Friends, strategies that are based on option levels are gaining enormous popularity recently. And you know, this is not surprising, because often sellers of options are market makers who, before expiration, begin to defend their positions. Having information about the intentions of major market participants, you can calculate the target areas to which they are most profitable to bring the price. If you correctly use this knowledge, you can more accurately determine the direction of the trading instrument and increase the number of profitable transactions.
The topic is really interesting and we will definitely consider it, however, this should be done only after studying the basic concepts.
What is an option?
An option is a derivative financial instrument that depends on the price of the underlying asset. The role of such an asset may be a product, stock, currency, etc.
Because if we will consider options that are traded on American exchanges, then we will consider this particular type of option.
The option gives its buyer the right (but not the obligation) to buy or sell the underlying asset at a predetermined price (strike) before a predetermined period (expiration).
Key point: the option provides the right to purchase, from which we can refuse if it is not profitable for us.
I will explain with a simple example.
Let’s say today oranges cost 100 rubles. You predict that before the New Year they will cost much more. But you do not want to overpay and would be glad to buy them at today’s price. To do this, you go to the options seller and buy from him a Call option with expiration on December 31 and a strike of 100 rubles. For this transaction, you will have to pay a premium of 5 rubles.
Several months pass, the New Year is approaching (the expiration date of your option). Now, depending on the cost of oranges in the market, events will develop as follows.
- Oranges fell in price to 70 rubles/kg. You do not use your right to buy at 100 rubles, but go to the market and buy them at the current price of 70 rubles.
Losses will amount to 5 rubles (the premium you paid when purchasing the option).
Benefit – saved 30 rubles (due to the difference in price).
- Oranges cost the same – 100 rubles. You can use your right to buy or refuse it. In any case, the loss will be limited to the premium paid in 5 rubles.
- Oranges went up to 130 rubles. You use your right to buy at 100 rubles.
Losses – a premium of 5 rubles.
The benefit is 30 rubles because, at a market value of oranges at 130 rubles, you get them at 100 rubles.
What conclusion can be made?
When you purchase an option, regardless of how much the underlying asset will cost at the time of expiration, your maximum losses will not exceed the premium size.
When selling an option, the situation is completely opposite: the maximum that you can earn is a premium, but you can lose everything because they are not limited by anything. Therefore, professional traders do not recommend selling uncovered options.
Types of options.
There are 2 types of options:
- Put – the right to sell;
- Call – the right to purchase.
For those who are used to trading in the market by pressing the buy & sell buttons, this terminology is not so easy to understand. But if you look at the figure below, everything will fall into place.
Imagine that we have a certain range limited by the prices of 80 and 120 (strikes) above and below. Now the price is within this range. Below are put options, above are call options. According to our forecast, the price will come out of this corridor after some time (before expiration) and we are going to make money on it. If we believe that the price will rise, then we need to buy call options, to fall – put. Please note that in both cases we buy options. If with the purchase of call everything looks quite logical, then the purchase of put to make money on lowering the price looks very illogical. Therefore, some novice traders may be mistaken when placing orders, which in turn leads to sad consequences. So be careful.