Every Option Trader Needs to Understand Important Terms

DLMvn > Glossary > Every Option Trader Needs to Understand Important Terms

When participating in the options market, understanding the basic terms is the first but very important step. DLMvn always believes that without mastering these concepts, it will be hard to make accurate investment decisions. Options are not a simple investment tool, and they can easily overwhelm you when you first start. However, if you know how to master the terms and strategies, you will find that options can be a very powerful tool, yielding superior profits when used correctly.

Important Terms in Options

1. Call Option

A Call option is a type of option that gives the holder the right to buy the underlying asset at a predetermined price (Strike Price) within a specified time frame. This means that if the price of the underlying asset rises above the strike price, the holder can buy it at a lower price, thus making a profit.

2. Long Call

Long Call is a strategy of buying a call option when you expect the price of the underlying asset to rise significantly in the future. When executing this strategy, you will pay the option premium to purchase the call option, and if the underlying asset rises above the strike price, you can exercise the option and make a profit. The potential profit is unlimited, while the maximum risk is only the premium paid for the option.

3. Profit/Loss Chart for Long Call Strategy

When engaging in the Long Call strategy, the profit/loss chart will give you a visual representation of the profit and loss in every scenario. DLMvn often encourages you to carefully review this chart, as it helps you identify the risks and determine the break-even point. Specifically, you will break even when the price of the underlying asset rises to the strike price plus the premium paid.

4. Put Option

A Put option is a type of option that gives the holder the right to sell the underlying asset at a predetermined price within a specific time period. When the price of the underlying asset falls, the put option gains value and provides profit for the holder.

5. Long Put

The Long Put strategy is when you buy a put option with the expectation that the price of the underlying asset will fall. Similar to the Long Call strategy, the potential profit in this strategy can be unlimited (until the underlying asset drops to near zero), while the maximum risk is only the premium paid for the option.

6. Profit/Loss Chart for Long Put Strategy

When implementing the Long Put strategy, you will see a different profit/loss chart compared to the call option. The profit increases as the price of the underlying asset falls below the strike price, and you will reach the break-even point when the price of the underlying asset drops to the strike price minus the premium paid.

7. Option Premium

The option premium is the amount you must pay to purchase an option. This premium depends on various factors, such as the price of the underlying asset, the time left until expiration, and market volatility. One important thing to remember is that, regardless of whether your strategy succeeds or not, you will still have to pay the initial option premium.

8. Strike Price

The strike price is the price at which you can exercise the right to buy or sell the underlying asset. The strike price directly influences whether or not you can make a profit from the option. Choosing the right strike price is one of the key factors in options trading.

9. Expiration Date

The expiration date is the last day the option can be exercised. After this date, the option expires and becomes worthless. This means that you need to decide early whether or not to exercise the option.

10. Moneyness (Profit, Loss, and Break-even)

Moneyness refers to the relationship between the option and the price of the underlying asset.

• In-the-money (ITM): The option has value when the strike price of the call option is lower than the price of the underlying asset, or the strike price of the put option is higher than the price of the underlying asset.
• Out-of-the-money (OTM): The option has no value when the strike price of the call option is higher than the price of the underlying asset, or the strike price of the put option is lower than the price of the underlying asset.
• At-the-money (ATM): The option is at break-even when the price of the underlying asset is equal to the strike price.

11. Exercising an Option

When you decide to exercise the option, you will trade the underlying asset at the previously determined strike price. Exercising the option can result in a profit if market conditions are favorable.

12. Settlement of Options

Options can be settled in two ways:

• Settlement by Underlying Asset: You receive the underlying asset (such as stocks) when exercising the option.
• Cash Settlement: You receive cash instead of the underlying asset. This form of settlement is common in many index options.

Popular Options Strategies

1. Credit & Debit Spread Strategy

Credit Spread and Debit Spread are two popular strategies used to reduce risk. In a Credit Spread, you sell an option with a higher premium and buy an option with a lower premium, creating an initial income (premium). In contrast, Debit Spread requires you to buy an option with a higher premium and sell an option with a lower premium, but it can limit risk due to the premium paid out.

2. Covered Call

The Covered Call strategy is when you sell a call option on an underlying asset that you already own. The goal of this strategy is to generate income from the premium received from selling the call option, while still holding the stock if the price does not increase too much. This is a strategy to protect your portfolio and generate additional income.

3. Protective Put

The Protective Put strategy is buying a put option to protect your portfolio from significant declines in the price of the underlying asset. When the price of the underlying asset falls, the put option can help reduce losses.

4. Straddle and Strangle

Both Straddle and Strangle are strategies used to profit from significant market volatility, regardless of whether the market trend is upward or downward. You buy both a call option and a put option at the same time, with the same expiration date but different strike prices (Strangle) or the same strike price (Straddle). This strategy is ideal when you expect a significant change but are unsure of the specific trend.

5. Iron Condor

The Iron Condor strategy is a combination of both call and put options with different strike prices. The goal is to limit risk and maximize profit when the market remains flat. This strategy can yield steady profits but also requires you to closely monitor factors that impact option values.

Types of Options

1. American Options vs European Options

One of the biggest differences between American and European options is the timing of when the option can be exercised. With American options, the holder can exercise the option at any time during its validity period, meaning up until the expiration date. This provides flexibility for traders, as they can exercise the option when the price of the underlying asset is favorable. In contrast, European options can only be exercised on the expiration date itself. As a result, American options are often considered more valuable due to this flexibility, although they may come with a higher premium.

2. Asian Options

Asian options have a unique feature: their payoff is determined based on the average price of the underlying asset over a specific period, rather than the price of the asset at a fixed point in time (like American or European options). This can help reduce the impact of sharp price fluctuations in a short period. These options are popular in highly volatile markets, where you want to minimize risk due to strong fluctuations at certain times.

3. Binary Options

Binary options are the simplest type of options, with only two possible outcomes: profit or loss. This type of option requires you to predict the direction of the underlying asset’s price over a short period. If your prediction is correct, you receive a fixed payout; if wrong, you lose the amount paid to purchase the option. Binary options are mainly used in short-term trades and are a popular tool in short-term investment strategies or when the market is highly volatile.

Factors Affecting Option Value

1. Intrinsic and Extrinsic Value

Intrinsic value refers to the real value of the option, meaning it can generate a profit if exercised immediately. For example, for a Call option, when the price of the underlying asset is higher than the strike price, the option has intrinsic value. In contrast, extrinsic value refers to the value of the option when it has no immediate real value if exercised, meaning the option is not currently profitable. However, extrinsic value can be influenced by factors such as the time remaining until expiration, market volatility, or future expectations.

2. Time Value

The time value of an option is the part of its value that comes from the time remaining until expiration. Theoretically, the longer the time to expiration, the greater the time value. This means that long-term options typically have higher premiums because the underlying asset has more time to change in value. However, as expiration approaches, this time value gradually diminishes (a phenomenon called time decay), and the option loses value if not exercised.

3. Historical Volatility

Historical volatility refers to the price fluctuations of the underlying asset in the past. These price changes can help you predict the level of volatility in the future. However, historical volatility doesn’t always accurately reflect future price changes, but it is a useful indicator for estimating the risk level of an option.

4. Implied Volatility

Implied volatility is the market’s expectation of how much the underlying asset will move in the future. It can significantly affect the value of an option because the expectation of higher volatility can increase the option premium. Implied volatility is a crucial factor to consider when trading options, particularly in times of market instability.

5. Time Decay

Time decay refers to the reduction in the value of an option as the expiration date approaches. This means that if you hold an option and don’t exercise it before expiration, its value will gradually decrease over time, even if there are no significant changes in the price of the underlying asset. Time decay is an important factor to consider when choosing an options trading strategy.

The Process of Buying and Selling Options

1. How to Choose the Right Option

Choosing the right option is one of the key factors in options trading. DLMvn always emphasizes that you should consider factors like the strike price, the time remaining until expiration, and market volatility when selecting an option. For example, if you expect the price of the underlying asset to rise significantly over the long term, a long-term Call option would be a suitable choice. Conversely, if you want to protect your portfolio from potential declines, the Protective Put strategy could be a good option.

2. Popular Options Trading Platforms

When trading options, you need to choose a reputable trading platform. Some of the popular options exchanges you can consider include the CBOE (Chicago Board Options Exchange) and CME (Chicago Mercantile Exchange). Additionally, other options trading platforms offer various tools to help investors track the movements of the underlying asset, analyze the market, and make informed trading decisions. Choosing the right platform not only facilitates easier trades but also ensures transparency and security when executing options transactions.

Risk Management and Optimization Strategies

1. Using Options to Hedge Risk

In today’s volatile financial markets, risk management is extremely important for all investors. Options can be an excellent tool for protecting a portfolio from unpredictable market movements. For example, an investor holding shares of a company might be concerned that the stock price will drop significantly in the near future. To protect themselves, they could buy a Put option, which allows them to sell the stock at a predetermined strike price, even if the stock price falls. This is a hedging strategy that helps minimize losses if the market moves against the investor’s expectations.

However, it is important to note that using options for risk management also comes with costs. Option premiums can be significant, especially when choosing options with long expiration dates or high implied volatility. Therefore, investors must carefully calculate and ensure that the cost of hedging their portfolio does not outweigh the benefits of risk protection.

2. Risk Management Tools

DLMvn frequently shares with investors the importance of using risk management tools to protect their investments. Some common risk management tools include:

• Stop-Loss Orders: These are automatic orders placed before a trade to sell an asset when its price falls to a predetermined level. This helps investors minimize losses if the market moves unfavorably.

• Trailing Stops: A type of dynamic stop-loss order. Instead of setting a fixed price, a trailing stop adjusts the stop level as the price of the asset moves in your favor. This helps maximize profits while still protecting you from sudden market reversals.

• Hedging: A risk management strategy using derivatives like options to offset adverse market movements. For example, if you hold a long position in a stock, buying a Put option can help protect that position from a price drop.

The choice of which risk management tool to use will depend on the investor’s risk tolerance, profit goals, and investment timeline.

Costs and Taxes Related to Options

1. Options Trading Costs

The costs of trading options include not only transaction fees but also other potential costs such as commissions and settlement fees. The option premium is the amount you pay to purchase an option, and this can vary depending on market volatility and the expiration date. Options with longer expiration dates or high implied volatility typically have higher premiums because they offer greater profit potential.

In addition, commissions are an important factor to consider when trading options, as exchanges often charge a fee for each trade you execute. This can increase the overall cost of an options trade, especially if you are making multiple trades in a short period. Investors need to be aware of these costs and factor them into their calculations to avoid having transaction fees erode their profits.

2. Taxes in Options Trading

An important yet often overlooked aspect of options trading is taxation. In many countries, profits from options trading are taxed similarly to profits from regular securities transactions, but the way the taxes are calculated and the tax rates can differ. In some countries, profits from Call options may be considered long-term gains if the options are held for a sufficiently long period, while profits from Put options may be treated as short-term income and taxed at a higher rate.

Therefore, investors should understand the tax regulations in their country and seek advice from tax professionals to optimize their options trading strategy and minimize any tax liabilities.

The Future of the Options Market

1. Trends and New Opportunities

The options market is undergoing a period of rapid growth, especially with the emergence of new technologies like blockchain and digital options. DLMvn notes that the use of blockchain technology in options trading could help reduce the risk of fraud and increase the transparency of transactions. Additionally, the rise of electronic options trading platforms allows investors to trade options more easily, quickly, and at a lower cost than with traditional trading methods.

Moreover, the introduction of digital options and blockchain-based derivative products could open up an entirely new market for investors, particularly those seeking opportunities in the technology and digital finance sectors.

Real-World Examples of Options Trading

An investor named Minh holds shares in a large tech company in his portfolio. After analyzing technical signals and noticing that the stock price might decline soon, Minh decides to purchase a Put option with a strike price of 100 USD and an expiration date of 3 months. Suppose that after one month, the stock price drops significantly to 80 USD. Minh can exercise the option and sell the stock for the strike price of 100 USD, making a substantial profit from this decline, while also protecting his portfolio from significant losses.

In the opposite case, if the stock price increases as Minh had originally anticipated, Minh would lose the premium he paid for the option. However, this premium can be considered as a cost of portfolio protection, similar to paying for insurance to protect against unforeseen risks.

Through examples like this, you can see that options are not just profit-making tools but also effective risk management instruments in the stock market.