Financial Options: A Guide to Puts and Calls

If you are interested in trading financial options, you need to understand the basics of puts and calls. These are the two types of derivative contracts that give you the right, but not the obligation, to buy or sell an underlying asset at a specified price before a certain expiration date. In this article, we will explain how puts and calls work, how they are priced, and what are some of the common strategies that combine both types of options.

In order to better understand the options you should be aware of a couple of essential terms:

• Option strike price is the price at which the holder of an option can buy or sell the underlying asset. It is also known as the exercise price.

• Option expiration is the date and time when an option contract becomes invalid. For American options, the buyer can exercise the option at any point up to and including the expiration date. For European options, the holder can only exercise the option on the expiration date itself.

• Underlying asset of an option is the financial asset upon which a derivative’s price is based. For example, the underlying asset for an option on stock XYZ is the stock of XYZ. 

Puts and Calls: What Are They?

For example, if you think that XYZ stock will rise to $60 in the next month, you can buy a call option with a strike price of $55 and an expiration date of one month. The advantage of buying an option instead of investing in the stock itself is that you are able to enter a position using less money to initiate it. Let’s imagine that the call contract is priced at $2, and the price reaches your target price by the end of month. You would receive a net profit of $3. If you invested in 100 contracts, your total investment of $200 would return a $300. If the stock traded at the money beginning of month (stock price = strike price), you would be able to afford only three shares with a total investment of $165 and net return of $15 at the end of month.

Puts and Calls: How Are They Priced?

The price of an option depends on several factors, such as:

• The current price of the underlying asset
• The strike price of the option
• The time remaining until expiration
• The volatility of the underlying asset
• The interest rate and dividends

The relationship between these factors and the option price is determined by mathematical models, such as the Black-Scholes formula.

One important concept to understand is that options have intrinsic value and extrinsic value. The intrinsic value is the difference between the current price of the underlying asset and the strike price of the option, if it is in-the-money. An option is in-the-money if it would be profitable to exercise it right now. For example, a call option with a strike price of $55 on a stock that is trading at $60 has an intrinsic value of $5. Similarly, a put option with a strike price of $55 on a stock that is trading at $50 has an intrinsic value of $5.

The extrinsic value is the amount that you pay for the option above its intrinsic value. It reflects the time value and the volatility value of the option. The time value is based on the probability that the option will become more in-the-money or less out-of-the-money before expiration. The volatility value is based on the expected fluctuations in the price of the underlying asset. The extrinsic value decreases as the expiration date approaches, which is known as time decay.

Option Greeks

What are the so-called Option Greeks and how can they help you make better decisions in the market? Option Greeks are measures of how sensitive an option’s price is to various factors, such as the underlying asset’s price, volatility, time to expiration, interest rate, and dividend. By understanding option Greeks, you can better estimate how your option’s value will change in response to market conditions, and adjust your position accordingly. Some common option Greeks are:

• Delta: measures how much an option’s price changes for every one unit change in the underlying asset’s price. Delta ranges from 0 to 1 for call options, and -1 to 0 for put options. The higher the delta, the more the option behaves like the underlying asset.
• Gamma: measures how much an option’s delta changes for every one unit change in the underlying asset’s price. Gamma is highest for at-the-money options and decreases as the option becomes more in-the-money or out-of-the-money. The higher the gamma, the more sensitive the option is to price movements.
• Theta: measures how much an option’s price decreases for every one unit of time that passes. Theta is usually negative, meaning that options lose value as they approach expiration. The higher the theta, the faster the option decays.
• Vega: measures how much an option’s price changes for every one unit change in the underlying asset’s volatility. Vega is usually positive, meaning that options increase in value as volatility increases. The higher the vega, the more sensitive the option is to volatility changes.
• Rho: measures how much an option’s price changes for every one unit change in the interest rate. Rho is usually positive for call options and negative for put options, meaning that call options increase in value as interest rates increase, and vice versa for put options. The higher the rho, the more sensitive the option is to interest rate changes.

Option Strategies

Option strategies are combinations of buying and selling different types of options (calls and puts) with different strike prices and expiration dates. By using option strategies, you can create various outcomes depending on your view of the underlying asset’s price direction, volatility, and time decay. Some common option strategies are:

• Covered call: selling a call option while owning the underlying asset to generate income and reduce downside risk.
• Protective put: buying a put option while owning the underlying asset to protect against a large drop in price.
• Straddle: buying a call and a put option with the same strike price and expiration date to profit from a large price movement in either direction.
• Strangle: buying a call and a put option with different strike prices but the same expiration date to profit from a large price movement in either direction, but with lower cost than a straddle.
• Butterfly: buying two options with the same strike price and selling two options with a higher and lower strike price, all with the same expiration date, to profit from a narrow range of price movement.
• Iron condor: selling two options with the same strike price and buying two options with a higher and lower strike price, all with the same expiration date, to profit from a low volatility environment.

Final Remarks

Option strategies and option Greeks are essential tools for any option trader who wants to understand and manage their risk exposure, diversify their portfolio, and enhance their performance. By combining different types of options with different parameters, you can create various scenarios that suit your market outlook, trading style, and risk appetite. By monitoring how your options react to different factors, you can adjust your position accordingly and optimize your returns. However, keep in mind that option trading involves high risk and complexity, so you should always do your research before entering any trade.

Please note, none of the information on this blog represents the opinion of my employer and all information does not represent a financial advice.

Please note, none of the information on this blog represents the opinion of my employer and all information does not represent a financial advice.