Understanding Options Contract 

CASE 1: CALL OPTION

 

Meet Elly, a full time investor. On 30 June 17, she bought 1 lot of Option Contract for Apple Inc, AAPL 19 JAN 18 145 CALL options at USD9. At the time of purchase, AAPL price is at USD145. She expects AAPL shares will go up higher in near term.  Total premium she paid is USD900 for the contract which will expire on 19 Jan 2018. 

CASE 2: PUT OPTION

 

Elly's prediction seems to be working. AAPL share price increases from USD145 to USD160. She decided to exercise her CALL option. Hence, she is able to buy AAPL shares at USD145 via the CALL option and she earns USD15 of capital gain (net is USD6 after deducting the premium she paid to purchase the Option Contract). 

If AAPL shares falls to below USD145, she may decide to let the option to expire. She will lose the premium paid. 

Taking the same example, Elly with her favourite AAPL shares... 

Elly expects AAPL shares will drop from USD145 within one month due to correction in the overall market movement. 

She bought AAPL 21 JUL 17 145 PUT options at USD3. 

The following week, AAPL shares drop to USD135 per share. To capitalise the capital gain, Elly decided to exercise the PUT contract and managed to secure USD10 capital gain (net is USD7 after deducting premium paid). 

How are Options Contract priced?

The price of an Option Premium is based on two factors – intrinsic value and time value of the option

Intrinsic Value + Extrinsic Value (Time Value) = Option Price

Options

What is an Options Contract?

An options contract is just simply an agreement between a two parties (buyer and seller) that gives the purchaser of the option the right to buy stock at a later date at a predetermined price.

The right to sell a security is called a ‘Put Option’, while the right to buy is called the ‘Call Option’.

The seller of an Options Contract is called "options writer". Unlike the buyer of an Options, the seller has no rights and must sell the assets at the agreed price if the buyer executes the Options Contract on or before the agreed date, in exchange for an upfront payment from the buyer.

Options can be used as a tool for:

Leverage

 

Options enables you to profit from changes in share prices without putting down the full price of the share.

 

For example, a price of Apple Inc (NASDAQ: AAPL) is USD 144 (on 30 June 17) while AAPL 19 JAN 18 145 CALL options is at USD9.25. 


Hedging

 

Options protects your position from price fluctuations and allows you to buy or sell the shares at a pre-determined price for a specified period of time.


Though Options has its advantages, trading in options is more complex than trading in regular shares. A good understanding of trading and investment practices as well as frequent monitoring of market movement are required to protect against losses.

There are few terms that we need to familiarize regarding Options Contract:

 

Structure of Options Contract
  • There are two Option Contract types: (1) American - can be exercised any time and (2) European - only to be exercised at a specific time

  • Expiration Date - is the date where the contract expired. Normally the expiration date for listed stock options in the United States is on the third Friday of the contract month

  • Open Interest - number of option contracts that are currently open (still being held by the buyers)

  • Strike Price - a specific derivative contract can be exercised

  • Lot Size - one contract size of an Option Contract is 100 units of deliverable quantity of the underlying

  • Implied Volatility - derived from an option's price and shows what the market "implies" about the stock's volatility in the future

  • Delta - amount of option price is expected to move based on USD1 move up in the underlying market (the speed)

  • Gamma - rate of change in Delta based on USD1 change is stock price (considering this as acceleration)

  • Theta - amount of price of calls & puts will decrease every single day as the option approaches its expiration (good news for option sellers but not for buyers)

  • Vega - amount of call & put prices will change for every 1% change in Implied Volatility. As Vega increases, option price increases to compensate for higher probability of being In The Money (ITM) at expiration

The Greeks are just snapshots in time. More important is the impact of future time decay & volatility of the underlying.

Wait, what is In the Money (ITM)? 

3 more concepts to learn - 

In the Money (ITM) - a call option's strike price is below the market price of the underlying asset or that the strike price of a put option is above the market price of the underlying asset

Out of the Money (OTM) - a call option with a strike price that is higher than the market price of the underlying asset, or a put option with a strike price that is lower than the market price of the underlying asset

At the Money (ATM) -  an option's strike price is identical to the price of the underlying security

Stock Price USD 50

 

Strike Price USD 60

 

Strike Price USD 50

 

Strike Price USD 40

 

OTM

if Call Option Strike > Stock Price

 

ATM

if Call Option Strike = Stock Price

 

ITM

if Call Option Strike < Stock Price

 

ITM

if Put Option Strike > Stock Price

 

ATM

if Put Option Strike = Stock Price

 

OTM

if Put Option Strike < Stock Price