Options are contracts that give the buyer (taker) the right to sell or buy securities at predetermined prices before or on predetermined dates. To get this right, the buyer is required to pay premiums to the seller (writer) of that contract.
For example, Thiotech Solutions Limited (TTS) has a share’s last sale price of $12. Their three-month available option would be TTS $12 call. The contract take has the right, not the obligation, to purchase 100 TTS shares for $12/share at any time until the set expiry date. As such, the taker will pay the purchase price (premium) to the option seller (writer). So, if the taker takes up the TTS shares buying rights at the set price, s/he must exercise that option before or on expiry.
On the other hand, the seller has the obligation of delivering 100 TTS shares at $12 per share should the taker exercise the option. Once the obligation has been accepted, the seller will receive and keep the premium irrespective of whether the option gets exercised or not.
Benefits of option trading
- Risk management: You can hedge against possible falls in your share values when you take put options.
- Time: You will have time to make up your mind because the call options share’s purchase price gets locked in. So, you will have time (until the date of expiry) to choose if you want to exercise that option to purchase shares or not.
- Diversification: Options make it possible for you to generate diversified portfolios. This is done at lower onset outlays as compared to direct purchasing of shares.
- Income generation: You have the option of making additional income when you write call options against the shares you have. This includes the shares you bought using any margin lending firm.
- Speculation: Options positions are easy to trade. This makes it easy for you to trade options without the intention of exercising them. Once there’s an indication of a possible market rise, you could then purchase call options. Likewise, if there’s a fall expectation, you have the option of purchasing put options. No matter the direction you choose, you can limit your losses and take profits before expiry.
- Leverage: This makes it possible for you to make high returns from lower initial outlays instead of direct investing. However, it is worth noting that leverage comes with more risks as compared to direct underlying share investments. Trading options can also make it possible for you to benefit from a share price change without the need to pay the full share price.
Fundamentals of option pricing
When thinking of options, the first and most important thing is to understand the calculations involving premium. Option premiums transform in accordance with different factors like underlying shares price and expiry duration left. Option premiums are divided into two – time value and intrinsic value, and some factors influence both.
This is the difference between an option’s exercise price and the underlying share’s market price at any time.
This represents the amount to be paid in the event the market moves in your favor. Time value varies out-of-the-money, at-the-money, and with in-the-money options. It’s highest for the at-the-money options.
Time value will decrease when the time comes close to expiry, and the chances of profit will reduce. When option value erodes, it is known as time decay. However, time value options do not have a constant decay rate. Instead, the decay is more rapid the more the expiry date nears.
The option taker
Option takers are traders or investors who anticipate a significant move of a given share price. When an option is taken, there is an opportunity to make leveraged profit with a limited and known risk.
Taking call options means you have the right to purchase shares that are covered by the option any time to expiry. When the price for underlying shares falls, the put options premiums typically rise.
Trading options is no rocket science. It does, however, require lots of understanding before you commence trading. It can be used to hedge bets and also protect you from the volatility of the market. You need to know the risks involved with each move to choose the most suitable one.