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Trading Stock OptionsIn finance options are types of derivative contracts, including call options and put options, where the future payoffs to the buyer and selle Since the option gives the buyer a right and the writer an obligation, the buyer pays the option premium to the writer. The buyer is considered to have a long position, and the seller a short position. For every open contract there is a buyer and a seller. Traders in exchange-traded options do not usually interact directly, but through a clearing house such as, in the U.S., the Options Clearing Corporation (OCC). The clearing house guarantees that an assigned writer will fulfill his obligation if the option is exercised. Options/Derivatives are not rated and/or are below investment grade; however the OCC's clearing process is considered AAA rated. Whether it is a put option or call option. Put options give the holder the right to sell the asset at the strike price. Call options give the holder the right to purchase the asset at the strike price. Traded options (also called "Exchange-Traded Options" or "Listed Options") is a class of Exchange traded derivatives. As for other classes of exchange traded derivatives, trade options have standardized contracts, quick systematic pricing, and are settled through a clearing house (ensuring fulfillment).
Vanilla options are 'simple', well understood, and traded options; Exotic options are more complex, or less easily understood. Asian options, lookback options, barrier options are considered to be exotic, especially if the underlying instrument is more complex than simple equity or debt. Employee stock options are issued by a company to its employees as compensation. The premium for an option contract is ultimately determined by supply and demand, but is influenced by five principal factors: The price of the underlying security in relation to. The strike price. Options will be in-the-money when there is a positive intrinsic value; when the strike price is above/below (put/call) the security's current price. They will be at-the-money when the strike price equals the security's current price. They will be out-of-the-money when the strike price is below/above (put/call) the security's current price. Options at-the-money or out-of-the-money have an intrinsic value of zero. The cumulative cost required to hold a position in the security (including interest + dividends). The time to expiration. The time value decreases to zero at its expiration date. The option style determines when the buyer may exercise the option. Generally the contract will either be American style ！ which allows exercise up to the expiration date ！ or European style ！ where exercise is only allowed on the expiration date ！ or Bermudan style ！ where exercise is allowed on several, specific dates up to the expiration date. European contracts are easier to value. Due to the "American" style option having the advantage of an early exercise day (i.e. at any time on or before the options expiry date), they are always at least as valuable as the "European" style option (only exercisable at the expiration date). The estimate of the future volatility of the security's price. This is perhaps the least-known input into any pricing model for options, therefore traders often look to the marketplace to see what the implied volatility of an option is ！ meaning that given the price of an option and all the other inputs except volatility you can solve for that value. Pricing models include the Binomial options pricing model for American options and the Black-Scholes model for European options. Even though there are pricing models, the value of an option is a personal decision, requiring multiple trade offs and depending on the investment objective. Because options are derivatives, they can be combined with different combinations risk-free T-bills the underlying security, and futures contracts on that security to create a risk neutral portfolio (zero risk, zero cost, zero return). In a liquid market, arbitrageurs ensure that the values of all these assets are 'self-leveling', i.e. they incorporate the same assumptions of risk/reward. In theory traders could buy cheap options and sell expensive options (relative to their theoretical prices), in quantities such that the overall delta is zero, and expect to make a profit. Nevertheless, implementing this in practice may be difficult because of "stale" stock prices, large bid/ask spreads, market closures and other symptoms of stock market illiquidity. If stock market prices do not follow a random walk (due, for example, to insider trading) this delta neutral strategy or other model-based strategies may encounter further difficulties. Even for veteran traders using very sophisticated models, option trading is not an easy game to play. Models of option pricing were very simple and incomplete until 1973 when Fischer Black and Myron Scholes published the Black-Scholes pricing model. Scholes received the 1997 Bank of Sweden Prize in Economic Sciences (Nobel Prize of Economics) for this work, along with Robert C. Merton. In a departure from tradition, Fischer Black was specifically mentioned in the award, even though he had died and was therefore not eligible. The Black-Scholes model gives theoretical values for European put and call options on non-dividend paying stocks. The key argument is that traders could risklessly hedge a long options position with a short position in the stock and continuously adjust the hedge ratio (the delta value ！ one of the option sensitivities known as "Greeks") as needed. Assuming that the stock price follows a random walk, and using the methods of stochastic calculus, a price for the option can be calculated where there is no arbitrage profit. This price depends only on 5 factors: the current stock price, the exercise price, the risk-free interest rate, the time until expiration, and the volatility of the stock price. Eventually, the model was adapted to be able to price options on dividend paying stocks as well. The availability of a good estimate of an option's theoretical price contributed to the explosion of trading in options. Other option pricing models have since been developed for other markets and situations using similar arguments, assumptions, and tools, including the Black model for options on futures, Monte Carlo methods, Path Integrals, and Binomial options models. As with all securities, trading options entails the risk of the option's value changing over time. However, unlike traditional securities, the return from holding an option varies non-linearly with the value of the underlier and other factors. Therefore, the risks associated with holding options are more complicated to understand and predict.
Thus, at any point in time, one can estimate the risk inherent in holding an option by calculating its hedge parameters and then estimating the expected change in the model inputs, dS, dσ and dt, provided the changes in these values are small. This technique can be used effectively to understand and manage the risks associated with standard options. For instance, by offsetting a holding in an option with the amount − Δ of shares in the underlier, a trader can form a delta neutral portfolio that is hedged from loss for small changes in the underlier price. The corresponding price sensitivity formula for this portfolio is: A call option expiring in 99 days on 100 shares of XYZ stock is struck at $50, with XYZ currently trading at $48. With future realized volatility over the life of the option estimated at 25%, the theoretical value of the option is $1.89. The hedge parameters Δ, Γ, κ, θ are (0.439, 0.0631, 9.6, and -0.022), respectively. Assume that on the following day, XYZ stock rises to $48.5 and volatility falls to 23.5%. We can calculate the estimated value of the call option by applying the hedge parmeters to the new model inputs as: Under this scenario, the value of the option increases by $0.132 to $2.022, realizing a profit of $13.20. Note that for a delta neutral portfolio, where by the trader had also sold 44 shares of XYZ stock as a hedge, the net loss under the same scenario would be ($8.75). A special situation called pin risk can arise when the underlier closes at or very close to the option's strike value on the last day the option is traded prior to expiration. The option writer (seller) may not know with certainty whether or not the option will actually be exercised or be allowed to expire worthless. Therefore, the option writer may end up with a large, unwanted residual position in the underlier when the markets open on the next trading day after expiration, regardless of their best efforts to avoid such a residual. The most common way to trade stock options is trading standardized options contracts that are listed by various futures and options exchanges ！ there are currently six exchanges in the United States that list standardized options contracts based on underlying stocks ！ The Philadelphia Stock Exchange (PHLX), American Stock Exchange (AMEX) and NYSE Arca in San Francisco, and the Chicago Board Options Exchange (CBOE) which are all open-outcry marketplaces, and the International Securities Exchange (ISE) and Boston Options Exchange (BOX) are electronic marketplaces. However, even for the non-electronic exchanges, competition and the introduction of automated execution (AutoEx) has led, by late 2006, to hybridization where all but the largest trades are executed electronically. In Europe the main exchanges where stock options are traded are Euronext.liffe and Eurex. There are also over-the-counter options contracts that are traded not on exchanges, but between two independent parties. At least one of those parties is usually a large financial institution with a balance sheet big enough to underwrite such a contract. The basic trades or traded stock options These trades are described from the point of view of a speculator. If they are combined with other positions, they can also be used in hedging. Long Call Payoffs and profits from a long call.A trader who believes that a stock's price will increase might buy the right to purchase the stock (a call option) rather than just buy the stock. He would have no obligation to buy the stock, only the right to do so until the expiry date. If the stock price increases over the exercise price by more than the premium paid, he will profit. If the stock price decreases, he will let the call contract expire worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same amount of money, he can obtain a larger number of options than shares. If the stock rises, he will thus realize a larger gain than if he had purchased shares. This is an example of the principle of leverage. Short Call (Naked short call) A trader who believes that a stock price will decrease can short sell the stock or instead sell a call. Both tactics are generally considered inappropriate for small investors. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases, the short call position will make a profit in the amount of the premium. If the stock price increases over the exercise price by more than the amount of the premium, the short will lose money. Unless a trader already owns the shares which he may be required to provide, the potential loss is unlimited. However, such a trader who sells a call option for those shares he already owns has sold a covered call. Long Put Payoffs and profits from a long put.A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price. He will be under no obligation to sell the stock, but has the right to do so until the expiry date. If the stock price decreases below the exercise price by more than the premium paid, he will profit. If the stock price increases, he will just let the put contract expire worthless and only lose his premium paid. Short Put (Naked put) Payoffs and profits from a short put.A trader who believes that a stock's price will increase can sell the obligation to buy the stock at a fixed price. The trader now has the obligation to purchase the stock at a fixed price. Hence when the price of the stock falls, the trader is committed to buying the stock at a fixed price and hence will lose money generating the negative payoff. When the price of the stock rises, the counterparty will not exercise their right to sell at a fixed price and hence the gain of the trader is the premium. In some exchanges the option contracts are cash settled as well. The trader has sold insurance to the buyer of the put requiring the trader to insure the stockholder below the fixed price. This trade is generally considered inappropriate for a small investor. If the stock price increases, the short put position will make a profit in the amount of the premium. If the stock price decreases below the exercise price by more than the premium, the short position will lose money. Combining any of the four basic kinds of option trades (possibly with different exercise prices) and the two basic kinds of stock trades (long and short) allows a variety of options strategies. Simple strategies usually combine only a few trades, while more complicated strategies can combine several. Covered call Long the stock, short a call. The term "buy-write" also is used for this strategy. This has essentially the same payoff as a short put. Covered call = Long stock + Short call Straddle Long a call and long a put with the same exercise prices (a long straddle), or short a call and short a put with the same exercise prices (a short straddle). Same exercise Prices Long Straddle = Long Call + Long Put Short Straddle = Short Call + Short Put Strangle Long a call and long a put with different exercise prices (a long strangle), or short a call and short a put with different exercise prices (a short strangle). At different exercise price Long strangle = Long call + Long put Short strangle = Short call + Short put Bull spread Long a call with a low exercise price and short a call with a higher exercise price, or long a put with a low exercise price and short a put with a higher exercise price. Long call @ Low Exercise Price Short call @ higher exercise price or Long a put @ low exercise price Short a put @ higher exercise price Bear spread Short a call with a low exercise price and long a call with a higher exercise price, or short a put with a low exercise price and long a put with a higher exercise price. Short call @ Low Exercise Price Long call @ higher exercise price or Short a put @ low exercise price Long a put @ higher exercise price Butterfly Butterflies require trading options with 3 different exercise prices. Assume exercise prices X1 < X2 < X3 and that X1 + X3 = 2〜X2 X1 X2 X3 are exercise prices X1 < X2 < X3 and X1 + X3 = 2〜X2 Long butterfly ！ long 1 call with exercise price X1, short 2 calls with exercise price X2, and long 1 call with exercise price X3. Alternatively, long 1 put with exercise price X1, short 2 puts with exercise price X2, and long 1 put with exercise price X3. Long call @ X1 Short call @ X2 Short call @ X2 Long call @ X3 OR Long put @ X1 Short put @ X2 Short put @ X2 Long put @ X3 Short butterfly ！ short 1 call with exercise price X1, long 2 calls with exercise price X2, and short 1 call with exercise price X3. Alternatively, short 1 put with exercise price X1, long 2 puts with exercise price X2, and short 1 put with exercise price X3. Short call @ X1 Long call @ X2 Long call @ X2 Short call @ X3 Or Short put @ X1 Long put @ X2 Long put @ X2 Short put @ X3 Condor Condors require trading options with 4 different exercise prices. Assume exercise prices X1 < X2 < X3 < X4 and that X1 + X4 = X2 + X3. Note that a condor is like a butterfly but has two center prices instead of one. Thus, while a butterfly has strike prices X1, X2, X2, X3, a condor has strike prices X1, X2, X3, X4. The short and long butterfly combinations above can be used to construct short and long condors as well. Long condor ！ long 1 call with exercise price X1, short 1 call with exercise price X2, short 1 call with exercise price X3, and long 1 call with exercise price X4. Alternatively, long 1 put with exercise price X1, short 1 put with exercise price X2, short 1 put with exercise price X3, and long 1 put with exercise price X4. X1 X2 X3 X4 are exercise prices X1 < X2 < X3 < X4 and X1 + X4 = X2 + X3 Long call @ X1 Short call @ X2 Short call @ X3 Long call @ X4 OR Long put @ X1 Short put @ X2 Short put @ X3 Long put @ X4 Short condor ！ short 1 call with exercise price X1, long 2 calls with exercise price X2, and short 1 call with exercise price X3. Alternatively, short 1 put with exercise price X1, long 2 puts with exercise price X2, and short 1 put with exercise price X3. X1 X2 X3 X4 are exercise prices X1 < X2 < X3 < X4 and X1 + X4 = X2 + X3 Short call @ X1 Long call @ X2 Long call @ X3 Short call @ X4 Or Short put @ X1 Long put @ X2 Long put @ X3 Short put @ X4 Box spread Any combination of options that has a constant payoff at expiration. For example, combining a long butterfly made with calls, with a short butterfly made with puts will have a constant payoff of zero, and in equilibrium will cost zero. In practice any profit from these spreads will be eaten up by commissions (hence the name "alligator spreads"). Any combination of options that has a constant payoff at expiration or break-even In practice any profit from these spreads will be eaten up by commissions.
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