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Options Trading

Purchasing an option gives the buyer the right, but not the obligation, to buy or sell a specific amount of an underlying security at a specific price within a specified time period. By comparison, a futures contract requires both the buyer and the seller to perform under the terms of the contract, if an open futures position is not offset before expiration.

The decision whether or not to exercise an option is entirely that of the options buyer.

An option buyer cannot lose more than the amount he or she invested in the options premium. The same cannot be said, however, for the buyer of a futures contract.

An option buyer is never subject to margin calls. This enables the buyer to maintain a market position, despite any adverse moves, without putting up additional funds.

Following are some further options basics:

•  Buying an option gives you the right to buy or sell an underlying security.
   
• As an options buyer, you have the right, but not an obligation, to buy or sell an underlying security at a specified price.
   
• As an option seller (writer), you have obligations to the options buyer.
   
• There are two types of options:
  • Calls (call options) - give you the right to buy an underlying security.
  • Puts (put options) - give you the right to sell an underlying security.
  • Each option corresponds to 100 shares of an underlying security.
  • The price of an option depends on several factors:
  • The current price of the underlying security;
  • The strike price of the option;
  • The amount of time remaining until the option expires;
  • The volatility of an underlying security.
     
• Strike Price. The price at which an underlying security can be purchased or sold, if an option is to be exercised.
   
• Expiration Date. The date on which an option expires. It is the 3rd Friday of the expiration month. Each option has an expiration day. After expiry, you have lost the right to buy or sell the underlying security at the strike price.
   
• Premium. The price of an option. If an option costs $3 per contract, your total premium is $300 (one contract = 100 shares), plus commission (transaction) costs.
   
• Please note that options are not available on every stock (i.e., not all stocks are optionable).

Options Open Interest

For a given option, the open interest is the number of open contracts - either puts or calls - that have not been exercised, closed or expired on a particular day. While each open transaction has a buyer and a seller, for the purposes of calculating the open interest, only one side of the contract is counted. Open interest increases when a buyer opens a put or call position and, vise versa, it decreases when a buyer sells/closes a put or call position.

For Example:

• On Jan 1 A buys an option which leaves an open interest and also creates trading volume of 1.
   

• On Jan 2 C and D create trading volume of 5 and there are also 5 more options left open.
   

• On Jan 3 A takes an offsetting position and therefore open interest is reduced by 1, and trading volume is 1.
   

• On Jan 4, E simply replaces C and therefore open interest does not change, trading volume increases by 5

Volume and open interest are important indicators in futures and equities markets.

An option’s fair value is simply its value at the current moment. The fair value will therefore fluctuate with market conditions.

It is important to know the parameters that affect the price of an option:

• Valuation Date: This is the date for which you are determining an option’s fair value (i.e., the current date.)
   
• Expiration Date: The date on which an option expires. After this date, it cannot be exercised and is therefore worthless..
   
• Price: The price of an underlying security – provides the basis for pricing the option at the time of its valuation.
   
• Strike Price: This is the price at which the option may be exercised.
   
• Volatility: The volatility of an asset provides a measure of the random variability or dispersion of price data per unit of time, usually quoted as the annual standard deviation of an asset's price.
   
• Type of option: Call or put.
   
• Option Style: There are American style and European style options. American style options can be exercised at any time up to the expiration date. European style options may be exercised only on the expiration date itself.

On an options exchange, every 3rd Friday of the month is an expiration day – this means that a number of options series expire on this day.

At the end of the expiration date, all those call options whose strike prices are higher than the price of the underlying stock or index will be worthless. On the other hand, those options series, whose strike prices are lower, will have some intrinsic value and may be exercised. In the case of put options, the opposite applies.

The options expiration date is the most important factor in calculating options prices:

• The Black Scholes model is used to price European style options. This is done by factoring in current stock prices, strike prices, time left until expiration, interest rates, any dividends, as well as the volatility of the underlying security.
   
• The binomial model is used to price American style options. The binomial model calculates a tree of stock prices for various given time intervals within the expiration period. Using the volatility of a stock and the time left to expiration, the model determines how much a stock might increase or decrease in value. This calculation gives all possible prices for a stock. Then, working backward from the expiration date to the present, option prices are calculated using a risk neutral valuation. Ultimately, a each option is priced .

Option Style: There are American style and European style options. American style options can be exercised at any time up to the expiration date. European style options may be exercised only on the expiration date itself.

Investing in Options

Before you begin investing in options, you must decide how much of your money you can safely put at risk. If you are new to options, we recommend no more than 10% of your portfolio.

Remember:

• With every passing day, your option loses time value
   
• The easiest way to profit from options is to be an options buyer. You simply buy calls if you think the index will rise, or puts, if you think the index will fall.
   
• If the index price rises above the strike price of your call option, or if the index falls below the price of your put option, you win your bet.
   
• If the index does not move the way you thought it would, you could lose the entire premium you paid for your option.

Never wait for an option to expire, always sell it before the expiry date:

Just as important as selecting the right option and paying the right price is knowing how and when to take profits. Most option buyers lose, not because they buy the wrong option, but because they fail to take profits properly.

• When your option begins to show a profit, you must get ready to act.
   
• Get ready to sell your position if the index drops by 5%(if you bought a call option), or if it rises by 5% (if you bought a put option).
   
• If your option is in the money and the index makes a big move in your favor, sell your position and pocket the profit.
   
• Also take profits if your option is in the money, moves past the strike price and enters its last week before expiration.

Cutting your losses is just as important as taking profits.

• The hardest part is convincing yourself to cut your losses.
   
• If you do not cut your losses quickly, you will not last as an options player.
   
• If you own an option that has fallen by 50% or more, sell it and close out your position.

Basically, as an options trader you have to know

• When to buy
   
• When to sell
   
• Your likely profit target
   
• At what predetermined target will you take a loss

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