An Option is a contract under which a seller gives a buyer the right to buy a certain asset within a set time at a previously agreed upon price. There are two major types of options - call options and put options. Options can be more convenient hedging instruments than futures contracts. They operate like insurance, where an option can safeguard against a loss for the price of the option premium, similar to an insurance premium. In a situation where market prices move in a favorable direction, initial gains will equal the paid premium on the option hedge, and, unlike futures, one can profit. Premium paid when buying an option has two components - "internal" and "time" cost. If profit is made having executed the option right after the purchase, we say that it has an internal cost and brings profit. Accordingly, in an opposite situation, the option will make a loss. If the spot price is equal to the execution price we say that the option will make no profit. If the option cost is higher than its internal cost we call it “time” cost. It is equal to zero at the execution date and is proportional to the square root of the duration to such date.
American options differ from European options. An American contract may be executed at any trading day before the expiration date, while a European option may be executed only at the contract expiration date. When doing operations with options, a broker is paid a commission which is usually lower than during the purchase of the basic asset. This difference is recovered when executing an option, as a commission is paid equal to the sum when buying or selling an asset.
Margin Support Terms
If a seller issues a covered call writing option, i.e. he owns a basic asset for an option than there is no requirement for a deposit and the necessary amount of asset is stored with a broker’s company.
If a naked call writing option is issued, i.e. a seller does not own a basic asset than the deposit is the higher amount out of two calculations. In the first calculation the amount is equal to the option premium plus 20% of the basic asset market price, minus the difference between the option execution price and the asset market rate (provided that the execution price is higher than the market rate). In the second, the amount is equal to the option premium plus 10% of the basic asset market price.
If a covered put writing option is sold, and the broker’s account has enough money (or other assets) in the sum of the option executed, then a margin payment is not required.
If there aren’t sufficient funds in a seller’s account (or other assets), the issued option is called naked put writing. The margin sum is calculated similarly to the call option with the only difference in the first calculation: the difference between the execution price and the market rate is deducted if the market rate is higher.
Various situations for option sellers and buyers from the point of view of profit or loss are shown on the following charts, where asset price is taken for 100:
.aspx)
Operations with options are made via a financial intermediary in the form of standard orders. They look like and have the same value as orders used on other markets.
Depending on the type of basic asset and circulation markets there are stock and out-of-stock OTC (over-the-counter):
- Index options
- Currency options
- Interest options
- Stock options
- Commodities options
One may combine selling and buying options to implement price plans which are shown on charts. See some widely used option strategies:
"Vertical spreads" foresee purchase and sale of options with various execution prices
"Volatile strategies” are based on a rate volatility forecast. The major question for the forecast is whether the prices will stay within a certain range.
"Long and short spreads" – purchase of put and call options with the same execution price and the same expiration date, or sales under similar conditions. rate Short spread Long spread
.aspx)
"Long and short strangles " - purchase of put and call options with the same expiration date but different execution price. Short strangle Long strangle rate
.aspx)
"Long and short “butterfly” spread ". Purchase of “butterfly” spread is a purchase of “profit spread”, sales of two options “call without profit” and purchase of option “call with loss” with similar contract execution date.
.aspx)