{"id":521,"date":"2019-06-06T08:34:15","date_gmt":"2019-06-06T08:34:15","guid":{"rendered":"http:\/\/algotrading101.com\/wiki\/?p=521"},"modified":"2019-06-09T17:51:51","modified_gmt":"2019-06-09T17:51:51","slug":"options-trading-basics","status":"publish","type":"post","link":"https:\/\/algotrading101.com\/wiki\/options-trading-basics\/","title":{"rendered":"Options Trading Basics"},"content":{"rendered":"\n<p class=\"has-medium-font-size wp-block-paragraph\"><strong>Definition<\/strong><\/p>\n\n\n\n<hr class=\"wp-block-separator\"\/>\n\n\n\n<p class=\"wp-block-paragraph\">An option gives the option holder a choice to buy or sell a pre-agreed asset at a certain pre-agreed price.<\/p>\n\n\n\n<p class=\"has-medium-font-size wp-block-paragraph\"><strong>Description<\/strong><\/p>\n\n\n\n<hr class=\"wp-block-separator\"\/>\n\n\n\n<p class=\"wp-block-paragraph\">There are 2 main types of options: 1) Call option and 2) Put option.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Call options gives the option holder a choice to <em>buy<\/em> a pre-agreed asset at a certain pre-agreed price. <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Put options gives the option holder a choice to <span style=\"background-color: rgb(232, 234, 235);\"><i>sell <\/i><\/span>a pre-agreed asset at a certain pre-agreed price.  <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">This pre-agreed asset is called the underlying asset, in other words, it is the asset that is attached to this option.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">This pre-agreed price is called the strike price.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Example of an Option Trade<\/strong><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><em>Call option example:<\/em><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Trader A buys the Apple&#8217;s call option at strike price $190. In this case, Apple is the underlying asset.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Let&#8217;s assume Apple is trading at $180 today. Trader A&#8217;s call option is not very valuable as we can buy Apple stock directly for $180. Thus, we don&#8217;t want to exercise the choice to buy it at $190 (a more expensive price).<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">If Apple goes to $200 tomorrow, Trader A&#8217;s call option becomes more valuable. We can now exercise our choice to buy Apple at $190 and immediately sell Apple at the exchange for $200 (a $10 profit).<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><em>Put option example:<\/em><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Trader B buys the Google&#8217;s put option at strike price $1200.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Let&#8217;s assume Google is trading at $1300 today. Trader B&#8217;s put option is not very valuable as we can sell Google in the market for $1300. Thus, we don&#8217;t want to exercise the choice to sell it at $1200 (a lower price). <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">If Google drops to $1100 tomorrow, Trader B&#8217;s put option becomes more valuable. We can now immediately buy Google from the exchange at $1100 and exercise our choice to sell Google at $1200 (a $100 profit). <\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Payoff Charts<\/strong><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">We use charts to get a better look at our payoffs, i.e. how much we will make (or lose) as the underlying asset&#8217;s price moves.<\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter\"><img loading=\"lazy\" decoding=\"async\" width=\"487\" height=\"297\" src=\"http:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/call-option-payoff-diagram.png\" alt=\"call-option-payoff-diagram\" class=\"wp-image-628\" srcset=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/call-option-payoff-diagram.png 487w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/call-option-payoff-diagram-300x183.png 300w\" sizes=\"auto, (max-width: 487px) 100vw, 487px\" \/><figcaption>Call Option Payoff Diagram. Strike price at $50.<\/figcaption><\/figure><\/div>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter\"><img loading=\"lazy\" decoding=\"async\" width=\"488\" height=\"298\" src=\"http:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/put-option-payoff-diagram.png\" alt=\"put-option-payoff-diagram\" class=\"wp-image-629\" srcset=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/put-option-payoff-diagram.png 488w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/put-option-payoff-diagram-300x183.png 300w\" sizes=\"auto, (max-width: 488px) 100vw, 488px\" \/><figcaption> Put Option Payoff Diagram. Strike price at $50.  <\/figcaption><\/figure><\/div>\n\n\n\n<p class=\"wp-block-paragraph\">From the diagram above, we can see that when the payoff is:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li>$50. The payoff is $0.<\/li><li>$40. The payoff is $10.<\/li><li>$30. The payoff is $20.<\/li><li>$20. The payoff is $30.<\/li><\/ul>\n\n\n\n<p class=\"wp-block-paragraph\">This makes sense as if we own this put option when the underlying is $30, we can immediately buy the underlying from the exchange at $30, and exercise our choice to sell it at $50. Thus, netting a $20 profit.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">To exercise an option means to buy or sell the underlying assets at the pre-agreed strike price.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Moneyness<\/strong><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Moneyness describes how we name options at different profit or loss levels. There are 3 terms used to describe this:<\/p>\n\n\n\n<ol class=\"wp-block-list\"><li>In-the-money (ITM): Our payoff is positive.<\/li><li>At-the-money (ATM): Our payoff is zero. Strike price = Underlying asset&#8217;s price.<\/li><li>Out-of-the-money (OTM): Our payoff is zero (or negative after considering the cost of the option). <ul><li>For call options, strike price is greater than underlying asset&#8217;s price.<\/li><li>For put options, strike price is less than underlying asset&#8217;s price. <\/li><\/ul><\/li><\/ol>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Expiration<\/strong><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Options expire at a certain pre-agreed date. <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">If the options holder did not exercise the option by then, the option becomes worthless if it is ATM or OTM. If the option is ITM, it will be automatically exercised.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Cost of Options (Premiums)<\/strong><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">If the stock goes higher than your call option strike price, you make profits. If it doesn&#8217;t, you don&#8217;t make losses. It might seem like a deal too good to be true.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">And yes, it is.  <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">The catch is that you need to pay to buy call or put options. The costs of the option is known as the premium.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">The premium goes up as the the option gets more ITM as we need to take into account the profit already accumulated by this option.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">The premium goes down as the option gets less ITM as we need to take into account that the profit is far in sight.<\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter\"><img loading=\"lazy\" decoding=\"async\" width=\"400\" height=\"300\" src=\"http:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/call-option-with-premium.gif\" alt=\"call option with premium\" class=\"wp-image-637\"\/><figcaption>Call option with $200 premium. Credits to theoptionsguide.com.<\/figcaption><\/figure><\/div>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter\"><img loading=\"lazy\" decoding=\"async\" width=\"400\" height=\"300\" src=\"http:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/put-option-with-premium.gif\" alt=\"put option with premium\" class=\"wp-image-638\"\/><figcaption> Put option with $200 premium. Credits to theoptionsguide.com. <\/figcaption><\/figure><\/div>\n\n\n\n<p class=\"wp-block-paragraph\">The premium shifts your diagram down, as you need to earn the premium amount before you go on to make a profit.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">This is an example of some of Apple&#8217;s options as viewed in a trading terminal:<\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter is-resized\"><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/option-trading-terminal-1024x731.png\" alt=\"\" class=\"wp-image-707\" width=\"768\" height=\"548\" srcset=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/option-trading-terminal-1024x731.png 1024w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/option-trading-terminal-300x214.png 300w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/option-trading-terminal-768x548.png 768w, https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/option-trading-terminal.png 1313w\" sizes=\"auto, (max-width: 768px) 100vw, 768px\" \/><figcaption>Apple stock options<\/figcaption><\/figure><\/div>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Selling Options<\/strong><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Traders are able to sell options too. The payoff will be the exact opposite of that of an option buyer.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">In this case we are selling that option without first owning it. When you do that, you are said to have shorted that option.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Option buyers pay a premium and hope that the option goes ITM.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Option sellers receive a premium and hope that the option does not go ITM.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">In this aspect, options seller have a limit on how much they can make but their potential losses are unlimited. Vice versa for option buyers.<\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter\"><img loading=\"lazy\" decoding=\"async\" width=\"295\" height=\"230\" src=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/short_call.png\" alt=\"\" class=\"wp-image-643\"\/><figcaption>Short call option payoff diagram. Credits to optionsplaybook.com.<\/figcaption><\/figure><\/div>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter\"><img loading=\"lazy\" decoding=\"async\" width=\"295\" height=\"230\" src=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/short_put.png\" alt=\"\" class=\"wp-image-644\"\/><figcaption> <br>Short put option payoff diagram.  <br>Credits to optionsplaybook.com. <\/figcaption><\/figure><\/div>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Option Combinations &#8211; Strategies<\/strong><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">You can combine different options to create unique structures. Here is a short non-exhaustive list:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li>Straddle<\/li><li>Put Spreads<\/li><li>Iron Condor<\/li><\/ul>\n\n\n\n<p class=\"wp-block-paragraph\"><em>Straddle<\/em><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">When Trader A buys a call option and a put option at the same strike price, the resulting position is a long straddle.<\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter\"><img loading=\"lazy\" decoding=\"async\" width=\"295\" height=\"230\" src=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/long_straddle.png\" alt=\"\" class=\"wp-image-641\"\/><figcaption>Long straddle.  <br>Credits to optionsplaybook.com. <\/figcaption><\/figure><\/div>\n\n\n\n<p class=\"wp-block-paragraph\">The above is your payoff diagram when you long a straddle.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">You long a straddle when you want to bet that there is going to be a big move, but you&#8217;re not sure if the move will be up or down.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">The cost of this trade is double that of a regular call or put option.<\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter\"><img loading=\"lazy\" decoding=\"async\" width=\"295\" height=\"230\" src=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/short_straddle.png\" alt=\"\" class=\"wp-image-642\"\/><figcaption>Short straddle.  <br>Credits to optionsplaybook.com. <\/figcaption><\/figure><\/div>\n\n\n\n<p class=\"wp-block-paragraph\">The above is your payoff diagram when you short a straddle. <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">This involves selling a call and put option at the same strike price.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">You short a straddle when you want to bet that there isn&#8217;t going to be much movement.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><em>Put Spread<\/em><\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter\"><img loading=\"lazy\" decoding=\"async\" width=\"295\" height=\"230\" src=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/long_put_spread.png\" alt=\"\" class=\"wp-image-647\"\/><figcaption>Long put spread. Credits to optionsplaybook.com. <br><\/figcaption><\/figure><\/div>\n\n\n\n<p class=\"wp-block-paragraph\">When Trader A sells a put option at strike price A and buys a put at strike price B (where B is greater than A), the resulting position is a long put spread.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">The rationale of this trade is that you want to bet that the underlying asset will fall by a little. But you want some insurance to protect yourself if the price rises.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">The long put option at strike price B will provide that insurance. The cost of this insurance is the premium of that put option.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">A long put spread is also known as a bear put spread or vertical spread.<\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter\"><img loading=\"lazy\" decoding=\"async\" width=\"295\" height=\"230\" src=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/short_put_spread.png\" alt=\"\" class=\"wp-image-648\"\/><figcaption> Short put spread. Credits to optionsplaybook.com.  <\/figcaption><\/figure><\/div>\n\n\n\n<p class=\"wp-block-paragraph\">When Trader A buys a put option at strike price A and sells a put at strike price B (where B is greater than A), the resulting position is a short put spread. <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">The rationale of this trade is that you want to bet that the underlying asset will rise by a little. But you want some insurance to protect yourself if the price falls. <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">The long put option at strike price A will provide that insurance. The cost of this insurance is the premium of that put option. <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">A short put spread is also known as a bull put spread or vertical spread. <\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><em>Iron Condor<\/em><\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter\"><img loading=\"lazy\" decoding=\"async\" width=\"295\" height=\"230\" src=\"https:\/\/algotrading101.com\/wiki\/wp-content\/uploads\/2019\/06\/iron_condor.png\" alt=\"\" class=\"wp-image-652\"\/><figcaption>Iron Condor<\/figcaption><\/figure><\/div>\n\n\n\n<p class=\"wp-block-paragraph\">The iron condor is formed by buying a put option at strike A, selling a put option at strike B, selling a call option at strike C and buying a call option at strike D.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">The rationale of this trade is that you want to bet that the underlying stock price will stay between B and C. <\/p>\n\n\n\n<p class=\"wp-block-paragraph\">You give up some profits (when the underlying is between B and C) in order to gain some premiums from selling 2 options, to reduce the cost of this structure.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><em>We have only listed 3 option strategies that can be made by combining options and stocks. Here are 40 more option strategies: <\/em><a rel=\"noopener noreferrer\" href=\"https:\/\/www.optionsplaybook.com\/option-strategies\/\" target=\"_blank\"><em>Options Strategies &#8211; Optionsplaybook.com<\/em><\/a><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Why Trade Options<\/strong><\/p>\n\n\n\n<ul class=\"wp-block-list\"><li>To create creative trades by trading structures as seen in the above section.<\/li><li>To hedge certain exposure. Think of this as buying insurance on your trades by giving up potential gains.<\/li><li>To leverage. Option premiums are relatively low compared to the potential gains. (This doesn&#8217;t mean trading options is generally profitable.)<\/li><\/ul>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Regular Options<\/strong><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">These are common options that are traded in the markets.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><em>American Options<\/em><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">These are the most common options which can be exercised anytime. Despite it&#8217;s name, it has nothing to do with American stocks.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><em>European Options<\/em><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">These are options which can only be exercised on expiration. Despite it&#8217;s name, it has nothing to do with European stocks.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Exotic Options<\/strong><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">There also exist unique options with quirky features.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><em>Barrier Options<\/em><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">These come into existence or become worthless once the underlying asset reaches a certain pre-agreed price.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><em>Asian Options<\/em><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Asian options&#8217; payoffs are determined by the average price of the underlying asset over a pre-set period of time.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><em>Basket Options<\/em><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Basket Options are based on more than one underlying asset. The payoff of the basket option is based on the average price of a group of underlying assets.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><em>Lookback Options<\/em><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Lookback options have no strike price initially. On the expiry date, the option holder will choose a strike price among all the prices that have occurred during the lifetime of the option. Usually the holder will choose the most favorable strike price. <\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><em>We have covered 4 exotic options, read about another 8 more here: <\/em><a rel=\"noopener noreferrer\" href=\"https:\/\/corporatefinanceinstitute.com\/resources\/knowledge\/trading-investing\/exotic-options\/\" target=\"_blank\"><em>What are Exotic Options &#8211; Corporate Finance Institute.<\/em><\/a><\/p>\n\n\n\n<p class=\"has-medium-font-size wp-block-paragraph\"><strong> Links to Other Explanations<\/strong><\/p>\n\n\n\n<hr class=\"wp-block-separator\"\/>\n\n\n\n<ul><li><a rel=\"noopener nofollow noreferrer\" href=\"https:\/\/www.investopedia.com\/terms\/o\/option.asp\" target=\"_blank\" aria-label=\" (opens in a new tab)\">Options &#8211; Investopedia<\/a><\/li><li><a rel=\"noopener nofollow noreferrer\" aria-label=\" (opens in a new tab)\" href=\"https:\/\/en.wikipedia.org\/wiki\/Option_(finance)\" target=\"_blank\">Option (Finance) &#8211; Wikipedia<\/a><\/li><\/ul>\n\n\n\n<p class=\"has-medium-font-size wp-block-paragraph\"><strong>Related Terms<\/strong><\/p>\n\n\n\n<hr class=\"wp-block-separator\"\/>\n\n\n\n<ul class=\"wp-block-list\"><li><a href=\"https:\/\/algotrading101.com\/wiki\/algorithmic-trading-strategies\/\">Algorithmic Trading Strategies<\/a><\/li><li><a href=\"https:\/\/algotrading101.com\/wiki\/stochastic-calculus\/\">Stochastic Calculus<\/a><\/li><li><a href=\"https:\/\/algotrading101.com\/wiki\/backtesting-biases-and-risks\/\">Backtesting Biases and Risks<\/a><\/li><\/ul>\n","protected":false},"excerpt":{"rendered":"<p>Definition An option gives the option holder a choice to buy or sell a pre-agreed asset at a certain pre-agreed price. Description There are 2 main types of options: 1) Call option and 2) Put option. Call options gives the option holder a choice to buy a pre-agreed asset at a certain pre-agreed price. Put [&hellip;]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_links_to":"","_links_to_target":"","footnotes":""},"categories":[2],"tags":[],"class_list":["post-521","post","type-post","status-publish","format-standard","hentry","category-finance-resources"],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v28.7 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Options Trading Basics Simplified - AlgoTrading101 Wiki<\/title>\n<meta name=\"description\" content=\"Quantitative Finance - Explain Like I&#039;m Five\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"http:\/\/algotrading101.com\/wiki\/options-trading-basics\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Options Trading Basics Simplified - 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