Intro to Options. Part I : How options work

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I am not an options specialist , and I’ve never been. This article is part of a series that I intend to write about options, however. Quite most MetaTrader folks never been into options. Never available on MT4, or not automated on option platforms, or without the possibility to hedge with underlying, we were kinda kept out of the options realm. And how good are options – asymetric trading assets, providing exactly the flavour needed for trading, going beyond simple directional trading!

Definition of an option:

An option is contract who gives the buyer the right to buy or sell a security (underlying contract) at a specified price (strike), by paying to the seller of the option a premium. Or, basically, the buyer buys the option to buy/sell or do nothing, and the seller sells his option, abiding to the request of the buyer. Options are of many types, but in terms of exercise there are two basic classes : american option, that gives its buyer the right to exercise the option all the time to expiry, and european option, which can be exercised only at contract expiry.

We will not dwelve into the intricacies of the exercising mechanism. Under MetaTrader there will be no exercise, and also most likely no american options. There will be offered european options, that will be traded by the traders at their market value (the current option premium). The value at expiry will be the one given by the option mechanism, while the market value is dictated by the option models which are the basis for option quotes posted by market participants. The two values will be equal at expiry.

By mechanism, options divide into call options (that give the right to buy) and put options (that give the right to sell). These are called vanilla options, because they were the first type of options created. Nowadays there are a plenty of exotic options , which are nothing more than bets with a market value. Our article series will focus on vanilla options.

To get acquainted with how options work, you have to become familiar with payoff diagrams. Payoff diagrams show the profit at expiry. Since there are two basic option types, which can be bought or sold, we have four basic payoff diagrams, also known as the four basic option strategies.

From this place on I’m using charts from OptionTradingTips.com and  TheOptionsGuide.com . These are some of the best free option sites that can be found on Internet. I will return frequently to their articles that contain key information on option trading.

long-call

This is a long call diagram, a call from the perspective of the buyer. The buyer acquired a call with a strike of $40, paying $200. (Actually he bought 100 calls , with an individual call premium of $2). As you see, he remains with his $200 loss for underlying at expiry below $40, because there is no reason to receive a stock that values less. This is what he payed the premium for. From $40 to up, there is a slight profit. Gets the stock delivered at $40, while the market value is higher. Even so, it is not enough to breakeven. Breakeven point is, as graphics show, between 40 and 50.

(Breakeven – Strike) x Call Options = Premium

(Breakeven – 40) x 100 = 200

That yields a breakeven happening at $42, where the underlying gain of $2 for 100 calls recovers the  $200 payed.

From the perspective of the writer (seller) , the diagram is mirrored around the stock price axis. For share price lower than 40 at expiry, he can keep all the $200 received from buyer. For higher prices, the buyer exercises his option to buy, and the seller has to deliver a more expensive stock (from the current market price) to the buyer for the strike price, lower ($40). That causes losses. The breakpoint is the same, since chart is mirrored.

long-put

This is a long put diagram, a put from the perspective of the buyer. The buyer acquired a put with a strike of $40, paying $200. This example is forged to have same data as the call one. In real markets, this will never happen. As you see, he remains with his $200 loss for underlying at expiry above $40, because there is no reason to sell a stock that values more. This is what he payed the premium for. From $40 to down, there is a slight profit. Deliveres the stock at $40, while the market value is lower. Even so, it is not enough to breakeven. Breakeven point is, as graphics show, between 30 and 40.

(Strike – Breakeven) x Put Options = Premium

(40 – Breakeven) x 100 = 200

That yields a breakeven happening at 38, where the underlying loss of 2 for 100 puts recovers the  $200 payed.

From the perspective of the writer (seller) , the diagram is mirrored around the stock price axis. For share price higher than 40 at expiry, he can keep all the $200 received from buyer. For lower prices, the buyer exercises his option to sell, and the seller has to buy a less valuable stock (the current market price) from the buyer for the strike price, higher (40). That causes losses. The breakeven is the same, since chart is mirrored.

Don’t forget the real breakevens are not in the same position. Fees and spreads will push it away – not only per option type, also per option operation – the buyer will not have same breakeven as the seller , as in regular trading.

According to where the underlying price is in respect to the strike, options are divided in :

out of the money options (strike > underlying, for Calls, strike < underlying, for Puts)

at the money options (strike ~ underlying)

in the money options (strike < underlying, for Calls, strike > underlying, for Puts)

In the following articles, abbreviations such as OTM, ATM, ITM will be used for the “money” state of the options.

Option markets are risk markets. Buyers are risk haters, sellers are risk lovers.

From the breakpoint, the seller is exposed to unlimited losses, while the buyer will receive unlimited profits.

The buyer sacrifices funds on spot while hoping for delayed profits ; the seller receives funds on spot while being exposed to delayed losses. However, the buyer will not feel a dramatic equity loss, and the seller won’t feel an inflow of cash ; rather , both participants, but especially the seller, will see a growth in consummed margin . Costs are fees and spread for both participants.

Note that these are basic option strategies. The realities of option markets are far beyond these. Option pricing and greeks are the ones that matter. However, one cannot simply discard the fact that with the upcoming of MetaTrader 5, even the basic strategies become interesting. After all, now indicators can trigger option trades instead of regular underlying trades.