There are many financial instruments you can trade to try and make a profit. Most people are familiar with a common share of stock which represents a share of the company itself, but another very common investment instrument are options, which are a little more complex.
Options are instruments that allow you to trade future price changes in a stock or other asset. Each option represents the right, but not an obligation, to buy or sell a stock or asset at a set future date. It is the lack of obligation, making it an option to buy or sell, that gives this instrument its name. In US markets, one options contract is usually a buy or sell order for a block of 100 shares.
Often known as derivatives because they derive their price from another instrument or asset, there are two types of Options we can use, Call Options and Put options.
Call options give users the option to BUY an asset in the future at a specific price (the strike price) and date (expiration), while put options give is the option to SELL the asset in the future at a specified strike price and expiration date. This gives options traders significant flexibility.
For instance, an option may be for buying a specific stock in 3 months time at $250 (known as the strike price), with the underlying market price currently at $225 (known as the spot price). If you think the price of the stock is going to rise above that $250 level during those three months, then you may look at starting a call option position. As soon as the stock goes above that $250 level, the options trade is “in the money” or “ITM” (meaning you would be profitable if you exercised the right to buy shares at $250 and sell them on the open market at a price higher than $250). This can be at any point in that 3-month period, not specifically on the last day of the option contract.
This flexibility means you can use an option to trade in a falling market as well. In this case, you would purchase the right to sell the underlying stock at a specified rate below the current price so that once the market price dips below the option price, then that options trade would also be in profit or “in the money”
Figure 1: This image shows an options chain on TD Ameritrade which displays the contracts that are “in the money” and “out of the money based on the yellow and white shading.
History of Options Derivatives
We commonly think of most trading instruments as modern creations. After all, they are generally very sophisticated investment vehicles. However, trading stocks and commodities actually go back to early civilizations. Options are no different, with the earliest known examples going as far back as ancient Greece. Specifically, before 350BC, as they are referenced by the philosopher Aristotle in his writings. In the book ‘Politics’, he describes how Thales of Miletus made a fortune buying up options on the right to use olive presses, right before a strong harvest.
Options were seen again in the middle ages, where credit contacts were used by traders to agree to purchase cargo if the ship transporting it failed to arrive on time for the original supplier, a good example of the kind of risk mitigation that many investors use options for today.
Modern options as we use them today rise from the opening of the Chicago Board of Trade in 1848, where futures contracts became part of the regulated market system. Over time, this futures market become more structured, with first the Grain Futures Act of 1922 creating the oversight that eventually became the Commodity Futures Trading Commission.
However, while futures derivatives were fully established as part of investment portfolios throughout that period, options continued outside of the regulatory bodies, both in the US and across the world, including being made illegal in some areas of Europe, due to cases where a winning trade was turned into massive losses by the option seller not being able to fulfill the promise of the option asset.
In this unregulated world, every option was negotiated individually between two parties, and in the early 1900’s, this allowed a rise in fraudulent brokerage houses that offered fake securities to the gullible. Of course, this was a result of the unregulated nature of options at the time, which could have been solved much earlier by regulation itself.
After the 1929 market crash, a more formal regulation of all markets was put into place, including options, covered by the Securities Act of 1933. However, it was not until the grain crisis in the 1960’s that the Chicago Board Options Exchange was created to provide the dedicated markets for options trading as we understand it today, finally opening its doors in 1973.
Figure 2: An image of the inside of the Chicago Board Options Exchange. Image from Financial Tribune.
In those initial years after 1973, options trading was restricted entirely to call options in a market of just 16 stocks. The popularity of options, along with the changing needs of investors, has been expanded in today’s market, which includes call and put options that offer the options to buy or sell a huge number of stocks and indices, including the S&P 500 and NASDAQ-100 among others. Today, you can find options for almost any stock you can think of, and with the introduction of mini options, covering an option to buy or sell just 10 shares of a stock rather than the standard 100, along with weekly options that expire each Friday, the market has now become incredibly flexible.
Types of Options Derivatives
There are two variables with any option derivative, the strike price, that is the price of the asset you are getting the option to buy or sell, and the expiration date of the option, that is the time it is valid for. The second of those, the expiration date, is a crucial aspect of how you may pursue your options trading strategy. This can be split into two variations, short-term and long-term option derivatives.
Short-term options offer quick opportunities, but that is not the only thing that is different compared to longer-term option trading. As the expiry date of an option gets closer, the value of that option decreases as it is less likely to see a market move enough to put it in the money. In that way, short-term options usually thought of as 10 days or less until the expiration date, offer a more cost-effective trade, but also a riskier one.
With the time period short, any volatility, such as an interest rate announcement or other fundamental announcements, could remove any chance of a successful trade with no time to recover. The risks are much higher for this kind of trade, compared to longer-term trades that features expiry dates of a few weeks or months, where short-term market movements are not as big of an issue but can still affect the price of the longer-term premium.
Longer term options trading brings a different set of challenges. With expiration dates of 9 months or more, and as long as two and a half years, these options are known as LEAPS, Long-term Equity AnticiPation Securities. These options last so long that they are often used as an alternative to buying shares when looking to profit from a business. In operation they work the exact same way as all other options, however, the longer timeframes bring some advantages.
LEAP options give you a long time to realize profits and they lend themselves to a more risk-averse trading style much more than short-term options. Although, it is important to remember that even though the expiration is a long one on LEAPs, they do still expire, and you need to complete your trade when it is most profitable.
Options Derivatives: The Greeks
The Greeks are the terms used to describe the various aspects of risk associated with any options trade. They are called this as each term is represented by a Greek symbol, each one representing several variables in the underlying trade.
There are 4 Greek values that are most often used in trading decisions:
Theta – This represents the rate of change between the option price itself and the time remaining until the expiry date. This means how much the option price will fall for a given movement in time. As an example, a Theta value of -0.20 would mean that the Option’s price would fall by 20 cents per day, discounting any other changes.
Figure 3: This is the symbol for Theta.
Delta – Delta represents the rate of change between the option price and a $1 change in the price of the asset. For call options, the Delta value us between 0 and 1, while for put options, the range is 0 and -1. As an example, if the Delta value was 0,20, then for every $1 rise in the stock or another asset, the option price would rise 20 cents in theory.
Figure 4: This is the symbol for Delta.
Vega – The Vega value is a representation of the relationship between the option value and the implied volatility of the underlying asset. It is used to show the amount of price change per 1% of volatility change. Using our 0.20 value again, this level of Vega would show a 10-cent change if the implied volatility changed by 1%.
Figure 5: This is the symbol for Vega. This image is from binaryoptions.com.
Gamma – This value is an analysis of another Greek value, Delta. Gamma is used to show the rate of change between the asset price and the options Delta value. This is known as the second-order price sensitivity, and it represents how much Deltas would change for a $1 change in the asset price. With a Gamma value of 0.05 and a Delta Value of 0.30, then the Delta value would change by 0.05, becoming 0.35 if the change was positive, and 0.25 if it were negative.
Options Derivatives Strategies
As with all trading instruments, there are as many strategies for using options as there are traders using options. However, there are some approaches that make full use of the unique properties of options, especially time decay. Time decay is important because the time to expiry of an option is a quantifiable number, it’s not abstract or approximation, it is always a known value, and in financial trading, that is a rare thing.
Thanks to Theta values, we can see how the option could perform as it gets closer to the expiration date. A positive value means that the option increases in value, a negative Theta number means it will lose value.
With that information, one of the most successful strategies for options trading has been creating what are known as Iron Condors. These are intended to mitigate the risk and allow you to exploit the theoretical value of the movement in option price over time that Theta shows.
AN iron condor means taking opposing positions, so both a put and call option across the trading range of the asset, so sell the top of the range with a put option and then create a call option set at a level just above. In addition, post a call option for the bottom of the range, and a put option just below it.
This approach manages risk and allows you to benefit from the one certainty of options, that they change in value with the passage of time.
Hedge Fund Options Strategies
Hedge funds take on risk when they take a position in any market, just as every investor does. To mitigate that risk, hey often employ Option strategies that offset the downsides of their investment strategy.
Here they often offset price risk by creating an option position with a Delta value equivalent to the current position held, but in the opposite direction. Because hedge funds are committed to staying market neutral, this is a commonly used approach, with options enabling balanced positions in a simple way.
Options Derivative Hedge
It is not just hedge funds that are able to use Options to mitigate risk and act as insurance for investment positions. Many traders take this approach on a smaller scale, using simple strategies such as covered calls to protect against price movements. Here, if you have a long position on an asset or market, you would then write call options, that is, sell the option on that position to cover the risk.
This is not the only option, though, and options have proven an effective way for individuals and organizations to hedge against risk.
Hedging with Options
Options are perhaps some of the most versatile instruments available to us as investors, but to understand how they can be used effectively for hedging. The way this is most easily accomplished is through the use of a spread strategy.
By taking positions in both directions on a market, you can effectively minimize risk and in most circumstances produce a position that delivers at worst break even or small loss. This approach to managing risk through options makes full use of their flexibility and the exceptional analysis of the Greek values.
Figure X: Hedging reduces the risk of being this guy…
Options are a versatile and useful tool in any investment or trading portfolio. The ability to take either short or long positions in markets, and even both at once, set them apart as both a tool for trading and a way to mitigate risk. However, when used incorrectly, these vehicles and destroy an account if the user goes in too heavy and the market changes direction, not in favor of the contract.
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