When getting into options trading, you might find yourself scratching your head. Although it can seem complicated at first, once you break it down, you can begin to understand this trading concept. Like stocks, bonds, ETFs, and mutual funds, options are another asset class. To fully understand options trading, you also need to understand the Greeks. Let’s get started.
What Options Are
Options are contracts that give buyers the right to buy or sell a stock at a specified date and price. Although you have this right, you are not obligated to buy or sell the stock. Like many other asset classes, you can purchase options with brokerage investment accounts. The purpose of buying an option is to enhance your portfolio. You can use them to generate recurring income and to wager on the direction of a stock. Similarly to stocks and bonds, options come with risk since they are speculative in nature.
Put and Call Options Contracts
Options are a kind of derivative security, which means that their price is dependent on or derives from the price of something else. With a call option, the holder has the right to buy a stock. This is beneficial because you are able to buy an underlying asset at the strike price any time prior to the expiration date you agreed upon. If you anticipate this price to rise, you can benefit from buying the underlying asset at a lower price.
With a put option, the holder has the right to sell a stock. You would choose this option if you anticipate the price of an underlying asset to fall. This way, you wouldn’t lose out on the amount it depreciates. Like the call option, you must make your decision to sell before the agreed-upon expiration date.
What Influences Options Pricing
What influences the price of an option can either benefit or hurt traders based on what positions they’ve taken. The option Greeks are a major component of what influences the price of an option. Named after Greek letters, they consist of delta, gamma, vega, and theta. They are a set of risk measures that tell you the following:
- Delta: The impact of an underlying asset’s change of price.
- Gamma: Delta’s rate of change.
- Vega: The impact of a change in volatility.
- Theta: The impact of a change in time remaining.
Measuring Risk With the Greeks
When measuring options risks with delta, understand that its value ranges from 0 to 100 for calls and 0 to -100 for puts. Gamma relates to delta in that it measures delta’s rate of change in relation to how much the underlying asset’s price changes. It helps you predict how much you will gain or lose based on how the underlying position moves. With theta, if it’s a positive value, you can expect gains from time value delay, while if it’s negative, you should expect losses from time value decay. Finally, with vega, you can measure future volatility, while delta focuses on the actual price changes.
When getting into options trading, there’s a lot to know. By starting with these basic concepts, you can begin to enhance your portfolio.