Options trading can be a lucrative form of trading, and its flexibility makes it an ideal trading method for many traders. As more and more people hop on the trading wagon, many are eager to try out trading financial derivatives like this one.
If you too are interested in options trading, the most important first step to take is to ensure you are aware of what an options trading contract is and how you can interpret one. In this article, we will go through what options trading is, the components that make an options trading contract, and how sellers price their contracts. We will also go through why people trade options and offer some tips on how to make the most of your trades.
- 1 What is options trading?
- 2 How options trading works
- 3 The components of an options contract
- 4 How sellers price contracts
- 5 How to choose the right contract
What is options trading?
In a nutshell, options trading is a form of financial derivative trading. It involves a contract seller selling an ‘options’ contract to a buyer. The contract is a legally binding agreement that allows – but does not obligate – the buyer to buy or sell a security at a chosen price on (or by) a predetermined date. Options contract buyers pay a premium to access the agreement.
As mentioned, buyers have the option to exercise the contract. If they do not feel like exercising it by the contract’s expiration date for any reason, they can let it expire worthlessly. This way, the only money they lose is the premium they paid when they purchased the contract.
How options trading works
A trader uses an options contract to speculate on the future price movement of an asset. They set a price and the number of units of the asset they want to trade, and they set a date in the future.
That is the day when the transaction will take place. If the trader’s speculations are correct, they will exercise their option and make a profit. This can be done by paying less than the market price to buy an asset or selling an asset for more than the market price.
The components of an options contract
To understand how sellers price options contracts, traders should first understand the components that make up an options contract. Below, we examine all of them:
The underlying asset
The underlying asset is the security the trader wishes to speculate on. This can be anything ranging from Forex to stocks and commodities, indices, and ETFs, to name a few. Traders also refer to this as simply ‘the underlying’ or ‘the underlier’. In a contract, you will see this as an instrument symbol.
The strike price
Another must-have in an options contract is the strike price. This is the price at which the transaction will take place if the trader wants to exercise the contract. The strike price of the contract determines its value at expiration.
The expiration date and contract type
Each option contract has an expiration date or a maturity date. Depending on your type of contract, you may be able to exercise your contract any time before the expiration date (if you are using an American-style contract) or on the day of expiry (if you are using a European contract).
After a contract expires, the contract will cease to exist or be worth anything. The only downside to letting a contract expire is that the buyer will lose the premium they paid at the time of purchase.
Finally, buyers pay premiums to purchase an options contract. This is a sum of money that represents the sum of the contract’s intrinsic and time value.
How sellers price contracts
Options contract pricing can be complicated, and it is important for traders to understand them thoroughly before attempting to participate in trading.
There are three key components that determine the price of a contract, or it’s premium: its intrinsic value, time value, and implied volatility. All these factors make up what is commonly known as an options contract’s ‘moneyness’.
This is one of the biggest components of how sellers determine their contracts. Intrinsic value is the price difference between the current market price of a security and the strike price.
For example, a stock is currently trading at $60 per share. The strike price of the options contract is $56. In this case, the intrinsic value of the contract would be the difference between the current share price and the strike price, which is $60 – $56 = $4.
If the premium of the contract is $5, then we can say that $4 out of $5 of the premium is intrinsic value. This is important, and traders look for the ratio between an option’s intrinsic value and its premium. The higher the intrinsic value as a fraction of the premium, the more likely the option will move in direct proportion to market price fluctuations.
Secondly, all options contracts have expiration dates. The closer an option is to expiring, the less time value it has, and the less a trader must pay for the contract. This is because buying an option is essentially buying time, and the further away a contract expires, the more time the market has, to move in the trader’s favor.
Finally, implied volatility is when a trader looks at the current price and market movements to speculate on future price movements. If there have been a lot of fluctuations, there may be high implied volatility.
Higher implied volatility will often lead to a higher premium because it means there may be a good chance of the security moving beyond the strike price set in the contract. The increased opportunity for profit causes contract sellers to ask for a higher price.
How to choose the right contract
If you are newer to options trading and you are unsure of how to choose the right contract for you, you can ask yourself the following questions:
- What is your investment objective?
Before you make a move, you should always have an investment objective. For example, are you looking to hedge an existing position? This will determine when you want your contract to expire. As always, contracts with expiration dates that are further out may be a better match for you, so you can ride out market fluctuations.
- How is the market doing?
Before investing in a security, check out how it is doing. Look up its historical price charts to make comparisons with its current price chart and determine what its implied volatility is. This is important, as it will determine how much your premiums will cost, which can affect your risk/reward ratio.
- What are some major economic events that can affect market pricing?
Consider the factors that drive the security you want to speculate on and any major economic events that can affect market pricing. For example, if you want to trade a stock option, you may want to see if there will be any data releases before the contract expires. Will the company be releasing its annual revenue report? Are they looking for a turnover in management? Announcements like these can have an impact on the implied volatility of your chosen stock, which can affect how you want to set the timeframe of your contract.
- What is your risk appetite?
Finally, you should consider how much risk you can take. If you are an aggressive investor, you may want to opt for more high-risk writing strategies and buy puts on securities you think will depreciate. If you are a more cautious investor, you may prefer establishing firm parameters in your strike prices and expiration dates to ensure you purchase contracts at the lowest possible cost.
A successful options trading strategy begins with understanding how options contracts work. Options can be complicated products, so you should ensure you do sufficient research before dipping your toes in the market. If in doubt, you should contact a financial professional on how you can best get started.
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