Options are derivatives that offer profit potential but at significant risk. Learn about types of options, the risks involved, and how effectively to use them in your portfolio.
An options contract gives its holder the right to buy (Call) or sell (Put) the underlying security at an agreed price and agreed time. You pay a premium for that right, and that impacts your profit. Bullish traders could opt for call options, whereas bearish traders would consider put options. You can also use a combination of options for advanced trading strategies. But trading options is risky and some strategies can lead to unlimited losses.
Open interest in options is the number of open options contracts held by market participants at the end of the trading day. High open interest may indicate continuation of a current price trend whereas low open interest could mean the current price trend losing steam. High open interest also is an indication of market activity for the option.
Delta in options trading refers to how much an option price will change for any change in the price of the underlying security. A delta of 0.5 for an option would imply a 50 cent upward or downward movement in the option price for every dollar change in the price of the underlying security. All else equal, at expiry, delta for in-the money call and put options trend towards 1 and -1 respectively.
Gamma is a second-order Greek because it measures the rate of how another Greek, Delta, changes with the stock price, and not how the option price itself changes. Positive gamma, as seen in long calls and long puts, implies fast-paced gains or slower rate of losses. Negative gamma, found in written calls or puts, means accelerated losses or slower gains.
All options contracts have an expiration date, after which they become worthless. Traditionally, index options expired on the 3rd Friday of the month. But now there are options with weekly expiration (Monday, Wednesday and Friday expiry), end of month expiration as well as quarterly expiration. Expiry dates affect the premium you pay. You exercise European options at expiry but American options can be exercised earlier.
Theta measures how the value of an option decreases as it nears expiration. It is also called time decay. Theta is typically negative for call or put options you purchase and positive for puts and calls you sell. It is one of the many “Greeks” used by derivative traders to assess risk.
Spreads are options strategies that help minimize risk by buying or selling a combination of different options contracts on the same underlying security. Spreads can be classified in many ways — vertical (same expiry, different strike price), horizontal (same strike price, different expiry) or diagonal. They may also be categorized as credit or debit spreads. Some spreads get more colorful names such as Collar, Strangle, Butterfly Spread etc.
Implied volatility is a prediction of how much the price of a security will move over a given period of time. It's most often used to price options contracts.
Vega is a measurement used to understand the price sensitivity of an options contract as the expected volatility of the underlying security changes. It’s among the many mathematical calculations that investors often refer to as “the Greeks,” which are calculations used for assessing the overall risk of an investment
The bear spread is built by selling a call option with a strike price, and then buying a call option at a higher strike price.
A calendar spread is an investment strategy for derivative contracts in which the investor buys and sells a derivative contract at the same time and same strike price, but for slightly different expiration dates.
A strike price is set for each option by the seller of the option, who is also called the writer. When you buy a call option, the strike price is the price at which you can buy the underlying stock if you want to use the option.
Premiums are the fees for buying an options contract, and they vary based on the current profit, volatility, and expiration date.
A European option is a style of options contract that only allows the option holder to exercise the option contract on the option’s expiration date. Options holders have the right to exercise the option but are not obligated to do so. They can also choose to let the option expire without exercising it.
A covered call is used when an investor sells call options against stock they already own or have bought for the purpose of such a transaction. By selling the call option, you’re giving the buyer of the call option the right to buy the underlying shares at a given price and a given time. This strategy is “covered,” because you already own the stock that will be sold to the buyer of the call option when they exercise it.
A collar is an advanced options strategy where investors sell call options and buy put options on stock they own to limit their potential losses from those shares. But a collar also limits any potential gains from those shares.
An American option is a style of option that gives investors the right to exercise the contract at any time between the day they purchase the contract and the expiration date of the contract.
A call option, or the right to buy an asset at a set price, is in the money if the current price of the asset is higher than that agreed-on price. A put option, or the right to sell an asset at a set price, is in the money if the price of the underlying asset is lower than that agreed-on price.
Out of the money (OTM) refers to a situation where the strike price is higher than the market price for a call, or lower than the market price for a put.