Option contracts are derivative instruments of a financial asset since their value depends on the value of this other asset, which is known as the underlying asset.
The underlying asset of the options can be stocks, indices, currencies, raw materials, bonds, etc.
We will see those of shares, since once the topic is understood you can understand any other, what changes is the underlying asset.
A company's stock option contracts depend on the value of that company's stock.
Option contracts have an expiration date and a target price called "strike."
Therefore, an options contract represents that the share price will reach that price (strike) in a certain period of time (until the expiration date).
Option contracts are an agreement in which the holder obtains the right to buy or sell an asset, at a certain price (strike) during a period or on a specific date (expiration).
Main features of the options
Its price is much lower than the value of the underlying asset.
High leverage.
They have an expiration date, therefore the contract price will decrease as time passes if the underlying asset does not register significant changes in the price (for example when the share price remains lateral in the range of US $ 1
, the contract is devalued).
Its price varies based on changes in the value of the underlying asset.
Ideal for trading both up and down.
Ideal to use to cover losses, for example if we have the stock and we see that it is going down, we can make money with the option down and thus cover the losses a little.
They can be bought or sold in the American market at any time, until the day of expiration.
Summary of financial terms:
Strike: specific price at which the share should arrive, for the contract to be effective, that is, the price at which we want to buy or sell the underlying asset (shares in our case).
Premium: price paid for the acquisition of a contract.
Call option: it is valued only upwards, therefore when the underlying stock or asset rises in price.
This contract gives the buyer the right to buy, and therefore the seller the obligation to sell, the underlying asset (the shares) at the strike price until the expiration date, in exchange for the payment of a premium to the seller by the
of the buyer.
Put option: it is valued when the share price falls, it is for bearish scenarios.
This contract gives the buyer the right to sell, and therefore the seller the obligation to buy, the underlying asset (the shares) at the strike price until the expiration date, in exchange for the payment of a premium to the seller by the
of the buyer.
All this is expressed in a symbol of quick reading when one invests in them to be able to identify them.
We will take as an example a Netflix call contract with strike u $ s385 that expires on September 20, 2019:
.NFLX190920C385
Where:
.NFLX: company ticker.
190920: it is the expiration date, in English it is the other way around in Spanish, therefore it is 09/19/20, that is, September 20, 2019
C: option type, in this case CALL
385: strike
If the NFLX share rises in price, the premium value of this option contract will also, and whoever has the contract in their possession, will be able to sell it in the market even when the expiration has not arrived.
While the share price changes, the contract price also changes but to a lesser extent.
For this the terminology ATM, ITM, OTM is known and is related to strike.
ATM (at the money): The strike of an options contract is equal to or very close to the value of the share.
The value of the contract will vary by 50% of what the share price varies.
ITM (in the money): the strike of a CALL options contract is below the value of the share;
or above in the case of a PUT contract.
The value of the contract will vary more than 50% of what the share price varies.
OTM (out of the money): the strike of a CALL options contract is above the value of the share;
or below in the case of a PUT contract.
The value of the contract will vary less than 50% of what the share price varies.
For example:
ATM CASE
if the price of a share of X company is U $ S79, and a CALL option with strike 80 is bought at U $ S2 the contract, the valuation of the same would be:
ACTION: if the price increases from U $ S79 in U $ S2, its value is now U $ S81.
CONTRACT: since it is ATM, it goes from being US $ 2 to US $ 3, since I earn US $ 1 because I earn 50% of what the action earned.
OTM CASE
With the same example as before, the share price being U $ S79, and a CALL option with strike 65, the contract is purchased at U $ S 1.38, its valuation would be:
ACTION: if the price increases from U $ S79 in U $ S2, its value is now U $ S81.
CONTRACT: since it is OTM, it goes from being US $ 1.38 to US $ 2.08, since it earned US $ 0.70 because it earned less than 50% of what the stock won.
The strike was less than the share price.
ITM CASE
With the same example as before, the share price being U $ S79, and a CALL option with strike 85, the contract is purchased at U $ S 3.90, its valuation would be:
ACTION: if the price increases from U $ S79 in U $ S2, its value is now U $ S81.
CONTRACT: since it is ITM, it goes from worth US $ 3.90 to US $ 5, since it earned US $ 1.10 because it earned more than 50% of what the stock earned.
The strike was higher than the share price.
IMPORTANT: 1 contract is equivalent to the “movement” of 100 shares, therefore if we buy a contract for U $ S2, we will pay U $ S200 (U $ S2x100).
As you can see, option contracts have the same characteristics for any financial instrument that has them.
This we have explained, applies to any option contract.
Bid and Ask
Each option contract has 2 prices, which are:
IDB: higher purchase price.
It would be the best purchase offer.
ASK: lowest selling price.
It would be the best sale offer.
The difference between them is called SPREAD.
It is very important that you always keep this in mind since the spread can be small or large.
It should be small, indicating that there is a lot of demand for buying and selling those option contracts, and that there is a lot of volume.
Otherwise, the spreads are wider.
Market makers are the ones who win with the spread differences, since their objective is that you buy at the ASK price and someone else is willing to sell you at the BID price.
The Greeks
The Greek are a ratio that measures the sensitivity of the prices of option contracts to factors that influence them, such as the maturity and volatility of the underlying asset.
They help us manage the position.
The ideal is to choose 1 or 2, depending on what suits you best, however we will name several, although we will delve into Delta for being the most used.
Theta
This Greek indicates how much you lose an options contract over time in 1 day.
It has a negative sign when we buy since we lose value over time and it has a positive sign when we sell a contract.
The more value is lost the closer to maturity we are, for example if we have purchased a CALL option contract that expires within 50 days, the Theta will be -0.009 at that time, but if there are 5 days to maturity it will be -0.025
.
The Theta value rapidly decreases its value if the maturity is in the short term.
Vega
This Greek indicates the change in the value of an options contract with respect to volatility.
Option contracts can also be volatile, regardless of the volatility of its underlying asset.
By this we mean that assets can move little, but contract prices move a lot.
Of course, if the value of the underlying asset increases, the value of the contract will also increase, so Vega indicates the value in which the price of the contract varies compared to a unit of increase in the volatility of the stock.
Delta
It is one of the Greek most used since it represents the variation of the price of an option contract when the price of the underlying asset varies U $ S1.
For example, if a PUT option has a delta of 0.42, it is telling us that if the underlying asset falls U $ S1, the price of the PUT contract will increase by U $ S 0.42.
And if a CALL option has a delta of 0.42 it is telling us that if the underlying asset rises U $ S1, the price of the CALL contract will increase by U $ S 0.42.
IMPORTANT: CALL option contracts are always positive delta because a rise in their underlying asset implies a rise in the price of the contract;
and PUT option contracts are always delta negative because an increase in their underlying asset implies a decrease in the contract price.
This in the case of the purchase of contracts.
If we were selling and then buying (we will see later) the signs are the reverse.
The following must be taken into account:
Delta is greater as the options contract is more ITM (tends to 1)
Delta is smaller as the option contract is more OTM (tends to 0)
Delta is close to 0.50 if the contract is ATM, with its respective sign.
That is, delta moves between 0 and 1 (its absolute value would be the delta of the underlying asset).
The more ITM the contract is the more expensive it is, but the more they capture the movement of the underlying asset.
In conclusion, the greater the delta, the greater the benefit we will obtain if the movement is what we expect, and if it goes to the opposite side to ours, the greater the loss
