Welcome to Alpha’s Options Education Centre. Whether you are just beginning to trade or you are a seasoned investor looking for new trading strategies, this Centre provides a wealth of information on the most relevant topics.
What is an Option?
An Option gives the purchaser the right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock, commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of time.
For stock options, the amount is usually 1000 shares or 100 in the US. Each option has a buyer, called the holder, and a seller, known as the writer. If the option contract is exercised, the writer is responsible for fulfilling the terms of the contract by delivering the shares to the appropriate party.
In the case of a security that cannot be delivered such as an index, the contract is settled in cash. For the holder, the potential loss is limited to the price paid to acquire the option. When an option is not exercised, it expires. No shares change hands and the money spent to purchase the option is lost. For the buyer, the upside is unlimited. Options are therefore said to have an asymmetrical payoff pattern.
For the writer, the potential loss is unlimited unless the contract is covered, meaning, in the case of a written covered call option, that the writer already owns the security underlying the option. Options are used most frequently as either leverage or protection. As leverage, options allow the holder to control equity in a limited capacity for a fraction of what the shares would cost. The difference can be invested elsewhere until the option is exercised. As protection, options can guard against price fluctuations because they provide the right to acquire the underlying stock at a fixed price for a limited time. Risk is limited to the option premium (except when writing options for a security that is not already owned). However, the costs of trading options (including both commissions and the bid/ask spread) is higher on a percentage basis than trading the underlying stock. In addition, options are very complex and require a great deal of observation and maintenance.
Alpha offer Options trading in the following markets:
- US, Canadian, Australian, some European and Asian stocks and Indices
- ETF (Exchange Traded Funds)
- Currencies both Spot and Futures
For aggressive investors who have a strong feeling that a particular stock is about to move lower, long puts are an excellent low risk, high reward strategy. Rather than opening yourself to enormous risk of short selling stock, you could buy puts (the right to sell the stock).
Selling naked calls is a very risky strategy which should be utilised with extreme caution. By selling calls without owning the underlying stock, you collect the option premium and hope the stock either stays steady or declines in value. If the stock increases in value this strategy has unlimited risk.
Put Back Spread
For aggressive investors who expect big downward moves in already volatile stocks, backspreads are great strategies. The trade itself involves selling a put at a higher strike and buying a greater number of puts at a lower strike price.
Bear Call Spread
For investors who maintain a generally negative feeling about a stock, bear spreads are a nice low risk, low reward strategies. This trade involves selling a lower strike call, usually at or near the current stock price, and buying a higher strike, out-of-the-money call.
Bear Put Spread
For investors who maintain a generally negative feeling about a stock, bear spreads are another nice low risk, low reward strategy. This trade involves buying a put at a higher strike and selling another put at a lower strike. Like bear call spreads, bear put spreads profit when the price of the underlying stock decreases.
Is a low risk, low reward options strategy designed to take advantage of a range bound stock or market. It can be created using either call options or put options. An example of a Butterfly spread would be: Buying 1 in the money Call option, selling 2 at the money call options and buying 1 out of the money call option.
Is a limited risk, non directional options trading strategy (similar to the Butterfly spread) comprising 4 options with the only difference being the 2 at the money options in the Butterfly spread have strikes of in the money and out of the money (one of each) in the Condor structure.
Holding a position in both a call and put with the same strike price and expiration. The position is profitable (to the buyer) if the underlying stock changes value in a significant way, either higher or lower. If the options have been bought, the holder has a long straddle. If the options were sold, the holder has a short straddle.
The simultaneous buying or selling of out-of-the-money put and an out-of-the-money call, with the same expirations. Similar to the straddle, but with different strike prices.
Options are known as Derivatives of their underlying reference asset (stock index etc). As such, the change in a number of underlying parameters can cause a change in the value of an option. These sensitivities are termed The Greeks.
The Greeks are calculated from the price of the stock, the strike price of the option, the estimate of volatility of the stock, the time to expiration of the option, the current interest rate and any dividends payable on the stock before the expiration date of the option.
The Delta of an option measures the rate of change in the option value with respect to changes in the underlying asset’s price. The Delta of a long call is positive; the delta of a long put is negative. The delta is reversed for short calls and puts. This can be understood by knowing that, all things being equal, a long call makes money if the stock price goes up, and a long put makes money if the stock price goes down.
The Gamma of an option measures the rate of change in the Delta with respect to changes in the underlying price of the reference asset. If you look at delta as the “speed” of your option position, gamma is the “acceleration”. The gamma of long options, calls or puts, is always positive; of short options, always negative. Gamma is highest for the ATM strike, and slopes off toward the ITM and OTM strikes. One good way of interpreting gamma is that long gamma “manufactures” deltas in the direction the stock is moving. That is, positive gamma is why long calls get more positive delta when the stock price rises, and why long puts get more negative deltas when the stock price falls. With a small gamma, your position delta probably won’t change much. The more gamma your position has, your position delta can change a great deal and needs close monitoring.
But if you think the price of a stock is going to move a great deal very quickly, you want to buy an option with relatively high gamma. The high positive gamma will get you more deltas if the stock price moves the way you want it to, and reduce your deltas if the stock price moves against you.
The Theta of an option or “Time Decay” measures the sensitivity of the value of the option to the passage of time. Long calls and puts have negative theta and, all other things being equal, lose “Time Value” as time passes. Short calls and puts have positive theta and, all other things being equal, make “Time Value” as time passes. The theta of options is indirectly proportional to gamma. When gamma is big and positive, theta tends to be big and negative. That’s the trade-off. A position that has a lot of gamma (good for fast changing stocks) also has lots of theta that is continuously eroding its value.
Theta is highest for the ATM strike, and slopes off to the ITM and OTM options, and responds to the passage of time and changes in volatility the same way that gamma does.
The Vega of an option measures the sensitivity of the options value to changes in the volatility of the value of the underlying reference asset. Long calls and puts both have positive Vega and, all things being equal, increase in value when volatility rises. Short calls and puts both have negative Vega and, all things being equal, increase in value when volatility falls. Volatilities move up and down, sometimes by significant amounts.
The Rho of an option measures sensitivity of the option value to movements in interest rates. The value of an option is usually (except in extreme circumstances) the least sensitive to changes in interest rates compared to its sensitivity to the other primary Greek measures.
If you would like more information and learn about options trading please contact 03 8662 4000 to speak with one of our Financial Advisers
The Australian Stock Exchange (ASX) provides free general education online options classes to help build your knowledge.