Getting Started With Options

What are options, futures and stocks?

A stock represents a fraction of ownership in a company or asset. A unit of stock is called a share. The price of shares is decided by demand and supply. (Investopedia Link)

A future is a contract to buy a stock or asset at a set price regardless of the current market price. Futures have an expiration date and are sold for a premium. One can purchase a future to limit the risk of a price change. Once the future expires, the buyer is obliged to purchase the underlying asset. (Investopedia Link)

An option is similar to a future, but it gives the buyer the choice to buy or sell the asset at expiration. (Investopedia Link) Options are of two types.

Call Options : Gives buyer the option to purchase the stock/assets at predetermined price. (Investopedia Link)

Put Options : Gives buyer the option to sell the stock/assets at predetermined price. (Investopedia Link)

Moneyness

Moneyness refers to the state of profit/loss with respect to the underlying stock or asset’s current or future price. (Investopedia link) There are 5 types of of moneyness

1. Deep In The Money
2. In the Money
3. At the Money
4. Out of the Money
5. Deep Out of the Money

Elementary strategy

1. Simple Buy and Sell Strategy

Above is the profit/loss to underlying price diagram for all possible trades with a single option.

Depending how we feel the the price of the underlying is going to change, we can sell/purchase the call/put options accordingly.

We might think that one can always buy call option due its limited risk and the unlimited profit and no one will sell a call option due to its unlimited loss and limited profit. We need to take into account the probability of this huge price change, which is very low.

2. Combination Strategies

When considering an options trade, we do not need to limit ourselves to the purchase or sale of an individual option. We can create a profit/loss graph by combining different options.

For example if we buy a call option and a put option or we sell a put option and a call option. we can alter the graph as below.

Draw.io link

This graph can be changed further by purchasing options with different strike prices and buying or selling call and put options.

How to construct a expiration graph

As of the above diagrams we can conclude that:

If the graph bends, it will do so at an exercise price. We can calculate profit or loss at each exercise price and simply connect the points with straight lines.

Terminology

1. underlying asset or underlying : The asset to be bought or sold under the terms of the option
2. exercise price or strike price : The price at which the underlying will be delivered if the holder chooses to exercise his right to buy/sell.
3. expiration date : date after which the option may no longer be exercised.