What is an options contract?

An options contract is a financial agreement between two parties that grants the buyer the right, but not the obligation, to buy or sell the underlying asset at a preset price on or before a specific date.

Types of options

Vanilla options are financial instruments that give holders the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (strike price) within a specific time period. There are two main types of vanilla options: call options, which give investors the right to buy the asset at the strike price, and put options, which give investors the right to sell at the strike price.

The other difference between options depends on when they can be exercised. American options can be exercised at any time before expiration, whereas European options can only be exercised at the stated expiry date.

The investment universe also has exotic options, which are special options contracts that are tailored to specific investment plans. They differ from vanilla options in their payment structures, expiration dates and strike prices. They also tend to be highly customised, less liquid and are based on more than one element or condition for determining a payout from the counterparty.

Why do investors use options?

Investors use options for three primary reasons: to speculate, hedge or generate income.

Speculation: Investors engage in speculation when they use options to bet on the direction and price movements of an asset.

Hedging: Investors use options to protect against potential losses (hedge) in an existing investment.

Income Generation: Investors can deploy specific strategies to generate income when they are bullish, neutral, or bearish on the underlying asset.

How do investors and traders speculate using options?

When investors or traders want to speculate on whether the price of an underlying asset (stocks, index, exchange traded fund) will increase or decrease, they can utilize either a call or put option.

Call Options: If an options trader believes that the price of an underlying asset will increase, they can buy call options. When the price of that asset rises above the strike price (the price at which an options holder buys an underlying asset) the call option trade becomes profitable. When the holder of a profitable trade decides to exercise that option by buying the asset at a lower strike price, they profit from the price difference.

Put Options: If an options trader believes that the price of the underlying asset will decrease, they can buy a put option. When the price of the asset falls below the strike price (the price at which an options holder sells an underlying asset), the put option will become profitable, which allows the holder of the option the right to exercise that option to sell the asset at a higher strike price, thereby profiting from the price difference.

Understanding the Greeks of options pricing

Pricing options contracts involves complicated mathematics that relies heavily on both the Black-Scholes and Binomial pricing models. Whilst complex, an options price consists of both intrinsic value (the amount the option is 'in-the-money') and time value (the potential for the option to increase in value before expiration).

It's this delicate interplay between scientific modelling and real-world market conditions that helps investors understand and price the risk of each option.

All the risks that influence option pricing are named after Greek letters, all of which indicate how sensitive an option is to the time-value decay, changes in implied volatility, and the movements in the price of the underlying security.

Delta: Is a measure of the change in an option's price or premium resulting from a change in the price of the underlying asset.

Gamma: Measures the delta's rate of change over time, including the rate of change in the underlying asset. It helps to forecast price moves in any underlying asset.

Vega: Measures the risk of changes in implied volatility or the forward-looking expected volatility of the underlying asset price.

Theta: Measure the time decay in the value of an option or its premium

How do investors or traders hedge risk using options?

Investors and traders in financial markets assume market risk when they buy or sell options because the market can move against their price assumptions. To help them reduce this risk, they can  hedge or protect themselves against adverse price movements by following these steps.

1. Identify the Risk: Assess the overall investment portfolio to identify the assets that are exposed to significant risk. These could be single stocks, a collection of stocks (such as an ETF), foreign exchange, commodities, or other assets.
2. Choose the Right Option: Find out whether a call or put option will provide you with the best hedging strategy. When an investor or trader wants protection (hedge) against a decline the price of an underlying asset, a long put option is the right choice. If an investor or trader wants protection against the cost of a rising underlying asset, a long call option is the more suitable option.
3. Select the Strike Price and Expiry: The strike price is the price at which the option can be exercised, and the expiry date is when the option contract ends. If the option is in the money, the strike price is favourable to the underlying asset's current market price. When the option is out of the money, the strike price is disadvantageous to the underlying asset's current market price.
4. Monitor and Adjust: Once the hedge is in place, it should be monitored and adjusted continuously depending on market conditions to maintain the required level of protection (hedging).

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How do investors / traders use options to generate income?

Both long-term investors and short-term traders can use options to generate income through different investment strategies, including selling options using covered calls or selling puts. They can also sell short calls or short puts, both of which can be used to collect premium (income).

Covered Calls and Selling Puts:

• Covered Calls:

A covered call option involves a financial transaction where the investor selling the call option owns an equivalent amount of the underlying security. When making a 'covered call trade' the options trader holds a long position in an asset and simultaneously sells the call options on that same asset. If the underlying asset price does not rise significantly before the option expires, the options trader keeps the premium (income) and the options expire worthless.

• Selling Puts:

This trading strategy involves selling put options on an asset you are bullish on or want to acquire at a lower price. If the underlying asset price remains above the strike price at expiration, the put option expires worthless, and the trader keeps the premium. The trader collects the premium when selling a put option, generating income.

Buying Options:

• Long Calls:

If a trader expects the price of an underlying asset to increase, they can buy call options, which gives them the right to purchase the asset at a specific price (the strike price) within a certain timeframe. If the price rises above the strike price, the trader can exercise the option and profit from the price difference or sell the option for a profit if the price increases.

• Long Puts:

If a trader expects the price of an underlying asset to decrease, they can buy put options, which gives them the right to sell the asset at a specific price (the strike price) within a certain timeframe. If the price falls below the strike price, the trader can exercise the option and profit from the price difference. They can also sell the option for a profit, if the price decreases.

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What are the risks associated with hedging when using options?

While options can be a robust tool for hedging, they also carry risks and costs. It is therefore very crucial to understand these intricacies before using options as a hedging strategy. An inadequate understanding can result in poor decision-making and massive financial losses.

Options aren't free; they come at a cost, and the cost paid for the option could result in a financial loss if the price movement does not go as expected. There's also the risk that comes with trying to time the market. This risk is more pronounced with European options because you can only exercise them on the expiration date, which means  you might miss out on any beneficial price movements before then. American options also carry some risk because a favourable price movement could reverse before you decide to exercise the option.

Lastly, options require a high degree of forecasting and risk management. If your predictions about the market are incorrect, you could either miss a favourable opportunity or face losses.

How do traders speculate (profit from the price changes) using options?

Option traders buy call options when they believe that the price of the underlying asset will increase. If the price of the underlying asset rises above the strike price, the call option becomes profitable, and the holder can exercise the option to buy the asset at the lower strike price and profit from the price difference.

Option traders buy put options when they anticipate that the price of the underlying asset will decrease. If the price of the underlying asset falls below the strike price, the put option becomes profitable, and the holder can exercise the option to sell the asset at the higher strike price and profit from the difference.

How to apply leverage when using options

Options provide the investor with the ability to use leverage, allowing the options buyer to pay a relatively small premium for market exposure relative to the contract’s value. Instead of buying 100 shares of a stock, you can buy an option contract, which gives you the right (but not the obligation) to buy or sell that underlying asset. If the price of the underlying asset moves in your favour, the value of your option contract can result in magnified profits.

However, leverage also has downside implications; if the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage can also magnify the investment's percentage loss. Options offer their owners a predetermined, set risk. However, if the owner's options expire with no value, the loss can equal the entire amount of the cost paid for the option.

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What is triple witching hour?

The triple witching hour is the last sixty minutes of the trading day on the third Friday of March, June, September, and December. On these specific days, financial derivative contracts for stock index futures, stock index options and stock options all expire simultaneously. While the entire triple witching day is associated with unusual price fluctuations and a spike in trading activity as traders close, roll out or offset their expiring positions. In the last sixty minutes of each triple witching trading day, market volatility is more pronounced and offers investors increased opportunities to put more capital to work and profit.

Triple witching day trading strategies

Depending on whether you're a short-term trader or long-term investor, triple witching day can be either a good trading opportunity or largely a non-event.

For short-term option traders, it offers increased volatility, creating potential quick trading opportunities. Day traders can buy short-term dips and then sell them the same day or shortly thereafter for a profit. They're also able to short sell, which allows them to profit from a falling price of the underlying asset.

During triple witching day, there is a strong likelihood of large price swings as all expiring stock options become zero-day options, meaning they have little time value remaining, which could make even the most modest stock moves very profitable.

Options FAQs

What is the difference between American and European options?

American options can be exercised at any time before expiration. European options can only be exercised at a stated expiry date.

What is an in-the-money option?

An in-the-money option has intrinsic value because the strike price is favourable compared to the current market price of the underlying asset. This means  the option holder can exercise the contract for a profit.

What is an out-of-the-money option?

An out-of-the-money option is where the strike price is unfavourable relative to the current market price of the underlying asset. This means that it has no intrinsic value, and if the option holder exercised the contract, they would do so at a loss. If the options holder held it until the expiry date, it would expire without value.

What is a zero-day option?

A zero-day option is a normal put or call option that expires in less than one day. Option traders typically buy or sell options well in advance of their expiration date.

When does triple witching happen?

Triple witching occurs four times a year (or once a quarter) on the third Fridays of March, June, September, and December.

Who regulates options trading?

In the United Kingdom, the Financial Conduct Authority regulates options trading, while in the United States, the Securities and Exchange Commission, Commodity Futures Trading Commission and the Financial Industry Regulatory Authority all play a role in regulating the options market.

How do you calculate leverage?

If a stock is trading at $100 and the option premium is $10, the leverage ratio would be 10:1. This is calculated by dividing the stock price by the option premium.

What are binary options?

Binary options are  financial derivatives that allow people to make all-or-nothing bets on events and asset price changes. As the name suggests, they are based on a yes or no answer, where the buyer receives a payout or nothing at expiration.

Are binary options regulated?

The regulation of binary options varies by country. While some binary options are traded on registered exchanges or designated contract markets, which are subject to oversight by regulators like the Commodity Futures Trading Commission or the Securities and Exchange Commission, much of the trading in binary options goes through unregulated offshore platforms, which makes them susceptible to fraud and scams.

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This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.