Good evening everyone! Let’s talk about the basic building block of options trading. For those beginner who has never traded options before, options is a derivative which derives from the financial instrument. The financial instrument can be stock, ETF, futures, forex, etc.. We would normally call the financial instrument as ‘underlying’.
The options market that I trade is US market. We all understand that US market is the most liquid market in the world which provides plenty of trading opportunity. For those of us who live in Asia, it is definitely an advantage as we can trade in the evening/night while keeping our full time job in the morning.
When we want to initiate a position in stock market, we will buy if we perceive that the stock price will go up or we will sell short if we think the stock price will go down. This short sell opportunity is not applicable to retail investor with smaller trading account. However, in options market, there are more flexibility in this essence. We can easily buy or sell the options.
There are two types of options; call options and put options.
1. Call options : Provide the Buyer the right to buy the stock/underlying at the agreed price on pre-defined date.
2. Put options: Provide the Buyer the right to sell the stock/underlying at the agreed price on pre-defined date.
Example, Stock A is trading at $100. The Buyer buys a Call contract from the Seller today. The agreed price is $110 and the pre-defined date is 1 month from today. After 1 month, the Buyer and the Seller check the price. There will be three scenarios. (Do note that as an Options trader, we can be either the Buyer or the Seller)
Scenario 1: The Stock A is trading at $140 – This options is ITM (In The Money)
Scenario 2: The Stock A is trading at $110 – This options is ATM (At the Money)
Scenario 3: The Stock A is trading at $90 – This options is OTM (Out of the Money)
When an options is ITM, Call options Buyer can exercise his right to buy the stock at this agreed price (which is $110 in this example) from the Seller. It also means that the Call options Seller has the obligation to sell the stock at $110 to the Buyer. Of course, as a Buyer, in order to enter into this contract, he/she needs to pay a small fee (options premium) to the Seller.
If the options is ATM or OTM, the Call options Buyer will not exercise it. The main reason is the Buyer can buy the stock directly from the market with cheaper price as compare to the agreed price. Since the Buyer does not exercise the options, he/she will lose his options premium that has been paid to the Seller upon entering into this Call contract.
Before this post becomes too academic, I would like to stop here. The idea above should be adequate for your to understand the concept and you can derive the concept to Put Buyer and Seller.
I have one tips to share. This should be a very original idea as I haven’t seen anyone using it yet. For those new options trader who always confuse the Buy Call, Buy Put, Sell Call, Sell Put, you can try the following:-
1. Call (use + sign as it represents up)
2. Put (use – sign as it represents down)
3. Buy (use + sign as it represents up/aspire the stock price to go up)
4. Sell (use – sign as it represents down/aspire the stock price to go down)
Next, we have 4 combination
1. Buy Call (++) -> +
2. Buy Put (+-) -> –
3. Sell Call (-+) -> –
4. Sell Put (–) -> +
a. 1 & 4 show + sign; it means that if you Buy Call or Sell Put, you hope the stock price to go up
b. 2 & 3 show – sign; it means that if you Buy Put or Sell Call, you hope the stock price to go down
c. If you Buy, you pay premium and if you Sell, you receive premium
At a glance, you may feel that there isn’t much different between 1 & 4 or 2 &3. In reality, there are a huge different. The different would require the understanding of Options Greek to appreciate. So what is Options Greek? I will leave it to the next post to explain. Cheers!