delta ratio is if a stock has a delta of .50 and if the stock increases in the market by $1 per share the option value will rise $.50 per share
2. Gamma — The rate of change in an option’s delta per 1 point move in the underlying assets price
3. Theta — Refers to the rate of decline in value of an option from time passing and as time goes on the profitability of the options decreases typically. It’s best used to look at the decay of an option with intrinsic value
4. Vega — Measures the amount and speed at which an option’s price moves up or down
What are some important characteristics of an option contract? When looking at contracts what are some terms to keep in mind when analyzing its future performance?
1. Strike Price — The price at which an option can be exercised (it's active)
2. Expiration date — This is the date at which an option expired and becomes worthless
3. Option premium — The price at which the option was purchased
4. Spot Price — Current market price of the underlying asset
“Moneyness” will help you determine the strike price’s position in relation to the value of the asset. This will also help you understand option performance as it relates to risk metrics as well. There are three ways to determine the performance of your underlying assets.
1. In the Money — this means that the strike price is favorable when compared to the market price of the underlying asset
2. Out of the Money — the strike price is higher than the market price of the asset
3. At the Money — the option’s strike price is identical to the current market price of the underlying asset
I’ve been able to get some experience within the derivatives space so this is a chance to spread some knowledge. Mainly this is something you should know before entering any sort of role dealing with derivatives of any kind.
