Options basics
Sep. 16th, 2024 11:07 am![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
ny_quantThe holder of a call/put option (the long side) has the right to buy/sell the underlying stock at the agreed (strike) price from/to the seller (the short party, or the writer) before the agreed time in the future called maturity. To acquire this right, the buyer pays the seller a price for the option, known as premium. European options can be exercised only at maturity. American can be exercised any time before maturity. Most options in America are of course American. Unlike stocks, options trade in contracts of 100 calls or puts - that’s the minimum size that you can trade.
Example 1. Stock XYZ trades at 100. I bought a call option with strike $105. If the stock trades above $105 at/before maturity, I can buy the stock from an option seller for $105 and immediately sell it at the current price S in the market thus realizing instant profit S-105 per share.
Example 2. Stock XYZ trades at 100. I bought a put option with strike $95. If the stock trades below $95 at/before maturity, I can buy the stock in the market and immediately sell it to the option seller for $95 thus realizing instant profit 95-S per share.
Both of these situations – when the option holder can exercise them and receive profit – are describes as “options in the money” or ITM. The opposite situation is called “out of the money” or OTM. When the underlying price equals to strike we have an option at the money, ATM. In practice, you don’t have to exercise your options. You can sell them in the market exactly the same way as you bought them.
Conversely, an option seller can only sit and wait, hoping that the options that he sold would expire OTM worthless and he gets to keep his premium. Or he can close his position by buying it back at exchange.
The real question is – how much money you can make or lose on the trade? It should be very clear to you that the definition above translates into very simple formulas for the trade payoff:
Example 1. Stock XYZ trades at 100. I bought a call option with strike $105. If the stock trades above $105 at/before maturity, I can buy the stock from an option seller for $105 and immediately sell it at the current price S in the market thus realizing instant profit S-105 per share.
Example 2. Stock XYZ trades at 100. I bought a put option with strike $95. If the stock trades below $95 at/before maturity, I can buy the stock in the market and immediately sell it to the option seller for $95 thus realizing instant profit 95-S per share.
Both of these situations – when the option holder can exercise them and receive profit – are describes as “options in the money” or ITM. The opposite situation is called “out of the money” or OTM. When the underlying price equals to strike we have an option at the money, ATM. In practice, you don’t have to exercise your options. You can sell them in the market exactly the same way as you bought them.
Conversely, an option seller can only sit and wait, hoping that the options that he sold would expire OTM worthless and he gets to keep his premium. Or he can close his position by buying it back at exchange.
The real question is – how much money you can make or lose on the trade? It should be very clear to you that the definition above translates into very simple formulas for the trade payoff:
P(call) = D *[ max(S-K,0) – p] - commissions
P( put) = D * [max(K-S,0) – p] - commissions
where D is the direction (+1 for buyers and -1 for sellers), S is price of the underlying at the time of exercise (or at maturity for European options), K is the strike, and p is the option premium paid by buyer to seller. We can even combine it in one formula:P = D *[ max(CP*(S-K,0)) – p]where CP = +1 for call and -1 for put and I omitted commissions which are fairly small these days. It’s almost a zero-sum game.Potential gains/losses for buying/selling puts are limited by S, the price of underlying. For calls, they are unlimited. It is useful to have in mind the payoff profiles for calls and puts. I hope it is clear why they look this way.Long Put payoff profile below:
Calls and puts are often combined in various combinations or structures. The important one for us is the
horizontalvertical spread. It involves buying one call or put and selling another with the same maturity and different strike. For example, you are long a spread if your position is long call(K1) and short call(K2), where K1<K2 [typo fixed here] are the respective strikes. As a “homework”, I’d like you to figure out the maximum amount that can be made or lost on a spread trade, and to payoff profile of a spread trade. Если всё это ясно на 100%, пжста отметьтесь в комментариях, или поставьте лайк. Если нет, то напишите свои ответы для самопроверки. Ну и конечно самое время задать вопросы прежде чем мы перейдем к сути дела.
