The Fundamentals of Option Trading: the mechanics of trading options
The Fundamentals of Option Trading: the mechanics of trading options Options are everywhere. Every decision you make and risk you assume is an option that is being priced, bought, or sold by somebody.What path do you take to get to work each morning? Is there one path that is faster when perfect, but has a risk of high traffic? Is there another path you choose that is slower but with less risk of a holdup?
The first path is high volatility, high risk. Taking this path is the equivalent of selling an option representing the possibility that you could be late for the premium of a few minutes saved on average. The second path is low volatility. The distribution of outcomes is small. The reward, on average, is small.
Or maybe you were running late and chose to drive over the speed limit or, more extreme, run a red light to make up time. In each case, you “sold an option” with a variable probability of getting caught and therefore increased risk.
How do you decide what house to purchase, what school to attend, what job to take?
It may not seem like these decisions contain embedded options. But each has a level of risk, reward, and cost associated with it. Each has a variable range of favorable or unfavorable outcomes that may or may not be within your control. Consider purchasing a piece of artwork from an unknown artist as an investment. The initial outlay is relatively small, and the probability that the artist will be recognized is relatively slim. However, if the artist does go on to fame, your small initial investment may appreciate significantly. This is a call option. The Investor participates in the potential upside in exchange for a small initial financial payment.
Now, let’s look at automobile insurance. We are insuring an asset of varying value, driven by an individual of varying risk, and willing to accept varying amounts of deductible. Should an accident occur, our initial outlay of insurance premium assures that we will receive monetary compensation to help recover our loss. This is a put option.
Typically, insurance providers compete with one another to provide services to their clients. But their clients cannot do the same in selling the risk profile back to the insurance company. All transactions are one-directional. Risk is transferred from the insurance policy purchaser to the provider.
In the modern options trading market, any participants may choose to match their risk profile to another by buying or selling optionality at any time. The derivatives marketplace provides a variety of products to facilitate the transfer of risk profiles between participants. To that end, it Is imperative to understand fully the pricing and characteristics (modeling risk) of the products you are trading.
Investors have a variety of needs and risk profiles. They may choose to utilize equity options for any of the following reasons:
1. To manage cash flows
Equity options can be used to mimic existing market positions with a much smaller initial cash outlay. In other words, options can be used to get leverage.
2. To assume exposure to market risks
Equity options can be used to enhance or hedge positions or give an investor access to a market exposure that is difficult or impossible to access in another way.
3. To provide exposure to convexity
Equity options can be used to give an investor exposure that changes over time or with the movement in an underlying asset.