Understanding Options Trading

Options are financial derivatives that provide traders the right (but not the obligation) to buy or sell an underlying asset at a predetermined price within a specified time frame. There are two main types of options: call options, which grant the right to buy, and put options, which grant the right to sell.

Suppose you believe that the price of the FTSE 100, currently trading at 7462, will increase in the next few months. You may decide to buy a call option with a strike price of 7500 and an expiration date three months from now. This call option gives you the right, but not the obligation, to buy X contracts of the FTSE100 at the strike price of 7500, before the expiration date. This call option will cost you what is called a premium (the value of the option) and if price moves against you, say the FTSE 100 drops to 7400, the value of the call option will decrease as will the premium.

Now, let's say you're bearish on the FTSE 100 and believe its price will decrease. You decide to buy a put option with a strike price of 7400 and the same expiration date as before. This put option gives you the right, but not the obligation, to sell X contracts of the FTSE 100 at the strike price of 7400, before the expiration date.

In both examples, it's important to note that the options trader pays a premium for the call or put option, and this premium represents the cost of obtaining the right to buy or sell the underlying stock at the specified strike price. Additionally, options trading involves risks, and the value of options can fluctuate based on various factors, including the movement of the underlying stock price, time decay, and volatility – we go into more detail below.

Call Options

• Buyers of call options anticipate an increase in the price of the underlying asset.
  
  
• Max Gain – unlimited.
  
  
• Max Loss – the premium you paid.

• Sellers of call options anticipate a slight drop in price of the underlying asset and so a drop in the premium of the call.
  
  
• Max Gain – the premium.
  
  
• Max Loss – unlimited.

Put Options

• Buyers of put options speculate on a decrease in the price of the underlying asset.
  
  
• Max Gain: when the underlying asset price hits zero.
  
  
• Max Loss: the premium you paid.

• Sellers of put options anticipate a slight rise in price and the premium of the option dropping.
  
  
• Max Gain: the premium.
  
  
• Max Loss - when the underlying asset price hits zero.

Factors Influencing Option Premiums

• Intrinsic vs. Extrinsic Value:
  • Intrinsic Value: The amount by which an option is in-the-money (the option's strike price is favourable compared to the current market price).
  • Extrinsic Value (Time Value): The additional premium beyond intrinsic value, influenced by factors such as time to expiration, implied volatility, and interest rates.
    
    
• Implied Volatility (Vega):
  • The market's perception of future price volatility. Higher implied volatility often leads to higher option premiums, reflecting increased uncertainty and expectations of larger price swings in the underlying asset. Traders are willing to pay more for options to hedge against or capitalise on potential significant moves, driving up option premiums. The relationship stems from the market's perception of greater risk and the potential for larger gains or losses.
  • As options approach their expiration date, the time value diminishes, causing the option premium to decrease. This is because there's less time for the underlying stock to make significant moves. With less time for potential price changes, the options become less valuable, causing their premiums to decline. Traders need to be mindful of time decay, especially in short-term options.
    
    
• Underlying Asset Price (Delta):
  • The price of the underlying asset influences the premium of an option because it determines the potential for profit. For call options, as the asset's price rises, the option becomes more valuable. For put options, as the price falls, the option gains value. The underlying asset's price directly affects the option's perceived value and premium.
    
    
• Gamma:
  • Gamma measures how quickly an option's value changes with small shifts in the underlying asset's price. Higher gamma makes the option more responsive to price movements, increasing its value. Lower gamma has the opposite effect, making the option less sensitive and less valuable. So, gamma affects the premium by determining how much the option's value can change with small price shifts.
    
    
• Interest Rates:
  • Increasing interest rates can exert a modest yet measurable influence on option premiums. Call option premiums might experience a slight uptick, while put option premiums could see a marginal decrease in response to higher rates. The effect on short-term options is minimal, but the impact on longer-term options may be more discernible.