When it comes to investing, there are many ways to gain exposure to a particular asset.
Options are derivatives contracts that give the buyer the right, but not the obligation, to either purchase or sell an underlying asset at a fixed price on or before the contract expires.
Options can be used as a hedging device and for speculation, allowing investors to long or short the market with limited downside risk.
In the following article, we will provide a brief rundown of options basics, including key terms and risk measures.
Trading options involves buying calls and puts.
A call option gives you the right, but not the obligation, to purchase an asset within a specific period. The specified price is known as the strike price. You profit from call options when the underlying asset appreciates in value within the predetermined timeframe.
A put option gives you the right, but not the obligation, to sell a particular asset on or before expiration. The predetermined price that you can sell is also called the strike price. A trader buys a put option because they believe the price of an underlying asset will fall below the exercise price before expiration.
When you trade options, there are various risk measures you can use to analyze your position. These include:
- Delta: Measures the extent to which an option is exposed to changes in the price of an underlying asset. Delta values range from 1.0 to -1.0 (or 100 to -100). If you buy a call or put option that is out of the money (the strike price is above or below price of the underlying asset in a call or put, respectively) then the option will always have a delta value between 1.0 and -1.0.
- Gamma: Tells you how the option's delta will change over time as the price of the underlying asset changes.
- Theta: Measures the rate of an option's decline due to time. All things being equal, an option loses value as time moves closer to the maturity of the option.
- Vega: Calculates an option's price sensitivity relative to the underlying asset's volatility. It represents the amount that an option's price changes in reaction to a 1% move in the implied volatility of the asset.
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