If many newcomers find options hard to trade, this partly depends on the specific terminology associated with them.
To keep things easy, the FinNexus team has come up with a list of five essential terms every options trader must know. Dig in!
Options belong to the larger class of derivatives, contracts that “derive” their value from an underlying asset. When the price of the underlier moves, so does the value of the derivative.
In the case of options, the variety of underliers is vast. An options contract can be based on the movement of a stock of a publically-traded company, a commodity such as oil, or a fiat currency, giving the holder the right to buy or sell it at an agreed price. The underlier could also be a futures contract, in which case the options would be based on another derivative, or even a basket of mixed securities.
A particularly interesting case of options to have emerged in recent years are those based on crypto assets such as BTC and ETH. Pioneered by crypto centralized finance platforms, they are only now spreading to the Decentralized Finance space, where FinNexus allows investors to buy and exercise BTC, ETH, LINK, SNX, and MKR options on Ethereum and Wanchain.
Options Types: Calls and Puts
Call options give holders the right, but not the obligation, to buy a security — be it a stock or commodity, a cryptocurrency or bonds — at a specified price within a certain timeframe.
The options contract specifies the price at which the contract can be exercised — the so-called strike price, more on it below — and the time when the contract will become void, as well as the premium that will be paid to the writer of the option.
In brief, call options benefit buyers when prices go beyond a certain level — the strike price — before a certain time (the expiration date).
Let us assume, for instance, that Andrew buys an options contract giving him the right to purchase 200 stocks of Company X if the latter’s price reaches $100. We are, let us say, at $80. If the prices of Company X rises above $100 per stock, Andrew will be able to pocket the difference between the price at which he settles and the strike price.
For example, assuming the price goes to $150, he will get $50. (To these $50 he will need to subtract the price of the premium paid to the writer of the option.)
By contrast, put options provide traders with the right — but, again, not the obligation — to sell a specific quantity of an underlying asset at an agreed price. No matter how low the market price of an asset goes, a trader who holds put options can sell at the price specified in the contract. This means that the lower the price goes past the strike price, the more profitable a trader will be.
Imagine an investor buying a put options contract with stock A as an underlier. The stock trades at $150, the contract our trader purchases has a premium of $10, a strike price of $120, and an expiry date of one year.
If six months later the price drops to $90, our trader will be able to exercise the contract pocketing $30, which will translate to a $20 profit once the premium is taken into account.
Unsurprisingly given their nature, put options can be often used as insurance against losses when longing an asset. By paying a small amount — the premium — an investor ensures that if the stock he is longing falls, he will have a countermeasure in place.
The strike price is a pre-agreed price at which the buyer can exercise the options contract. (So much so that it can also be referred to as “exercise price”.) Once the price moves beyond the strike price in the case of a call option or below it with puts, the contract can be profitably exercised.
As long as the price does not cross this threshold, the contract cannot be monetized. This does not make it automatically worthless, however, for as long as it is not expired it may still move into the money over time.
The Expiration Date
This is another essential element of an options contract. At some point in the future, the agreement between the two parties will end and the buyer will not be able to exercise it anymore. The exact details vary depending on the type of options in question, with American options allowing traders to settle on any day prior to expiration, while European options can only be settled on the date of expiry.
On that day, options contracts can either be “in the money” — meaning that the strike price has been reached and the buyer has the right to pocket the difference between the strike price and the current one — or “out of the money”. In the latter case, the contract cannot be exercised because the strike price has not been reached and the contract expires worthless, with the buyer losing the premium he/she has paid to the seller.
The premium is the sum that the buyer of an option has to pay to the writer for the right to hold the contract and, potentially, exercise it at a later date. Or, to put it in another way, it is the compensation that the writer will receive to take the risks associated with having to fulfill the pledge made in the contract — which can be onerous at times.
Over at FinNexus, we do not use a typical order book-based options trading system. Our users’ trade with pooled liquidity and premiums are shared among participants — another way in which FinNexians benefit from joining the platform, besides mining and staking rewards.