Options Basics

An option contract gives the holder the right, but not the obligation, to buy/sell something at a predetermined date and price.

(1) There are two primary types of options: calls and puts.

- Call Options: Gives the buyer the right to buy a certain quantity of the underlying asset at a certain price within a certain period of time in the future until the expiration date

- Put Options: Gives the buyer the right to sell a certain quantity of the underlying asset at a certain price within a certain period of time in the future until the expiration date

(2) Key elements of options

Term

Definition

Underlying Asset

The security that you agree to buy or sell as stipulated by the Options Contract.

Exercise Time

The time at which the buyer can exercise their right as stipulated by the Options Contract

Strike Price

The price at which the Options Contract stipulates an asset can be bought or sold

Premium

Amount paid by the Options Buyer to buy the Options Contract

Exercise

Options buyer chooses to execute their right

Physical settlement

A manner of settling a derivative transaction under which physical delivery of the underlying or obligation is contemplated under the contract

Cash settlement

Options holder makes a direct profit based on the difference in price without actual physical delivery of the underlying

(3) Relationship between Options Strike Price and the price of the underlying asset

Direction

Relationship

Classification

Call Options

P > S

In-the-money

P < S

Out-of-the-money

P = S

At-the-money

Put Options

P > S

In-the-money

P < S

Out-of-the-money

P = S

At-the-money

S = Strike Price

P = Underlying asset Price

The Major Greeks

Greeks

Definition

Example

Delta

The change in its premium as a result of price changes in its underlying. Call options have positive deltas while put options have negative deltas.

If a call option has a price of $1 and a delta of 0.25, then the optionโ€™s price will move by 25% of the corresponding change in the underlyingโ€™s price.

Gamma

Speed at which delta changes. All options have positive gamma values.

If options A and B have the same delta values but option B has a higher gamma value. Then option B will have a greater degree of risk since it is more susceptible to price changes.

Theta

Quantifies the risk with a figure that represents a price drop for each day. All options have a negative theta value.

An option price at $5 with a theta of -0.25 will lose $0.25 daily.

Vega

Price sensitivity to implied volatility.

A call options purchased for $5 with an implied volatility of 25% and a vega of 0.2. If implied volatility increases by 3%, the new premium will be: option premium = $5 + (3 x 0.2) = $5.60

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