Options

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Options

Key takeaways
* Options are derivatives that give the buyer the right—but not the obligation—to buy or sell an underlying asset at a specified strike price before or at a set expiration date.
* Calls profit from rises in the underlying; puts profit from declines. Sellers (writers) receive a premium but assume obligations and potentially large losses.
* Option styles (American vs. European) differ by when they can be exercised. Risk and pricing are driven by the Greeks: delta, theta, gamma, vega, and rho.
* Spreads and combinations let traders tailor risk/return profiles for directional views, income, or volatility plays.

What is an option?
* An option is a contract tied to an underlying security (stock, index, ETF, commodity, etc.).
* The buyer pays a premium for the right to buy (call) or sell (put) at the strike price. The seller receives the premium and bears the obligation if the option is exercised.
* Standard U.S. equity options typically represent 100 shares per contract.

How options work
* Call — holder has the right to buy the underlying at the strike price before or at expiration.
* Put — holder has the right to sell the underlying at the strike price before or at expiration.
* Buyers risk only the premium paid; sellers risk the premium received plus any obligations (which can be substantial).
* Options are used for leverage, hedging, income generation, and volatility trading. Liquidity measures to watch include daily volume and open interest.

Types and styles
* By payoff:
* Call option — benefits when the underlying price rises.
* Put option — benefits when the underlying price falls.
* By exercise style:
* American — may be exercised any time up to expiration.
* European — may be exercised only at expiration.
* (Style refers to exercise rules, not geography.)

Key terminology
* Strike price — the exercise price of the option.
* Expiration (expiry) — the date the option ceases to exist.
* Premium — the market price paid for the option.
* In-the-money (ITM) — option has intrinsic value (call: underlying > strike; put: underlying < strike).
* At-the-money (ATM) — strike ≈ underlying price.
* Out-of-the-money (OTM) — option has no intrinsic value.
* Underlying — the asset on which the option is written.
* Implied volatility (IV) — the market’s forecast of the underlying’s volatility embedded in option prices.
* Exercise and assignment — when a buyer exercises, the seller (writer) may be assigned the corresponding obligation.

The Greeks — managing option risk
Greeks quantify how option value responds to changes in market variables.

Minor Greeks (vomma, vanna, speed, etc.) measure higher-order sensitivities and are used in advanced risk management.

Options strategies overview
* Single-leg positions:
* Long call/put for directional exposure with limited downside (premium).
* Short call/put to collect premium and take on obligation.
* Spreads and combinations:
* Vertical spreads (e.g., bull call spread) combine options of the same expiration but different strikes to limit risk and reward.
* Credit spreads vs. debit spreads: credit collects premium up front; debit requires net payment.
* Volatility and market-neutral strategies: straddles, strangles, iron condors, butterflies, etc.
* Covered and protective strategies:
* Covered call — sell calls against owned stock to generate income.
* Protective put — buy puts to hedge a long stock position.

Pros and cons
Pros
* Leverage — control more exposure with less capital.
* Defined downside for buyers — maximum loss is the premium paid.
* Flexibility — strategies for bullish, bearish, neutral, and volatility views.
* Hedging — efficient protection of existing positions.

Cons
* Complexity — pricing and strategy outcomes can be difficult to model.
* Time decay — long option positions lose value as expiration approaches.
* Potentially large or unlimited risk for option writers (e.g., uncovered call writing).
* Requires careful monitoring of Greeks, IV, and expiration effects.

Example (simplified)
* Suppose Microsoft (MSFT) trades at $508. You buy one one-month call with a $515 strike for $0.37 (premium).
* Cost = $0.37 × 100 = $37.
* If MSFT rises to $516 at expiration, the option’s intrinsic value ≈ $1. Profit per contract = ($1 − $0.37) × 100 = $63.
* If MSFT falls to $500, the option expires worthless and loss = $37 (premium). Compare that to holding 100 shares outright, which would have resulted in a much larger dollar loss.

Options vs. futures
* Options grant a right (but not obligation) to trade the underlying at a set price; futures create a binding obligation to buy or sell the underlying at contract maturity.
* Both are derivatives, but payoff profiles and risk characteristics differ significantly.

Practical considerations before trading
* Know contract specifications: multiplier (typically 100), expiry schedule, and strike intervals.
* Monitor liquidity (volume and open interest) and bid-ask spreads.
* Use Greeks to size positions and design hedges (delta/gamma/vega management).
* Understand assignment risk if short options are held through ex-dividend dates or near expiration.
* Start with education, simulated trading, or smaller positions before using advanced strategies.

Bottom line
Options are powerful, versatile instruments for leverage, hedging, income, and volatility trading. They require understanding of payoff mechanics, option styles, the Greeks, and strategy construction. Proper risk management and awareness of time decay and implied volatility are essential for success.