Option Strategies
Option Basics
What is an Option?
There are two types: call options and put options.
Call option is right to buy underlying instrument at a specific price before expiry date.
Example: IBM Jan 2008 120.0000 call (OPR:IBMAD.X) is trading for $5.00 as of 26th sep'2007. IBM last traded at $117.30
Buyer of this call option owns a right to buy 100 shares of IBM stock at $120/share on or before 3rd Friday of Jan'2008. Buyer of this option is not obligated to buy IBM shares if IBM stays below $120 by Jan'2008.
Each option represents 100 shares. the above call option costs $500.00 per contract + commissions.
Buyer of this option benefits if the stock goes above $125.00 by jan'2008. If IBM stays at $120 or drops below 120, he looses $500.00, that is his maximum loss.
Put option gives a right to sell the underlying at a specific price before expiry date.
Example: IBM Jan 2008 110.0000 put (OPR:IBMMB.X) last trading price is $2.75 as of 26th sep'2007
Buyer of this put option owns a right to sell 100 shares of IBM stock at $110/share on or before third Friday of Jan'2008. Buyer of this option is not obligated to sell if IBM stays above $110 by Jan'2008.
Each option represents 100 shares. the above put option costs $275.00 per contract + commissions.
Buyer of this option benefits if the stock drops below $110.00 by jan'2008. If IBM stays at or above $110, he looses $275.00, that is his maximum loss.
Option Strategies :
- buying call or put option is considered as basic options trade.
- Selling an option on the other hand is simply other side the basic option trade. any one can do it provided they have sufficient margin.
- Any other strategy is nothing more than combination of these basic trades with or without underlying instrument.
- Long call, long put, straddle, bull call spread and bear put spreads are speculative and involves initial debit. These are theta negative. means, if underlying stays at the same level, volatility remains same, the position decays as the day goes by.
- Short call, Short put, Bull put spread, bear call spread, condor, covered call and selling straddle are credit spreads and require more margin for trade. These are Theta positive means time decay benefits the position.
Options & volatility
Volatility is anticipated annual rate of change of the underlying. It directly impacts option prices. Higher Volatility, higher option premiums. Volatility is different for each stock/index/future. IBM typically trades around 20 volatility and GOOG trades around 35 volatility. During earnings, bases on expectations this volatility goes much higher than normal.
The example below shows volatility of IBM OCT 115 strike option as 25.2%
Easy way to understand Option Greeks in the example:
Trade is IBM Call expiring in 24 days. IBM is trading at 117.30. 115 call costs 4.50 or each contract costs $450 plus my minimum option trade commission of $1.00 , a total of $451
First dollar increase in IBM increases the option position by 68.16 and next dollar move by 73.09 (68.16 + 4.93)
Delta: This position gains 68.16 if IBM goes from 117.30 to 118.30 (Delta factor is .6816 and effect is 68.16)
Gamma: Rate of Delta change. first dollar move has position delta of 68.16 and next dollar move with 73.09 (68.16 + 4.93)
Theta: This position losses 6.78 per day IBM stays where it is. This increases as the expiration approaches. This is non-linear factor.
Vega: Option price effect with volatility. IF volatility of this option strike goes up by 1 points, the option position gains $11.15. If volatility drops by one point, the option position looses $11.15
Option Greeks: Delta, Theta, Vega and Gamma
Delta: Delta is a factor represents option price change for each dollar move of the underlying. The above call example shows delta effect of the option position as $68.16, If IBM moves from 117.30 to 118.30, options position gains $68.16. Conversely if IBM moves from 117.30 to 116.30, the position looses $68.16.
Gamma is the rate of change in Delta
Theta is Time decay
Vega is Volatility effect on the options.