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- Stock Trading vs. Option Trading
- Option Strategies
- 6 Options Trading Strategies for 2021
- All About Options Strategy
In options trading, choosing the premium is one of the most important components. In options trading, the underlying asset can be stocks, futures, index, commodity or currency. The price of Options is derived from its underlying asset. For the purpose of this article, we will be considering the underlying asset as the stock. The Option of stock gives the right to buy or sell the stock at a specific price and date to the holder. Hence its all about the underlying asset or stocks when it comes to Stock in Options Trading.
In options trading, all stock options have an expiration date. The expiration date is also the last date on which the Options holder can exercise the right to buy or sell the Options that are in holding. In Options Trading, the expiration of Options can vary from weeks to months to years depending upon the market and the regulations. There are two major types of Options that are practised in most of the options trading markets.
It is very important to understand the Options Moneyness before you start trading in Stock Options. A lot of options trading strategies are played around the Moneyness of an Option. It basically defines the relationship between the strike price of an Option and the current price of the underlying Stocks.
We will examine each term in detail below. Take a break here to ponder over the different terms as we will find it extremely useful later when we go through the types of options as well as a few options trading strategies. In the true sense, there are only two types of Options i. We will understand them in more detail. A Call Option is an option to buy an underlying Stock on or before its expiration date. At the time of buying a Call Option, you pay a certain amount of premium to the seller which grants you the right but not the obligation to buy the underlying stock at a specified price strike price.
Purchasing a call option means that you are bullish about the market and hoping that the price of the underlying stock may go up. In order for you to make a profit, the price of the stock should go higher than the strike price plus the premium of the call option that you have purchased before or at the time of its expiration. In contrast, a Put Option is an option to sell an underlying Stock on or before its expiration date.
Purchasing a Put Option means that you are bearish about the market and hoping that the price of the underlying stock may go down. In order for you to make a profit, the price of the stock should go down from the strike price plus the premium of the Put Option that you have purchased before or at the time of its expiration. The above explanations were from the buyer's point of view.
The Put option seller, in return for the premium charged, is obligated to buy the underlying asset at the strike price.
Stock Trading vs. Option Trading
Similarly, the Call option seller, in return for the premium charged, is obligated to sell the underlying asset at the strike price. Actually, there is. As we know that going short means selling and going long means buying the asset, the same principle applies to options. Keeping this in mind, we will go through the four terms. Break-even point is that point at which you make no profit or no loss. The long call holder makes a profit equal to the stock price at expiration minus strike price minus premium if the option is in the money.
Call option holder makes a loss equal to the amount of premium if the option expires out of money and the writer of the option makes a flat profit equal to the option premium. Similarly, for the put option buyer, profit is made when the option is in the money and is equal to the strike price minus the stock price at expiration minus premium. And, the put writer makes a profit equal to the premium for the option. All right, until now we have been going through a lot of theory. How do options look like?
If you were to look for an options quote on Apple stock, it would look something like this: When this was recorded, the stock price of Apple Inc. In a typical options chain, you will have a list of call and put options with different strike prices and corresponding premiums.
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The call option details are on the left and the put option details are on the right with the strike price in the middle. The columns are the same for the put options as well. In some cases, the data provider signifies whether the option is in the money, at the money or out of money as well.
Option Strategies
Of course, we need an example to really help our understanding of options trading. We will go through two cases to better understand the call and put options. Put-call parity is a concept that anyone who is interested in options trading needs to understand. By gaining an understanding of put-call parity you can understand how the value of call option, put option and the stock are related to each other.
This enables you to create other synthetic position using various option and stock combination. Put-call parity principle defines the relationship between the price of a European Put option and European Call option, both having the same underlying asset, strike price and expiration date. If there is a deviation from put-call parity, then it would result in an arbitrage opportunity.
Traders would take advantage of this opportunity to make riskless profits till the time the put-call parity is established again. The put-call parity principle can be used to validate an option pricing model. If the option prices as computed by the model violate the put-call parity rule, such a model can be considered to be incorrect.
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The amount of cash held equals the call strike price. S0 is the initial price of the underlying asset and ST is its price at expiration. If the share price is higher than X the call option will be exercised. Else, cash will be retained. If the share price is lower than X, the put option will be exercised. Else, the underlying asset will be retained. This gives us the put-call parity equation. Equation for put-call parity:. We can summarize the payoffs of both the portfolios under different conditions as shown in the table below.
From the above table, we can see that under both scenarios, the payoffs from both the portfolios are equal. For put-call parity to hold, the following conditions should be met. However, in the real world, they hardly hold true and put-call parity equation may need some modifications accordingly. For the purpose of this blog, we have assumed that these conditions are met. Hence, put-call parity will hold in a frictionless market with the underlying stock paying no dividends. In options trading, when the put-call parity principle gets violated, traders will try to take advantage of the arbitrage opportunity.
An arbitrage trader will go long on the undervalued portfolio and short the overvalued portfolio to make a risk-free profit.
6 Options Trading Strategies for 2021
Let us now consider an example with some numbers to see how trade can take advantage of arbitrage opportunities. In this case, the value of portfolio A will be,. Portfolio B is overvalued and hence an arbitrageur can earn by going long on portfolio A and short on portfolio B. The following steps can be followed to earn arbitrage profits. Return from the zero coupon bond after three months will be This stock will be used to cover the short.
All About Options Strategy
So far, we have gone through the basic concepts in options trading and looked at an options trading strategy as well. Options are attractive instruments to trade in because of the higher returns. This way, the holder can restrict his losses and multiply his returns. While it is true that one options contract is for shares, it is thus less risky to pay the premium and not risk the total amount which would have to be used if we had bought the shares instead.
Thus your risk exposure is significantly reduced. However, in reality, options trading is very complex and that is because options pricing models are quite mathematical and complex. So, how can you evaluate if the option is really worth buying? The key requirement in successful options trading strategies involves understanding and implementing options pricing models.
In this section, we will get a brief understanding of Greeks in options which will help in creating and understanding the pricing models. Recall the moneyness concept that we had gone through a few sections ago. For OTM call options, the stock price is below the strike price and for OTM put options; stock price is above the strike price.
The price of these options consists entirely of time value.
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It is based on the time to expiration. You can enroll for this free online options trading python course on Quantra and understand basic terminologies and concepts that will help you in options trading. We know what is intrinsic and the time value of an option. We even looked at the moneyness of an option.
But how do we know that one option is better than the other, and how to measure the changes in option pricing. Greeks are the risk measures associated with various positions in options trading. The common ones are delta, gamma, theta and vega. With the change in prices or volatility of the underlying stock, you need to know how your options pricing would be affected.