Getting Started With Options
What are options, futures and stocks?
A Stock represent a fraction of the ownership of the comapny/assets. A unit of stock is called shares. The price of the shares is decid ed by the demand and supply of the shares. (Investopedia Link)
A future is a contract to buy the stock at the set price regardless of the current price. Futures have expiration date and a set amount that are sold for a premium. One can purchase future for a premium to limit the risk of the price change. Once the future comes to an end the buyer is obliged to puchase the underlying assets. (Investopedia Link)
An option is similar to the futures, bu t it provides user the choice of accepting or refusing to buy the assets/stocks at the time of expirations.(Investopedia Link) These 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 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
- Deep In The Money
- In the Money
- At the Money
- Out of the Money
- Deep Out of the Money
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 the option trade we need not to limit ourself with purchase or sale of an individual option. We can create our profit/loss graph with combining differnet 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.
This graph can further be changed with purchashing options of different values and buying/selling a call/put option.
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/loss at each exercise price and simply connect points with straight line.
uderlying: The asset to be brought or sold under the term of the option
strike price: The price at which the underlying will be delivered if the holder chooses to exercise his right to buy/sell.
expiration date: date after which the option may no longer be exercised.