We have previously analysed two primary types of options—the call option and put option. Additionally, we looked at four diverse variants stemming from these two choices.
A trader has numerous options for creating viable strategies, commonly known as ‘Option Strategies‘. Picture this – a great artist can take a range of colours and paint an amazing masterpiece; similarly, a skilful dealer can employ these four option variants to master trading. Imagination and intelligence are necessary for crafting these trades. Consequently, it is imperative to give due attention to the four variants while we delve into options. Therefore, in this module let’s quickly recap the facts we have comprehended thus far.
Reorganising the Payoff diagrams in this manner can help improve our understanding of several points.
Remember that when buying an option, it is referred to as a ‘Long’ position. Specifically, buying a call option and a put option is known as a Long Call and Long Put position, respectively.
Whenever you sell an option, it is referred to as a Short position. This applies to both the sale of a call and put option, which are known respectively as Short Call and Short Put.
It is possible to purchase an option under two conditions:
The position of ‘Long Option’ is used when creating a new buy order, while if you are buying to offset an existing short position, then it is referred to as a ‘square off’.
Likewise, there are two circumstances under which you can sell an option:
Creating a fresh sell position is known as the ‘Short Option’, while closing an existing long position, it is simply called a ‘square off’.
– Option Buyer in a nutshell
As you have now understood call and put options from both the buyer’s and seller’s viewpoint, but I think it would be beneficial to reiterate some of the key points before continuing with this module.
Buying an option (call or put) can be a good decision when we are expecting the market to move considerably in a specific direction. The option purchaser needs to pick a strike price that will prove to be profitable – an issue we will learn more about later on. Here are some key items that ought to remain in our minds:
– Option seller in a nutshell
The option writers, either call or put, are in for two very different types of P&L experiences. When selling an option, it is because one anticipates the market either staying flat or going below the call strike price, or above the put one.
It is important to remember that the odds are in the favour of option sellers, all things being equal. This is because for them to be successful, the market can either remain static or move as specified, whereas for an option buyer to make a profit, it must move accordingly. Therefore, two scenarios are available to option sellers as opposed to one for buyers – yet this should not alone act as a reason to sell options.
Here are some important points to remember when it comes to selling options:
In his book “Fooled by Randomness,” Nassim Nicholas Taleb discusses how option writers can enjoy steady and moderate gains from selling options. However, in the event of a significant market disaster, they may face substantial losses. This idea is often captured by the saying: “Option writers eat like a chicken but shit like an elephant.”
Over the remainder of this module, our primary focus shall be on moneyness, premiums, option costs, option Greeks and strike choices. When all of these topics have been thoroughly explained, we will revisit calls and puts from a different perspective; one that will equip you to approach options trading at a professional level.