Part 3 Institutional Trading

Part 1: Introduction to Option Trading

Option trading is a sophisticated financial instrument that allows traders to speculate on or hedge against the future price movements of an underlying asset. Options provide rights, not obligations, giving traders flexibility compared to traditional stock trading. Unlike futures, where contracts are binding, options give the choice to exercise or let expire. This makes them attractive for hedging, income generation, and speculative strategies.

Part 2: What is an Option?

An option is a contract between a buyer and seller that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (strike price) on or before a specific date (expiration).

Call Option: Right to buy the underlying asset.

Put Option: Right to sell the underlying asset.

Options derive their value from the underlying asset, which can be stocks, indices, commodities, or currencies.

Part 3: Key Terminology in Option Trading

Understanding options requires familiarity with core terms:

Strike Price: Price at which the option can be exercised.

Expiration Date: Last date the option can be exercised.

Premium: Price paid by the buyer to purchase the option.

In-the-Money (ITM): Option has intrinsic value.

Out-of-the-Money (OTM): Option has no intrinsic value.

At-the-Money (ATM): Option’s strike price is near the current market price.

Part 4: Types of Option Contracts

Options can be categorized as:

American Options: Can be exercised any time before expiration.

European Options: Can be exercised only on expiration.

Exotic Options: Complex options with non-standard features, e.g., barrier, Asian, or digital options.

Part 5: Option Payoff Structure

Option payoffs determine profit or loss:

Call Option Payoff: Profit if underlying price > strike price at expiration.

Put Option Payoff: Profit if underlying price < strike price at expiration.

Graphs are often used to visualize potential profit/loss for both buyers and sellers.

Part 6: Option Pricing Components

Option prices (premiums) are influenced by:

Intrinsic Value: Difference between strike price and underlying price.

Time Value: Additional value due to time remaining until expiration.

Volatility: Higher volatility increases option premiums.

Interest Rates & Dividends: Affect option valuation for stocks.

Part 7: Option Pricing Models

Common models used to calculate option premiums:

Black-Scholes Model: For European options, considers volatility, interest rate, strike price, and time.

Binomial Model: Uses a tree of possible prices to calculate option value.

Monte Carlo Simulation: Used for complex or exotic options.

Part 8: The Greeks – Measuring Risk

Greeks quantify how an option’s price changes with market variables:

Delta: Sensitivity to underlying price.

Gamma: Rate of change of delta.

Theta: Time decay impact.

Vega: Sensitivity to volatility.

Rho: Sensitivity to interest rates.

Greeks help traders manage risk and structure positions.

Part 9: Option Strategies for Beginners

Simple strategies include:

Long Call: Buying a call to profit from price rise.

Long Put: Buying a put to profit from price fall.

Covered Call: Selling a call against owned stock for income.

Protective Put: Buying a put to hedge an existing stock.

Part 10: Advanced Option Strategies

Advanced strategies include:

Spreads: Buying and selling options of the same type to limit risk.

Vertical Spread, Horizontal/Calendar Spread, Diagonal Spread.

Straddles & Strangles: Betting on high volatility without direction bias.

Butterfly & Condor: Complex strategies for range-bound markets.