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Option Trading Course

Option Terms: OK - deep breath, as this will probably be the most difficultonline option trading anna page to grasp all the trading terms and options terminology quickly.  Options by nature are extremely flexible financial instruments which can be used either on their own, or in combination with other securities. This flexibility comes at a price though, as they are complex for the beginner to understand. So in order to start I will try to define in simple terms what an option is and to use some analogies to illustrate the points.

Online Option Trading: Definitions

What is an option - in simple terms it is a contract, and just like any other contract there are terms and conditions which apply. It is also a derivative i.e. it has been derived from something else - in the case of an equity option, the underlying asset is the stock.

Whenever you sign a contract, whether to buy a house, a car, or for a mortgage, you have signed an undertaking. With a house you have agreed to buy the house at a price at a particular date in the future - if you fail to fulfil your side of the contract there are severe penalties. If you sign a contract for a mortgage, you agree to the terms and conditions of the lender, and agree to make repayments regularly. If not you may forfeit your property. So remember an option is a contract and you have obligations under the terms of the contract. Now, in the electronic world of online trading, you do not actually sign the contract ( as you would have done in early 19th century ) but in selling the option, ( or writing the option as it is still called ) you have effectively sold this contract to someone else and therefore put your name to it at the bottom. As you will see below, as an option seller you have to fulfil the obligations of the contract. As an option buyer it is for your to decide whether to exercise the terms of the contract or not - the most important distinction between an option buyer and an option seller.

Now, there are two types of option CALLS and PUTS and you can buy or sell either of these, so you have four choices. You can sell a CALL, buy a CALL, sell a PUT or buy a PUT. Now you may wonder what is the difference between a put and a call - the answer is simple and is as follows:

Call Option : A contract that for a specific time gives the right to the holder to buy the specified underlying asset at a specific price at or before a specified time.
Put Option : A contract that for a specific time gives the right to the holder to sell the specified underlying asset at a specific price, at or before a specified time.

OK - let's look at these two statements in a little more detail and take the call option first. Firstly let's look at it from a buyers point of view and analyse each part of the statement above.

Firstly we see that the option or contract is only valid for a 'specific time'. This is very different from our stocks and shares which are valid for all time. So the option has a time limit. If we do not do anything within this time limit - what happens? The short answer is nothing, as the option will ' expire worthless' In other words the contract has expired, and is torn up. The most widely traded options are those over 4 weeks although as you will see it is possible to have options which extend over years.

OK, the next part of the statement says 'gives the right to the holder' what does this mean? It means that you have rights, but no obligations. In other words you can enforce the terms of the contract if you wish, but only if you choose to - in other words it is your decision, and you have no obligation to do anything.

The next part says 'to buy the specified underlying asset'. As the holder you have the right to BUY the underlying asset. Remember when we first looked at what an option is, they are derivatives, and have an 'underlying asset'. In this case the underlying asset would be the stock or share that is associated with that particular option. So as the holder of the option, we have a piece of paper (an electronic online piece of paper in our case ) which gives us the right to buy this stock. Remember we do not have to buy, but we can if we choose to, within the life of the option.

Finally we have 'at a specific price at or before a specified time'. The option specifies the price of the underlying asset, in this case a share or stock at which we can buy. So our piece of paper gives us the right to buy the shares ( stocks ) at a specific price, within the life of the option. We can buy at any time as long as the option has not expired (torn up ) which is normally 4 weeks.

So in summary, in buying our piece of paper ( our online option ) we have some things we can do if we choose, but we don't have to do anything, and we are not obligated to do anything either. OK, let's look at this statement from the other side of the fence, as a seller of a call option, or writer:

Now if you remember back to the first paragraph as a seller of an option you are effectively signing your name at the bottom of the piece of paper, and therefore agreeing to honour the terms of the contract, which you MUST DO - you have no choice about this - by selling the call you have signed an electronic contract to deliver the underlying asset ( the shares or stocks ) at the agreed price within the agree period, if the holder decides this is what they want to do. They may not of course, but you do not make this decision. It is the holder who holds all the cards at this stage, and you must wait and see what happens. Now you might be wondering why anyone would want to bother with taking all this risk, which seems on the surface to benefit the holder, rather than the writer. Well the answer is a thing called PREMIUM, which we will look at in a minute, but before we do, let's do the same exercise with the statement on a Put option.

Firstly we see that the option or contract is only valid for a 'specific time'. So whether it is a put or a call, the options has a fixed life. OK, the next part of the statement says 'gives the right to the holder' what does this mean? It means that you have rights, but no obligations. In other words you can enforce the terms of the contract if you wish, but only if you choose to - in other words it is your decision, and you have no obligation to do anything. So again, this is the same, whether it is a put or a call.

The next part is different as it says 'to sell the specified underlying asset'. As the holder of a put option you have the right to SELL the underlying asset. Remember when we first looked at what an option is, they are derivatives, and have an 'underlying asset'. In this case the underlying asset would be the stock or share that is associated with that particular option. So as the holder of the option, we have a piece of paper (an electronic piece of paper in our case ) which gives you the right to sell this stock or share. Remember we do not have to sell, but we can if we choose to, within the life of the option. Now this can be a little confusing for new traders as we now have the right to sell something we do not own ( the underlying shares or stocks ) This is one of the principles of short selling when prices are falling, we sell to open the trade, and buy back to close at a profit at a lower price.

Finally we have 'at a specific price at or before a specified time'. The option specifies the price of the underlying asset, in this case a share or stock at which we can sell. So our piece of paper gives us the right to sell the shares ( stocks ) at a specific price, within the life of the option. We can sell at any time as long as the option has not expired (torn up ) which is normally 4 weeks.

So in summary, in buying our piece of paper ( our option ) we have some things we can do if we choose, but we don't have to do anything, and we are not obligated to do anything either. OK, as before let's look at this statement from the other side of the fence, as a seller of a call option, or writer:

Now if you remember back to the first paragraph as a seller of an option you are effectively signing your name at the bottom of the piece of paper, and therefore agreeing to honour the terms of the contract, which you MUST DO - you have no choice about this - by selling the put, you have signed an electronic contract to buy the underlying asset ( the shares or stocks ) at the agreed price within the agree period, if the holder decides this is what they want to do. They may not of course, but you do not make this decision. It is the holder who holds all the cards at this stage, and you must wait and see what happens.

One last point before we move on with regard to calls and puts - the premium of a call goes up as the underlying asset goes up in price, whilst the premium of a put goes up as the underlying asset goes down in price. There is an easy way to remember this which is as follows :

Online Option Trading : The Greeks

The Greeks, as you would expect, are Greek letters that are used to estimate changes in the prices of options as various market factors change. The Greeks are often used to compare options and find one that suits a particular option strategy. It is important to remember that they are based on mathematical formulae and whilst they can be used to forecast future prices, there is no guarantee they will be right - remember they only theoretical.

Option Term Option Description
Delta A measure of how much an option price changes when the underlying stock changes. Values are between -1 and +1 where - figures relate to puts, and + figures relate to calls. A Call delta of 0.5 means that for every dollar increase in the stock price, the call premium increases 50cents.
Theta The rate at which premium decays per unit time as expiry nears.
Rho An estimate of how much the premium changes when interest rate changes.
Vega An estimate of how much an option price changes when the volatility assumption changes. In general greater volatility means a higher option premium.
Beta A measure of how a stocks volatility change in relation to the overall market. A Beta of 1.5 means a stock gains 1.5 points for every point the index gains.
Alpha A measure of how the stock performs in relation to the beta. A positive alpha means the stock outperformed the beta and a negative one, means it underperformed.
   

I hope you now have a basic understanding of an option let's move on to take a closer look at equity options, the forces that dictate the premium, and the various elements of an option chain. But firstly,  why do option writers go to all the trouble and risk of writing options, and holders go to all the trouble of buying something which could expire worthless. The answer is the magical word premium.

 

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