Options Basics

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.

Definitions

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.[1]

Risk Measures

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.[2]

 

[1] John Summa (May 31, 2020). "Options Trading Strategies: Understanding Position Delta." Investopedia

[2] James Chen (April 10, 2019). "Vega Definition." Investopedia

Retirement Day Trader - eBook

Sign up for our Newsletter & get the FREE eBook
Retirement Day Trader:
How to Sell Weekly Options for Steady Income

  • This field is for validation purposes and should be left unchanged.