Last Updated on January 17, 2021 by harsh vasistha
Options can be confusing for everyone, especially beginners. The various types of options, different technical nuances used in it, and a wide set of factors that can affect options are the prominent reasons that make it complex.
But don’t worry. In this ultimate beginners guide, we will help you know what are options, what are different types of options, how options work, and everything you may ever need to know about options.
So, just keep reading!
What are Options?
Options are contracts that give its holder the right (but not the obligation) to buy or sell a specific amount of an asset (in this case crypto) at a pre-chosen price, before or at a specific date (the expiration date).
Different options trading platforms agree to sell different options with different expiration dates, each with its own value and price.
Options can serve various purposes to meet different needs; one may use them to earn money, another to speculate, but mostly, options are used as a means of hedging the risk while trading.
Let’s see an example to better understand its concept:
Suppose a company sells an oil barrel for $100 each. They somehow predict that the price might drop to $90 per barrel during next month. Therefore, they buy an option to get the right to sell each barrel at $100, regardless of the market price.
Now, if the price drops, they don’t need to worry about it. The seller of the option is obliged to buy oil barrels at the determined price ($100). And if the price doesn’t drop, their only loss is the money they paid to buy the option.
The price a trader pays to buy an option is called the premium. And the whole possible loss at an option, as a buyer, is the price they pay for the premium. That is why options are a good way to hedge the risk.
In fact, options work like insurance. You pay the insurance company an amount of money, and when needed, the insurance is obliged to pay way more than what you have paid. But if nothing bad happens, the money you pay for insurance will go waste.
Options are Derivatives
Options are derivatives, which means their value is derived from something else. In other words, the price of an option is dependent on the price of another asset.
Thus, if the asset turns out to be of no value, the option will also be worthless. And vice versa, if the asset’s price increases, the value of options will also increase.
Commonly used terms in Options
Before proceeding to options types, let’s first learn the commonly-used terms in options to help make things more clear.
- Premium: As mentioned above, the premium is a price that the buyer of an options contract should pay. In simpler terms, it is the price of the contract.
- Expiration Date: Each option contract has an expiration date, which is the time interval at which the contract can be exercised. Once the expiration date passes, the option contract is worthless and cannot be exercised.
- Holder: The buyer of the option is called the holder. The holder has the right but not the obligation to buy or sell.
- Writer: The seller of an option is called the writer. The writer (seller) of the option is obliged to buy or sell the underlying asset at the strike price if the holder wants so.
- Strike Price: Also called exercise price, it is the price that the trader will pay when the option is exercised. In other words, when buying an option, a trader pays to receive the right to buy an asset at a specific price before or at the expiration date; that specific price is the Strike price.
- Options Contract Multiplier: Contract Multipliers standardize the number of shares each option control. In general, a contract multiplier for an option is 100, which means that the contract and the rights it grants apply to 100 shares of the underlying asset.
Different Types of Options
There are two types of standard options contracts: Call Options & Put Options
A call option contract gives the right to its holder to buy a specific amount of an asset (generally 100 shares) at a pre-chosen price (strike price) before or at the expiration date.
This contract can prove to be very powerful and beneficial, let’s see how:
Suppose you want to buy 100 shares of XYZ Inc which is now worth $100 per share. You are sure that the price will rise to $120 per share in just a couple of months.
However, right now, to buy the 100 shares, you would need $10,000, which you don’t have.
You can find the $10,000 in one month, but you suspect that the price would have already raised by that time. Here, to make sure you can buy shares at $100 per each one month later, your only choice is to buy a call option.
You find someone willing to sell such a call option with the rights you want for $1,000, and you buy the contract. One month later, as you predicted, the price has increased to $120 per share.
You have an option that lets you buy 100 shares each for $100, regardless of the market price.
Now, the contract has helped you gain a $20 profit per share; and since there are 100 shares, your total profit is $2,000.
However, remember that you have paid $1,000 to buy a call option contract. So, your net profit is $2,000 – $1,000 = $1,000.
In the above scenario, you used the call option to earn a profit. But there are times when a call option can hedge the risk, let’s see another scenario:
Now, in the above example, suppose you have the $10,000 to buy 100 shares of XYZ Inc. However, you fear that the price might drop and you lose all your $10,000.
To hedge the risk, you don’t pay $10,000 to buy the shares. But instead, you buy a call option contract for $1,000 that gives you the right to buy each share for $100 within one month, even if the market price increases.
If the price goes up, as you had expected, you have a contract that lets you buy the shares at a lower price.
On the other hand, if the price goes down, you have the right (but not the obligation) to buy shares above the market price, but why on earth would you want to do that.
Thus, you saved $10,000 by just risking $1,000. That is how a call option can hedge the risk.
As opposed to call options, put options give their holder the right (again, but not the obligation) to sell a specific amount of shares (generally 100 shares) at a pre-chosen price (strike price) before or at the expiration date.
Put options, just like call options, can be used to earn money or to hedge the risk. Different companies and product owners can buy a put option to ensure they would not bear great losses if their product price drops.
For example, after covid-19 stroke and the whole world went to quarantine, oil prices dropped significantly. If an oil company had bought a put option just when covid started, they could have sold the oil at its normal price even when the market price had dropped to half of it. This way, the put option works as insurance for companies and product owners.
Buying, Selling Calls/Puts
Now that you know calls and puts, let’s see what you can do with them:
- Buy Calls
- Buy Puts
- Sell Calls
- Sell Puts
Buying calls and selling puts give you a potential long position. That is to say, you can hope to gain profit during a time interval that ends with the expiration date of the call option. Exactly the opposite, buying puts and selling calls give you a potential short position, a hope to gain profit in a short time.
One main advantage of options is the leverage that enables high returns (100% or even higher). The amount of premium you pay to buy an option is small compared to the real cost of buying shares and the potential benefit it brings.
For example, to buy 200 shares of a $50 stock, you would need $10,000. However, you can purchase a $10 call ($10 for 200 shares, which sums up to a $2,000 total).
Just by paying $2,000, you gained the right that otherwise you should have paid $10,000 to gain. This way, you have another $8,000 that you can use to trade more.
A Hedge Against Risk
One central function and usage of options is to hedge the risk. As mentioned above, options can work as an insurance company that takes an amount of money (in options, we call it premium), and in return, helps compensate for losses.
We have mentioned many examples for this function of options. You can refer to the company that sells oil barrels per $100.
To ensure that they would not have to sell barrels for less than that, they buy an option. Now, if the price drops, they don’t have to worry about it. They can still sell each barrel for $100 to the option contract writer.
Source of Income
For an option contract buyer (holder), the only possible loss is the amount she paid as a premium, while the potential for gain and return is unlimited.
For example, an investor doubts that the price of an asset may rise.
The investor is the cautious kind; thus, he doesn’t quickly buy the shares and risk loss.
What he does is to buy an option for a small amount (premium). This way, he gains the right to purchase the shares at a specific price (current market price), even if the price increases. Later, if the price increases, he will gain a profit. But if the price doesn’t change or decreases, the loss is limited to the premium paid.
For several diverse scenarios, there are various solutions an option offers. Do you think the price will double, or will it decrease; even if you fear your product price may drop, regardless of the scenario, the option offers a way to solve the problem or gain profit.
It is important to remember that in options, time is against you. The more you approach the expiration date, the less valuable your option contract becomes. And once the expiration date passes, the option contract becomes useless.
Leverage is always a two-edged sword. It can bring high returns, but if things go wrong, it can also cause magnified losses. It is also necessary to use that much leverage that you can afford to lose. Since you make a risk, consider losing as well while hoping for a win.
In options trading, the premium is the only loss a contract holder can have. Of course, it is small compared to losing the whole capital. But if an investor continues to invest recklessly, the sum of all lost premiums can turn to be catastrophic.
Options can be overwhelming due to their complex nature. Many factors can affect options, and the fact that there are unlimited ways to write an option contract makes the job even harder.
How Options Work
Basically, options are used for predicting price, only with less risk than other trades. So, it is logical to expect that the more likely something is to occur, the more it will cost you to buy an option regarding it.
For example, market ABC has been steadily going up 2% every 24 hours for the last week, but another market XYZ has a volatile situation. Now, buying an option for the market ABC will surely cost more than an option for market XYZ.
Another important feature in options is time. The more time a contract has, the more valuable it is. That is because when there is time, there is a greater chance of price movement, hopefully in the desired direction.
If someone buys an option contract for a specific asset and that asset price doesn’t move, the option will become less valuable as each day passes.
Volatility is a good thing in options, and it can cause the price of an option to increase. Volatility increases uncertainty, and uncertainty makes the odds of an outcome higher. As volatility increases, possibilities of substantial moves increases, and the options price increases.
It is good to know that only 30% of options expire worthlessly. A major percentage (60% percent) is traded (which we will cover later how options are traded), and the remaining 10% are exercised.
American & European Options
American and European options are the same in most ways, except at their exercised date. To be more specific, American options can be exercised at any time from when the contract is purchased to its expiration date.
On the other hand, European options can only be exercised near or at their expiration date. This difference in exercising date impacts the price of premiums. Since American options allow for exercise any time before the expiration date, and this is assumed a bonus, their premiums are a little more expensive.
Long-term & Short-term Options
We can also categorize options by their duration. An option with an expiration date of more than a year is called long-term equity anticipation securities or LEAPs. To clear things, LEAPs are like regular options, just with a longer expiration date.
Also, any option with an expiration date of less than a year is called short-term options.
Straddles in Options
If you buy a call and a put with the same strike and expiration date simultaneously, it is called a straddle. This technique is profitable if you are sure that a certain market has high volatility but can’t predict the direction of price movement.
For example, ABC Inc stock is worth $100 per share. You are sure that the market price will significantly change, let’s say it is time for the monthly revenue report. Since you don’t know whether the monthly revenue report is good or bad, you can’t speculate on the price movement.
Thus, you buy a call and a put for the same strike price of $100. This enables you to both (1) buy shares at $100 if the market price increases and (2) sell at $100 if the price decreases. However, to have such an opportunity, you would have to pay two premiums (one for the call, one for the put).
Let’s say you paid $1,000 for each premium, which sums up to a total of $2,000 for two premiums. Now, in order to gain profit from this scenario, the share price has to move over $120 or below $80. If the price ends up somewhere between $80 to $120, you will end up bearing some loss.
To benefit from straddle, the price should be very volatile (at least change 20%). If you buy a straddle and the price doesn’t change 20 to 30 percent, you would not only earn any profit but also waste your premiums (which is your only loss).
Strangles in Options
The concept is similar to straddle but with a few differences. In strangles, you buy a call and a put with the same expiration date and classes, just with different strike prices. Strangles is beneficial if the market is very volatile (more volatile than straddle) and you want to spend fewer premiums on calls and puts.
For example, the same scenario as above, ABC Inc with each share worth $100. A strangle is to buy a call for $110 and a put for $90 per share. Let’s say you need to pay $700 to buy each premium and a total of $1,400 (since there are two premiums).
Now, to earn a profit, the market price should go either over $125 or below $75. Remember, the premium in strangle is cheaper than premium in straddle, but the market should also be more volatile to make a profit out of it.
Spreads in Options
Spreads mean buying and selling two or more options of the same class and expiry date with different strike prices. Using spreads in options is interesting; they combine speculating (expressing a market opinion) and hedging the risk. Spreads also offer limited potential upside, but due to less cost, they are desirable options strategies.
Vertical spreads are selling one option to buy another. Usually, these two options have the same class and expiration date but different strike prices. A bull call vertical spread is to buy a call option and simultaneously sell another call option of the same class and expiration date with a higher strike price.
A bull call vertical spread is profitable if the market price increases, but at the same time, doesn’t contain much potential for loss. Let’s see an example to learn the concept better.
Let’s say you buy a call option of the strike price of $60 with two months expiration date for a $300 premium. You also sell a call option with a strike price of $65 that expires in two months for $150. This is a bull call vertical spread.
It is easy to see how spread minimized the risk to only $150 even in the worst possible case. However, it is not only the risk that is minimized, the profit is also limited. In this example, even if the price increases tremendously, your biggest possible profit is $350.
Combination in Options
In options, combinations are constructed when more than one option type, strike price, or expiration date is used on the same underlying asset. In simpler terms, combinations are created from various contracts of differing options.
Different combinations can be useful for creating custom risk/reward conditions. Using a good strategy in combinations, traders can benefit from up, down, and other market trends with the lowest possible risk.