Trading with options.
If you’re thinking about trading with options and you don’t know where to start from or simply you would like to understand better what they are and how they work in a speculative context, this small guide is exactly what suits you.
If vice versa you need to create some structured operation on the forex market, on some index or interest rate… well you would be better buying the Hull, start from page 1 and go thorough it till the end. Believe me, you will enjoy yourself a lot among caps, collar, future and swap: 300 pages intriguing formulas.
But actually there’s also another way. Tomorrow you have the examination on derivative instruments at the university and your last chance to succeed is to get some quick and handy information on the web, leaving everything else in the hands of hope and luck.
Well in this case, my suggestion is to read the tutorial, drink a cup of coffee and study on your school book all night long. For this kind of examinations, I’m sorry but you are usually required to know how to calculate a couple of things which are unnecessary for trading and will not be reported here. (…by the way, good luck…!).
Options: the definition.
Taken for granted your speculative or, more in general, knowledge purpose let’s start our journey in the options world with the first brick of the building which is obviously the classical definition. We both know that it’s simply a formality in fact if you meet options for the first time the definition below will probably look like messy words all mixed together.
But it doesn’t matter, this is one of those kind of things that must be done just to feel the conscience clear and since we care about clear conscience but overall we like to strut with friends, here it is:
With the word option we mean the specific derivatives which give the owner the right, but not the obligation, to buy or sell the security on which the option itself has been written, called underlaying instrument, at a fixed price and/or within a specific date. Options can have the most different underlaying instruments: stock, commodities, interest rates, exchange rates, etc.
If you are brave and wish to go deeper in this topic on a strictly formal basis on Wikipedia you can find all the definitions and the basic formulas. Following instead you’ll find:
The financial options concept in easy words.
Let’s start from a very simple statement: nobody can foresee the future except magicians who could earn loads of money using this ability on the financial markets but inexplicably keep on earning their living by asking money for their forecast. I’m confident you have got clearly the point…
Having said this, if you want to get into options trading and you are not a renegade magician, you must know that buying and selling an option is a bit like gambling. And I can tell you more for free: anyone who says the contrary, if not speaking about edging, is trying to sell you something. In such an aleatory environment this is one of the few certainties.
At this point you can say, fine but there is gambling and gambling, for example lottery is different from roulette and you are right, in fact anyone that likes to bet knows that roulette is much better than lottery, but in both cases we speak about hazard. So, like for any proper gamble, there are two basic aspects:
- One uncertain future event.
- Rules that define when and how much you can bet and win.
The underlaying of options.
Concerning the options, the uncertain future event is given simply by some quoted economical variables.
Like we said at the beginning it can be a stock, an index, an interest rate, a currency, a commodity, etc. The value of these variables, as you can see every day on television in the news, can increase or decrease and their trend depends on demand and supply dynamics on the financial markets.
So, in poor words, we can say that buying or selling an option written on one of these variables, which in technical slang are called underlaying, simply means betting on their future trend according to our expectations.
At this point it should be evident to you which the first important option feature is. While when you buy a security, for example a stock, you are betting on a company’s economical results, in the case of an option the object of your bet is the trend of another security. This is the reason why options are included in the derivative instruments family. In fact their value sees its origin by another financial instrument.
Now you can say ok, fairly cool, but apart from the underlaying, buying or selling awaiting for a value increase or decrease is something that happens with any security. Any time I open a position on any financial market I face that, so what’s different with options?
The options pay – off.
Easily said. The second most relevant element which distinguishes options and makes them different from any other financial instrument you can find on the markets is what is called pay – off structure. That is trivially to say the mechanism which defines when you win/lose and what you win/lose.
But once at this point of our journey, if we want to easily understand we have to split the path. We must introduce two different types of options, the so called Call options and the Put options (..just names, it’s all very simple, no worries) and to start with, let’s see how a Call option works…
