The Mechanics Of Options Trading
To become a successful options trader, it’s essential to understand the fundamental mechanics of options trading. In this chapter, we will explore the key components that make up options contracts, including option premiums, strike prices, expiration dates, and contract sizes.
Option Premiums
An option premium is the price you pay (or receive) for an options contract. It’s the upfront cost of buying an option or the amount you receive for selling one. Option premiums are determined by various factors, including:
1. Intrinsic Value
The intrinsic value of an option is the difference between the current market price of the underlying asset and the option’s strike price. For call options, intrinsic value exists when the market price is higher than the strike price. For put options, it exists when the market price is lower than the strike price.
2. Time Value
The time value of an option represents the portion of the premium that is not due to intrinsic value. It’s influenced by factors such as the time remaining until expiration, implied volatility, and market conditions. As the time to expiration decreases, the time value diminishes.
3. Implied Volatility
Implied volatility is a measure of the market’s expectations for future price fluctuations of the underlying asset. Higher implied volatility tends to result in higher option premiums, reflecting the increased potential for larger price swings.
4. Interest Rates
Interest rates also affect option premiums. Higher interest rates generally lead to higher call option premiums and lower put option premiums.
Option premiums are quoted on a per-share basis, with one contract typically representing 100 shares of the underlying asset.
Strike Prices
The strike price, also known as the exercise price, is the predetermined price at which the owner of an option can buy (for call options) or sell (for put options) the underlying asset. Strike prices are a crucial component of options contracts, and they come in different levels, allowing traders to choose options that align with their strategies and market expectations.
In-the-Money (ITM), At-the-Money (ATM), and Out-of-the-Money (OTM)
In-the-Money (ITM): An option with a strike price that would result in a profit if exercised immediately. For call options, the market price is higher than the strike price; for put options, it’s lower.
At-the-Money (ATM): An option with a strike price closest to the current market price of the underlying asset. There is no intrinsic value for ATM options.
Out-of-the-Money (OTM): An option with a strike price that would result in a loss if exercised immediately. For call options, the market price is lower than the strike price; for put options, it’s higher.
Expiration Dates
Every options contract has an expiration date, which specifies when the contract becomes invalid. After this date, the option can no longer be exercised, and it essentially expires worthless. Options typically have monthly expiration dates, although some assets may have weekly or even daily options.
American vs. European Style Options
American Style: American options can be exercised at any time before or on the expiration date. Most equity options in the U.S. are American style.
European Style: European options can only be exercised at expiration. European options are common for index options and some ETFs.
Contract Size
The contract size of an options contract determines how many shares of the underlying asset the contract controls. In most cases, one options contract controls 100 shares of the underlying asset. However, this can vary, especially for index options, where the contract size may be different.
Contract size is a critical consideration because it affects the total exposure and potential profit or loss for each options contract.
Conclusion
Understanding the mechanics of options trading is essential for making informed decisions and effectively managing your options positions. Option premiums, strike prices, expiration dates, and contract sizes are the building blocks of options contracts. By mastering these components, you’ll be better equipped to analyze and execute options trades that align with your trading goals and market expectations.