- About Us
- Trading Products
- Online Trading
This section will discuss:
Introduction to option trading
Understanding the process of trading or option trading transaction can be obtained through property purchasing below. This analogy at the least may describe on basic principles of option trading.
For instance, one day You want to buy a house. You will, then, find a house that suits your desire after all this time. You come to the owner and as if the house is for sale and ask the price offered. The owner then says that the house will be sold only for a price of US$200,000. Because You do not have such amount of money at that moment, You, then, propose an agreement to the owner, to give the right to buy to You within the next 3 (three) months so that You will have the time to collect money. Within the 3 (three) month-period the owner shall not sell the house to another buyer, and as a compensation for the willingness of the owner, You give the person an amount of $3,000. If You are succeeded to collect the money, You have the right to buy the house. But if You failed, You shall not buy the house. Even You are or not be able to buy the house, the $3,000 You gave has become the owner's right.
By the example above, You just done an option trading, see figure 1 below.
Figure 1: Illustration of option trading
The example of transaction above is just a description of the option trading concept. The price of the house agreed at the beginning of the contract, whereas the buyer has the right to buy, but not an obligation (in the example is $200,000), in this particular option trading is called strike price. The amount paid by the buyer to get the right (in the example is $3,000) is called premium.
As explained in the option trading 1 scenario box, when the price rises to $500,000, buyer has the right to buy at the price of $200,000 as agreed. This right can only be done as the contract applies, oe only valids for 3 (three months). If within 3 (three) months the buyer does not execute the right, then the contract will be invalid and the premium has become the right of the owner. The remaining period when the contract is still valid within option trading is called time value.
Meanwhile, in the option trading 1 scenario, when the house is acknowledged to be prone to flooding then the price is decreasing to $100,000. In this case, because if the buyer insists to buy in accordance with the contract then the buyer might have loss as much as $100,000. Then the buyer may opt not to take the right and let the contract to be invalid until maturity, and only be taking a loss on the premium paid in advance of the contract. The decision not to take the right in option is called lapse.
Definition of option
Option trading in terminology is described as an option or choice. The definition of option in a larger scale in the financial world is a financial contract that gives right to buyer and obligation to seller to buy or sell an asset on a certain price, unit or time.
The buyer in this matter is the party that diverts risk to the seller (see figure 2) by paying a premium. Through this agreement, buyer will not accept risk higher or bigger than the premium paid but has the right to take an unlimited profit. On the other side, seller is the party that receives premium as a maximum profit and has the will to attain unlimited risk.
As a byuer You have the right to choose to use or not to use that right. If You choose to use the right, then the usage of it is called exercise. By exercising option, You have the right to buy or sell at the agreed price based on the contract. If You choose not to use the right or lapse then the contract will end without any value.
Option trading is done in or out of the exchange (OTC) via certain broker. This type of instrument that can be coped by option trading varies, can be forex, physical commodities, security (stocks) or property.
Figure 2: Risk diversion from buyer to seller
As illustrated on the figure, that option trading risk can be transferred from buyer to seller in a process of exchange with a premium as a compensation.
Types of option trading
Option trading has 2 (two) basic types:
Option trading has the right (not obligation) to buyer to buy or to attain certain assets with the conditions based on contract (at certain price, premium and time). For example if You are interested to buy 100 Microsoft (MSFT) shares, and MSFT is traded at $25/ share. But, rather than just buying the stocks form the market exchange, You prefer to do it via option trading.
This amount is the money You paid to Tomi because his acceptance for fluctuative risk on price. Meaning, Tomi shall sell MSFT shares at $25 (current price) in the end of the month to You, even if the price in the end of the month changes into $100 per share. Tomi shall sell the shares to You at $25.
Tomi, in this case, eventually is issuing a CALL on option trading, and named as call-writer, with a price of $2 per share to You. And You are a call option buyer. If the price in the end of the month depreciated or decreased compared to the current, You may opt not to exercise the call option, and let Tomi to enjoy the premium You have paid.
Option trading gives right (not obligation) to a buyer to sell assets based on a contract. For instance above, You may not exercise the call option trading. Then Tomi, later on (because You did not buy or exercise) plans to sell the shares to You with a price of $25 in the end of the month. He agreed to pay a premium as much as $2 per share to You as a compensation because You are willing to take a risk to buy the shares at $25 eventhough if the price went even lower in the end of the month.
In this example, Tomi buys put option trading from You, and You are the issuer of the put option trading (writer). If the price went lower than $25, let just say $20, then You recognize loss and Tomi gets the profit. But if the price went higher (appreciated) in the end of the month, then Tomi shall not sell the shares and lost the premium, meawhile You gain an amount of profit as much as the premium paid.
Option Market Participants
In option trading transaction there are participants that causing the process to happen. If in a conventional way there were 2 (two), buyers and sellers, that having a transaction. Then the position of the participants for option trading differentiated through their own functions. The 4 participants in the option trading market based on positions taken are:
Buyer of call options (call buyer)
Seller of call options (call seller)
Buyer of put options (put buyer)
Seller of put options. (put seller)
The important element that has been the main characteristic of the 4 (four) option trading participants can be elaborated by the table 1 below.
Table 1: Option trading participants specification
From table 1, it is obvious the market risk stands on the seller or writer side, with a chance of loss unlimited if the price appreciates (in Call) or if the price depreciates (in Put). On the other side if the trade is on benefit, then the profit only attached to the premium.
For option trading buyer, the profit potential is unlimited if the price appreciates (Call) or the price depreciates (Put). In the meantime, the maximum loss os only at the amount ot premium paid.
The key characteristic of 4 (four) type of market participants also be explained in the next following diagram model:
Diagram 3: The Principle of Pay-out option
Diagram 3 iilustrates that call buyer wants a price appreciation and meanwhile put seller wants the opposite, that is price depreciation. Both sides pay premium (the green box) to option trading seller (writer) that be the maximum amount of loss accepted. Profit potential is represented by the broken lines heading up or down with a chance or a unlimited loss.
On the other hand, for the seller or call writer, builds upon the price to decrease or to move in a range (ranging). With the maximum profit potential limited to premium (green box) and the profit potential represented by the broken lines heading down. Also for the put writer, builds upon the price to rise or sideway with a profit potential limited to premium, meanwhile with an unlimited loss (broken lines heading down).
Understanding option price
Option price quotation is also the premium amount. Like other instruments, option price, in this case, also fluctuates accordingly to current market conditions. The price of the option trading premium depends on the 2 (two) values below:
The most influencial factor that determines the price of a option trading is the Intrinsic Value, the value whereas the price connected between spot price and strike price. An option trading is to be said having an Intrinsic Value when located in te money (ITM) condition.
Intrinsic Value for option Call = Asset Price - Strike Price
If the spot EUR/USD currently at 1.2700 and strike price at 1.2500. This option to be said has an Intrinsic Value as much as 200 pips (1.2700 - 1.2500 x 100,000).
Intrinsic Value for Option Put = Asset Price - Strike Price
If the spot GBP/USD currently at 1.5000 and Strike Price at 1.5300. This option trading has an Intrinsic Value as much as 300 pips (1.5300 - 1.5000 x 100,000)
An option trading that has no Intrinsic Value, has only to possibilities. Firstly at the condition of At The Money (ATM) or secondly at the condition of Out of The Money (OTM).
The variation works well for Call option trading or put option trading. For Call, option to be said at OTM when the Strike Price is higher than Asset Price (Strike>Asset). But for Put, applies the opposite, option to be said OTM if the Strike Price is lower than the Asset Price (Strike<Asset).
As for ATM (for Call and Put), ATM happend when Strike Price is at the same as Asset Price (Strike - Asset). Table 2 will show criteria comparison for ITM, ATM and OTM, for call and put option.