# Option By [Nemoe](https://paragraph.com/@nemoe) · 2022-05-19 --- Options trading The appeal of options trading is the “leverage” they provide. Since 1 option contract controls 100 shares of the underlying asset, buying a call option contract exposes the gains and losses of 100 shares at a fraction of the price of 100 shares. In this article, we will cover option contract trading. Since you’ve made it to this article, I assume you already know " option contracts.” I skip covering what an “option contract” is because that information is available everywhere online. For the retail traders “call options” and “put options” for retail traders are bets on the direction of the asset price. They purchase a “call option” if they believe the price will increase They purchase a “put option” if they believe the price will decrease. (Please do not do this. You will lose your money. It will gradually become a generous contribution to a hedge fund manager’s whine collection. You have learned in school, on television, or YouTube how to visualize atoms, protons, neutrons, electrons, etc. This model is entirely inaccurate, yet we use it because it helps us visualize the specifics of these abstract subjects. Consider everything in this article to be an oversimplification to assist you with more advanced reading about options trading Abstract subjects Unfortunately (or fortunately), retail traders like you and I do not have access to leverage as institutions have. Typically, if you are trading stocks, your broker will enable you to borrow the value of your portfolio. If you have $6,000 in your Robinhood account, the maximum amount you may borrow is $6,000. The leverage of 2x is relatively low. Thus, retail traders must find a way to maximize leverage without borrowing funds. You may have an idea where this is heading. Options trading. Small intro I also want to announce I “might” start a blog to independently write articles and maybe write daily or weekly newsletters. You can subscribe and I will most likely post there more in-depth analyses, articles, and newsletters. I write these articles mainly because it forces me to study more. Explaining subjects to others is a great way to get a deeper understanding. romanornr Trading, options, equities/stocks, ETFs and cryptocurrency [romanornr.ghost.io](http://romanornr.ghost.io) Anyways, in the professional world, most professional traders who work for hedge funds, quantitative funds, banks, etc., use option contracts mainly for hedging. They often use options to hedge against adverse price movements in the underlying asset, like paying a fee to transfer risk to other parties. Let’s focus on having a firm basic fundamental understanding of options trading. This article is only part 1. There will be more articles If you’ve been trading options before, you might have asked yourself Why is it that buying options took away all of my of options? Options trading is a complicated task. Fortunately, you do not need a deep understanding of the mechanics to earn money trading them. However, if you have a solid knowledge of the fundamentals, you can consistently earn money (or lose less money so fast). Now let’s start with the basics first. 1: Stocks and Options Buying an asset Consider bitcoin as an example. You purchase $10k worth of bitcoin at $30k. Later, the price of a bitcoin approaches $36k In this graphic, we have the price of bitcoin on the x-axis and on the y-axis is our PNL (return on investment/profit-net loss) I use this tool for these Deribit graphs: [https://pb.deribit.com](https://pb.deribit.com) If the price of bitcoin rises to $50k, we will earn around $5,881 in profit, which is good. Allow me to illustrate it more clearly. However, the price of bitcoin might decline to $10k. This price fall results in a loss of around -$5266, which is unfavorable. This 45-degree line represents the payoff, known as a “linear/delta one payoff.” Linear/delta one payoff. If bitcoin or another asset rises, we profit. If the asset’s price declines, we will suffer a loss. Our maximum loss occurs if the value of the asset reaches zero. Our maximum loss if the price falls to zero is our $10k investment. Shorting an asset The great thing about derivatives trading is that you can sell something you don’t own. That is called “short selling.” “Short-selling” is possible because it can borrow assets on an exchange platform. So you can “short sell” by borrowing assets you don’t own and selling them into the market. If the asset price falls, you can repurchase it at a lower price and return it to the exchange. The difference between the price you “sold” and the price repurchased is your profit. Now, what would that look like? We were “short-selling” $1000 worth of bitcoin at $30k. The price of bitcoin is currently $36k. This graphic demonstrates that if the price of bitcoin declines (moving towards the left side of the x-axis), PNL (y-axis) begins to rise. If the price of bitcoin falls towards the price of $20k, we will make a loss. We can see in the diagram below that we make a profit of around $2395 But be aware, in the case of shorting, we can only make a maximum profit of $10k, which is the amount we are “short-selling.” In our case, we sold at $30k, while the price of bitcoin is now trading at $36k. We are currently at a loss of -$2k. In this diagram, our maximum profit is around $8k instead of $10k. Would this example be more straightforward if bitcoin's current price is $30k instead of $36k since this requires extra mental maths for you? Yes, but I try to make it realistically and force you to try to calculate with me. Being “short” while the price goes up If the price starts to move up, on the x-axis, our PNL goes down. However, in the case of “short-selling,” our losses are not limited since we are using “leverage” with borrowed money. In theory, the price of an asset may increase infinitely. Therefore, our losses while “short-selling” an asset are unlimited. The only thing limiting our losses is the amount we deposited into the account of the exchange we are trading. The amount we deposited is our “margin.” When the price of an asset we are short-selling reaches a certain level, our position gets “liquidated.” A “liquidation” means that the exchange closed our position automatically to save us from losing more money than we deposited. The trading platform implemented this “safety mechanism” to prevent traders from declaring bankruptcy and falling into actual debt. The level at which our position gets liquidated is called the “margin call level.” It is different for every asset and every exchange. Usually, when getting your position “liquidated,” you pay a “penalty fee” to the exchange. The fee covers the exchange's risk by letting you trade with leverage. This penalty could be as high as 20% If you want to trade “spot” or “futures: trading, I highly recommend FTX or Binance. FTX 10% Fee Discount My referral link will give you a 10% discount instead of the usual 5% discount from other referral links. [https://ftx.com/#a=1847531](https://ftx.com/#a=1847531) Binance My referral link will give you a 10% discount instead of the usual 0% discount from other referral links [https://accounts.binance.com/en/register?ref=17605639](https://accounts.binance.com/en/register?ref=17605639) A quick intro to some of the terminology What is the meaning of Expiration Date? An option contract does not trade forever. Option contracts all expire or terminate; there is an expiration date. Options are dependent on an underlying futures product, and all futures have a settlement date. If the futures contract no longer exists, the option contract on that contract cannot either. When trading futures options, there are a variety of expiry dates from which to pick. Some of these expiry dates correspond to the expiration of the underlying futures contract. However, other options with shorter durations give more trading strategy flexibility. Essentially, options with multiple expiration dates provide varying possibilities to benefit from price fluctuations of the underlying asset. Options with shorter maturities are advantageous for traders seeking to benefit from short-term price fluctuations. In comparison, options with longer maturities are more beneficial for those seeking to profit from longer-term Trends. What is a strike price? The agreed-upon price also called the strike price or exercise price, is one of the essential parts of an option contract. Strike price The strike price is the price at which you buy (in the case of a “call option”) or sell (in the case of a “put option”) the underlying futures contract when the option is “exercised.” The “strike price” is also known as the “exercise price.” Call option (right to buy) — Put option (right to sell) The “strike price” is an important part of an options contract because it determines the amount of profit or loss you will realize if the option is “exercised.” If the option is not “exercised,” then the “strike price” has no bearing on the profitability of the trade. The strike price for an options contract can be set at the market price of the underlying contract (i.e., spot or futures contract) when the option is purchased. However, it is also possible to set the strike price at a specific price, either above or below the current market price. Call options A call option gives the buyer the right, but not the obligation, to purchase an asset at a predetermined price (the strike price) at an expiration date in the future. That means that the buyer of a “call option” contract is not required to purchase the asset at the “strike price.” They have the choice to do so but are not required to do so. That’s is why the payoff is “nonlinear.” The payoff for the option is “non-linear” because it depends on how the underlying asset’s price moves relative to the “strike price”. If the underlying asset price rises over the strike price, the buyer of the call option will benefit. If the underlying asset price falls below the strike price, the call option buyer will incur a loss. And if the price of the underlying asset at expiry is equal to the strike price, the buyer of the call option will break even. If we buy a call option on Tesla with a strike price of 300, how would the pay-off look? If we buy the stock (not the option contract) at $300, we start to make money if the price goes above $300. If, however, we buy the stock and the price goes down, then we lose money. Lose money if buying a stock and the price goes down In the case of options contracts, if the stock price is more than $300 at expiration, we would “exercise” our option to purchase the shares. That’s referred to as “exercising your option.” We would purchase the shares for $300, so we would have earned the same money as if we had bought the stock. So, if the stock price reaches $350, we will “exercise” our right, and the payout for “long” this “call option” would earn us $50 per share. Profit $50 per share If, however, the stock ends up below $300, we would not “exercise” our option. We would do nothing with our Option. We would let it expire, remaining on this horizontal reward line where our loss would not be unlimited. You get the “Non-linear payoff” when you buy options contracts. To buy this option contract and get this non-linear payment, we must spend initial capital. This initial cost is known as the “option premium.” So now, let’s factor in the actual price of the “call option.” Let’s assume it costs us $5 to buy a call option. So what does that mean, you might think. So when we buy 1 contract of an option, that gives us the right to trade 100 shares. So the actual premium we need to pay is $500: $5 \* 100 = $500 If we buy 100 Tesla shares at $300 instead of buying call options, we must pay $30k. In the case of this call option which cost us $5, we already have to spend $500 to buy this. That’s way less capital required than paying $30k for 100 shares. The appeal of options is the “leverage” they provide. Since 1 option contract controls 100 shares of the underlying asset, buying a call option contract exposes the gains and losses of 100 shares at a fraction of the price of 100 shares. It means gains amplify when buying options contracts, and losses amplify when selling options contracts. This leverage effect shows massive profits on options traders at Robinhood and huge losses. So for our example, the call option contract gives us the right to buy $30k worth of shares, while this “call option” only costs us $500. If we want to determine the real PNL of this option position, we must reflect the price we paid for the option. For example, if we paid $5 for this option, we must adjust our pay-off by the premium amount. The payment resembles a “hockey stick” with a payback of 0 below the strike and profits as the asset price rises. Once we factor in the premium and shift that hockey stick downward, we will lose money if the stock price falls below $300. Below $300, we will forfeit the “premium” that we paid. This premium is $5 per share or $500 for 100 shares. If Tesla’s stock price ends up above $300, we will begin to profit on the way up. At a certain time, when we cross the zero line, the money we get from the payout of the “call option” is equal to the “premium” we paid for the “call option.” This point is called the “breakeven” point. That’s the moment when the option would begin to generate a profit. This breakeven threshold is determined using. Strike price + the premium In our situation, the strike price is $300, and the premium is $5. Our breakeven price will amount to $305. If the price is more than $305 at expiry, we will have made a profit on the option buy. Put options A put option gives the right, but not the obligation, to sell an asset at a predetermined price (the strike price) at or before the expiration date in the future. Let’s retake Tesla stocks as our example. We buy a “Put option” with a $300 strike price. In the payoff diagram, we can see that if we have the right to sell our shares, if the stock trades anywhere below the “strike price,” we will start to make money just like we would if we would short the stock with a futures contract. If the price is above $300, we won’t exercise our right, and we would stay on the horizontal line at the zero payoff line. Non-Linear Payoff There’s that Non-linearity again. The hockey stick payoff where it looks like a “short stock” on the way down, but on the way up, there’s no payoff. Since “Put options” make money on the way down, they are often thought of like insurance, like an insurance product where you spent the premium. The premium you paid on a “Put option” is usually deemed an insurance premium to protect your portfolio or stock/futures position from a move down in the market. Because many investors own stocks, there’s a lot of demand for “Put Options” since they can give some protection if the market moves down with magnitude. If we spent $5 per Option, then we can see that the right to sell a 100 shares if we bought 1 “Put Option” would cost us $500: $5 \* 100 shares = $500 Like before, we need to shift the payoff line down by the premium. You can see that the true PNL is that “shifted” hockey stick that goes down by the premium. PNL option This diagram reflects the true PNL of the “Put Option” at the expiration date. As the stock goes below the strike price, we start to make money. We make back our premium below the breakeven point, which is on the downside this time. Our breakeven point for the “Put Option” can be calculated with this formula: strike price - premium = $295 $300 $5 Below our breakeven threshold, our “put Option” begins to generate profits. When deciding to buy an option contract for protection, it is crucial to consider where you begin to earn money, if that makes sense, and your stock and your view of the market outlook. The payout for “put options” is just a mirror copy of the payout for “call options.” Put Options payoff vs. Call Options payoff Typically, “put options” are bought to safeguard portfolios/investments that earn money on the way down. In the Money (ITM), Out of the Money (OTM), & At the Money (ATM) — Moneyness In our previous examples of Tesla options, we used strike prices equal to the stock price, which was $300. These were “At the money” strikes. When the strike price is the same or very close to the current price of an asset, we call these options “At the money.” “At the money” (ATM) Significant volume of “at the money” option contracts are traded, often by volatility traders. Options may be traded with strike prices above or below the current stock price. However, there are additional strikes available for trading. Both a “call option” and “put option” can be “At the money” at the same time. “At the money” (ATM) Both a Put and a Call option Strike prices above the current asset price are “upside strikes.” Strike prices below the current asset price are “downside strikes.” OTM (Out the money) An “Out the money” Option has a strike price that is away from the current market price, such that the Option would not be “exercised” if it was expiring today. If Tesla is trading at $300 and we have a “call option” with a strike price of $350. That “call option” gives the right to buy the stock at $350. That option is “Out the money” because we would not “exercise” that right. The strike price is away from the current price of $300. “Out the money” (OTM) Call option “Out the money” (OTM) Call option But if we have a “Put Option” for Tesla at a strike price of $350, then if the stock price trades below $350, the Option is “In the money” because we would “exercise” our right to sell. Because we are on the diagonal part of the hockey stick payoff. “In the money” Put Option where you would “exercise” our option and sell the Tesla shares at $300 You can see for “upside strikes”: Calls are “Out of the money” Options Puts are "In the money" Options So if we say again, Tesla shares are trading at $350 but this time own a “Put Option” with a strike price of $300. That is not an Option we would “exercise” on the expiration date because it’s the right to sell. It’s the right to sell at $300 while Tesla shares trade at $350, which is above the strike price of this “Put option.” So the “Out of the money” option on the downside is the “Put option.” “Out the money” (OTM) put option. “Out the money” (OTM) put option. If again, we look at a “call option” with a strike price of $300 while Tesla shares are trading at $350 We are well and truly “In the money” the current price of Tesla shares is above the “strike price,” and we would exercise our right to buy the stock. As you can see, the “In the money” option will be the “Call option” Downside puts are “out the money” and downside calls are “in the money” Suppose we own a “Call option” with a strike price of $350 while Tesla trades at $300. If we are on the flat zero line, the option is “Out the money.” We can think about that hockey stick payoff. Call option “Out the money.” However, if we are on the 45-degree payoff, the option is “In the money.” When we own a “Call option” with a “strike price” of $300 while Tesla shares trade at $350, then our option is “in the money.” Call option “In the money” if Tesla trades $350 while our strike price is at $300 Options maturity (American & European) So far, when talking about option expiry or maturity date, we just said that that’s the date in the future when you can “exercise” the option contract. However, there are two different types of expires. These two other expiries are American and European. American options An American expiration option means that you may “exercise” the option at any time between the day you buy the option contract and the date it expires. Usually, American expiries tend to be single stocks or ETF options. For European-style options, this is a different case. European style vs. American Style European options Europen Options only allow you the “exercise” the option at a specified time on the exact expiration date. Usually, people don’t “exercise” their American options early, even though they can. They tend to don’t “exercise” their options due to different factors such as dividends and time. Exercised at expiration vs. Exercised Before the expiration It’s uncommon to “exercise” options early, and not economically beneficial. Instead of "exercising" before expiration, you would rather sell your option contract to someone else. Settlement (Physical — cash settlement) Another essential concept about option contracts is the settlement procedure works in the case of American-style options, their settlement physically. Physical settlement So when we “exercise” our right to buy for a “call option” or “exercise” our right to sell for a “put option,” we have to transact in the stock at the “strike price” and take delivery of the shares you’re buying or deliver the shares to someone else if you’re a seller. People prefer to sell their options before expiry and let the market makers deal with those headaches as you might not have a lot of cash in your account to purchase the shares. Cash Settlement Cash settlement is more common for index options like the S&P500, Nasdaq, and VIX. A specific “exchange settlement price” is computed at the precise moment on the expiry date for a cash settlement. All open positions that expire on that date will convert into the appropriate amount of cash, based on whether or not they are “in the money” and worth something. If not, they will be worthless. So your option contract is closed out by the exchange you’re trading at, and you have to cash that to replace its value. That’s how a cash settlement works. Options trading requires that you understand the settlement. Therefore, you can comprehend the involved cash and position movements and how they operate. Most traders on Robinhood trade Americans style options with a physical settlement. The settlement procedure is "cash-settled " for cryptocurrency traders who trade at Deribit, FTX, ByBit, or DeltaExchange. You’re trading European-style options with a “cash settlement” procedure. The word “exercising” is confusing for you because their derivatives contracts have a “cash settlement” procedure. You don’t have to think or worry about “exercising” an option. Deribit is the largest cryptocurrency exchange for trading options. Deribit has European-style cash-settled options. Sign up on Deribit and receive 10% discount on fees for trading futures & options: [https://www.deribit.com/reg-572.9826](https://www.deribit.com/reg-572.9826) Deribit offers European-style cash-settled options. 2. Options Pricing Now let’s go over the “spot price” and “forward price” because they affect the pricing of an option. We need to know the factors that impact the price of an option contract. We are not going into details about the “BlackScholes model,” but we can at least go over the inputs for the “BlackScholes model.” The BlackScholes model is a mathematical model used to price options contracts. The model considers the underlying asset’s price, volatility, time to expiration, dividends, and interest rates and determines the probability of the option expiring in or out of the money. Once we at least understand the inputs and how an option's premium will behave in an option contract, you can construct trades that reflect your view of the market. Disclaimer: The BlackScholes model assumes that the underlying asset will follow a lognormal distribution. The BlackScholes model doesn’t take into account the possibility of a stock split or a merger. These events can also affect an option’s premium. The way I can visualize these variables is with this diagram: Options pricing graph Spot Price The spot price is the first variable we shall discuss. The “spot price” is the asset’s current price. The “spot price” is a crucial factor in determining the value of an option. The value of an option is highly correlated with the current price of the underlying asset. If the spot price rises, so do the value of “call options,” as they get closer to or more likely to become “in the money.” In contrast, a fall in the spot price raises the value of “put options” as they approach or become more likely to become “in the money.” What is the forward price? Now, conceptually speaking, the “forward price” is a “best estimate” of approximation or “theoretical value” of what the asset price should be at maturity. Therefore, we multiply the “spot price” by the interest rate, denoted as “R”, until the maturity date and subtract any dividends received on the asset. The theoretical value of the future price is referred to as “arbitrage-free.” Consider it our starting point for pricing an option contract using the model. Before determining the option’s value, the Black Scholes model needs an initial point or anchor point. This information is provided by the “forward price”. It gives a starting point for estimating costs. Then, we must include more variables, such as volatility, into the model to evaluate the option contract price. Consider the other variables that contribute to the “forward price,” such as interest rates and dividends. The price impact of Interest rates & dividends on the forward price While “interest rate” and “dividends” are important, they do not have quite the same influence as “spot price.” Consequently, if you consider how the “forward price” fluctuates, the “spot price” is the primary factor. The influence of changes in “interest rates” on the “forward price” is negligible, especially for option contracts with maturities of six months or less. Anything with a short maturity is relatively steady, well-known, and sometimes previously declared in terms of “dividends.” In the first six months to one year, dividends change relatively infrequently. Therefore, longer-term option contracts place a greater emphasis on dividend expectations and payout fluctuations. Time to maturity Now we will consider “time to maturity” as a price variable for options. The answer to the question “How long does it take for the options contract to expire?” affects the price. I hope it’s intuitive to you that the longer the term of an option contract, or the more time to expiration, the more valuable the option contract may be. If the identical strike option on the S&P500, for instance, that is struck 8% “out of the money” expires within a week, it will be worth a certain amount. Time to maturity The value of this option contract will increase if the identical “call option” expires in one year. If it passes in three years, its value increases because additional time remains. It has so much time for the market to move and for the option to become more valuable and maybe go “in the money” that it will be worth more today due to this additional time. Even though these two variables contribute to the price, their influence is minimal. Implied volatility Implied volatility is an input variable in the diagram, while implied volatility is mainly an output variable. Importantly, implied volatility estimates how market players “believe” an asset will fluctuate. It’s potential for movement. Even though we’re calling it an input variable, what happens is that we have option prices that are already out there in the market. So rather than taking all the variables, including implied volatility, sticking it into our model and having an option price The option price is predetermined by market participants convening on an exchange, submitting bids and offers, and settling on a price for an option contract. To determine the fair value of an option contract, we may examine the price of any option contract by seeing where participants are buying and selling this option on the market. Market players monitor the option price and “imply” the volatility number, the final variable, by considering all the other factors. The observed volatility is the implied volatility. We essentially subtract it from the option price. Therefore, implied volatility is “extracted” from the observed option price on the market. That is why it’s referred to as “implied volatility.” The market prices imply it for options, and it allows us to see the market's blended expectation of future potential movements in the asset. It’s a way of observing the market's changing expectations of how volatile an asset can be in real-time. These are the main price factors that determine an option contract’s price. (Spot, time, and volatility). Implied volatility video introduction We must comprehend how changes in these factors will affect the option contract price. Later in this article, we will assign “Greeks” to each of these variables, which measure an option’s sensitivity to changes in these key variables. The Greek term for the change in the spot price is “Delta,” the Greek term for the passage of time is “Theta,” and the Greek term for implied volatility is “Vega.” 1. Options Value Intrinsic value The intrinsic value is the payoff of an option if it expires today. For a “call option” contract, we know that we only have a payoff if the “spot price” is trading above the “strike price.” The intrinsic value for a “call option” would be: current price - strike price Intrinsic value “In the money” call option However, if the “spot price” minus the “strike price” would be negative because the “spot price” is below the “strike price,” then we know that the option has no payoff. So the intrinsic value is zero. “Out of the money” call option — No intrinsic value The intrinsic value can never be negative. The intrinsic value is either positive because there’s a payoff of zero. After all, the option would not be “exercised” if it expires today. For a “put option,” we need to have the “spot price” below the “strike price” for there to be an intrinsic value. In this case, we would calculate like this: strike price - spot price If that’s a positive number, that would be the intrinsic value of the “put option.” The intrinsic value is the minimum value of the option contract. It’s important to remember the intrinsic value of “At the money” and “Out the money” options contracts are always equal to zero, it can never be negative. Only “In the money” option contracts have intrinsic value. The intrinsic value of an option is also known as “moneyness.” Time value/Theta Time value (also called “intrinsic value”) is the value of an option contract based on the amount of time left before maturity/expiration. Even if an option contract is now “out of the money,” there is still time for it to become “in the money,” have intrinsic value, and be worth something, as long as the strike price is reached before the expiration date/maturity. The longer the maturity, the more time value That should seem obvious. Before expiration, the longer we have, the more likely the options contract will become “in the money,” hence more “time value.” Maybe less intuitive is that higher implied volatility also means more time value. For instance, we own a 105% call option, so a 5% “Out of the money” (OTM) call option will expire in one week. One call option is on a “boring” utility stock that fluctuates daily by less than 1%. The probability that this 105% “call option” will be “in the money” is low for this “boring” utility company, so the time value is probably low. We know that an option contract has no “intrinsic value” because it’s “out the money,” but we think the “time value” is low because the chances of getting “in the money” within a week are probably low. Now, if we take that same “call option” but on a different asset like bitcoin, what would that look like? Both options have no “intrinsic value.” We know that bitcoin can move 5% or more than 10%, so what’s the probability that bitcoin could be above the 105% strike within a week? We know that bitcoin can move 5% or more than 10% within a day, let alone a week so that 105% “out the money” call option contract in bitcoin is worth a lot more than a call option contract on a boring utility stock. Because of that higher “implied volatility” (the expectation of future moves) that bitcoin has, that’s what makes call option contracts on bitcoin worth more than one for a utility stock. Now another scenario, if the “implied volatility” goes to zero, what will happen to the time value? Essentially by taking “implied volatility” to zero, you’re saying that the asset will not move until the expiry of the option contract. So what you’re saying is that there’s no need for any time value because the asset will stay where it is between now and expiry. Therefore the time value would automatically go down to zero. As implied volatility goes to zero, the time value will be zero. Similarly, as implied volatility rises to a 100 like bitcoin, the “time value” will increase. In this diagram, we have represented the “intrinsic value” of a call option contract as the hockey stick payoff you’ve seen before. That is the payoff at expiry and is represented there on the diagram. So the curve of that hockey stick payoff shows the value option contract today. However, it must also incorporate the “time value” and the “intrinsic value.” The distance or gap between the curve indicating the overall value of the option contract today and the hockey stick representing the option contract expiration, which we know to be the “intrinsic value,” reveals the “time value” of the option contract. Time value You can see that “time value” is not constant for all underlying futures or spot price levels. You can see it moves with the curve. “Out the money” (OTM) options example When an options contract is deep “out the money,” there’s obviously no “intrinsic value” as the expiry payoff would be zero. “Out the money” call option — no intrinsic value You can see that the curve that includes the “time value” also sits very close to the zero line, suggesting that there’s no “time value” either. “Out the money” (OTM) call option — no time value either It makes sense that there is no “time value” since we are far “out of the money,” and the possibility of ever being in the money is so unlikely that the call option contract is not worth anything. The “time value,” or lack thereof, is linked to the probability of ever getting in the money. “Out the money” (OTM) call option — lack of time value “In the money” (ITM) options example This time, the option contract “intrinsic value” is high, as we are sitting above that 45-degree line of the option contract payoff. Call option “In the money” (ITM) intrinsic value Suppose a “call option contract” will expire in one month. Here the option contact’s value will be higher than the “intrinsic value.” That difference is the time value. Call option “In the money” — “Time value.” As the option contract comes closer to expiration, the time value shrinks or decays. You can see that the entire option contract value will always be greater than the intrinsic value until it expires. “Time value” shrinks/decays closer to expiration and further “in the money.” Anyways, note on the diagram below that the curve above it has very little distance above the hockey stick payoff. curve above it has very little distance above the hockey stick payoff. The little distance above the hockey stick suggests no “time value.” You may question why the option contract has no “time value” while we are “in the money” significantly. In prior cases, we have shown that time value correlates with the possibility of “making money.” We are really “in the money,” so the likelihood should be one hundred percent. Consequently, why would there be no “time value”? That’s because “time value” is actually about uncertainty. Now that we are so deeply “in the money,” there’s little uncertainty that the option contract will be “exercised.” That implies that it is nearly certain that when we purchase shares at the “strike” (as this is a “call option”) as time moves towards expiration. If it is 100% probable to happen, then the “option contract” ceases to behave like an option contract and acts as if you had already purchased the stock at the “strike price” that struck at a lower price, and that position will behave as if you were just “long” on the shares. option completely tracks the 45-degree line Therefore, the option perfectly follows the 45-degree line, representing a stock position. When a call option is “deep in the money,” it is equivalent to being “long stock.” There’s no uncertainty of “exercise,” there’s no more optionality and hence no “time value.” “At the money” (ATM) example When the option contract is “At the money” (“spot price” equals the “strike price”) The graphic depicts the most significant disparity between the “intrinsic value,” which is zero for “at the money” option contracts, and the option contract value is at its widest “At the money” (ATM) call option contract So an option contract has the most “time value” when it is “at the money” this is because that’s the point of maximum uncertainty of “exercise.” The price may increase or decrease. We just do not know. Option contract value as it approaches expiry We know that the option contract’s value decreases with its expiration date since the “time value” diminishes with time. Regarding the graphic depicting the current option contract value, we can see that as time passes, the curve begins to flatten and approaches the hockey stick payment, which it reaches on the day of expiration. Suppose a “call option contract” has a one-month expiration date. The option contract's value will exceed its “intrinsic value.” This difference is the “time value.” Call option “In the money” — “Time value.” As the option contract comes closer to expiration, the time value shrinks or decays. You can see that the entire option contract value will always be greater than the intrinsic value until it expires. “Time value” shrinks/decays closer to expiration and further “in the money.” The smooth curve that the option’s value for different “spot prices/”futures prices” has become more distorted as we expire and becomes more like the hockey stick payoff. Therefore, the real value of an option contract today, some time before expiration, acts like a curve that rests above the option contract’s eventual expiration payoff. The distance between the “spot price” and “strike price” determines the shape of this curve. Are we “out the money” “Out the money” (OTM) “At the money.” “At the money” (ATM) or “In the money.” “In the money” (ITM) Furthermore, it depends on the passage of time. Is it a beautiful, smooth curve, or is it getting more distorted as the expiry date nears? You become a more “skilled” options trader if you understand how the premium of an option contract behaves in space and time. You will be able to develop positions with enhanced risk profiles and capitalize on possibilities for options trading. 1. Options chain In this section, we will examine an “options chain” and how to analyze the various trading “strike prices.” You may witness the influence of pricing and available expiry dates on the market. Read strike prices from an options chain (Deribit example) So here’s the “options chain” for bitcoin. The maturity date we selected is June 24 (2022). Quarterly options. First, let’s begin with Deribit exchange since they are the largest exchange for trading bitcoin options. Sign up on Deribit and receive 10% discount on fees for trading futures & options: [https://www.deribit.com/reg-572.9826](https://www.deribit.com/reg-572.9826) The current “spot price” for bitcoin is around $29880 This table displays how the option contracts are structured. Options table (click on image to zoom in) On the left are “call options,” and On the right are “put options.” The strike price is the center bar labeled “strike.” Both the bid and ask prices for options show. We can see both the bid and ask prices for options. The graphic on the left side of the “options chain” depicts the bid and ask prices for “call options.” Bid-Ask for Call options on the left side of the options chain The bid-ask prices are shown on the right side of the “options chain” in the illustration below. Bid-ask for Put options on the right side of the options chain As mentioned before about “implied volatility,” there’s also on both sides a bid and ask offers for “implied volatility” (IV) “Implied volatility” — Bid & Ask For the $30k “At the money” options, the “call options” have an implied volatility of 76.3%. The “put options” also give us 76.3% As previously stated, “implied volatility” is the model's output obtained from the option contract prices. Let’s check the options chain for the S&P500 (spot price trading at $415) [https://www.barchart.com/stocks/quotes/$SPX/options](https://www.barchart.com/stocks/quotes/$SPX/options) Call options SPX500 The model, the internal model of this trading platform, computes the center of the bid-ask spread and “spits out” or “returns” 31.92% or an average of 31.1% as “implied volatility.” For the put options on the S&P500 Put options SPX500 It has an “implied volatility” of 31.95% or an average “implied volatility” of 31.1%. Therefore the “call” and “put” of the same strike are almost identical. Same “strike” option contracts with the same expiration date will have the same “implied volatility.” After examining “At the money” options, let’s examine “Out of the money” option contracts. We must look at higher “strike prices” for “call options” that are “out of the money” since such options are “out of the money. The more we scroll down, the higher “strike prices” we see—the screenshot's “strike prices” range from $31k to $70k. As we go through higher “strike prices,” the prices for those “call options” are dropping. The cost to buy these options is getting cheaper. The prices are getting lower and lower. Call options, higher strikes, prices dropping. The further options are “out of the money,” the closer their costs approach zero, as “time value” and the likelihood of being “in the money” decrease. In the same scenario for “put options” contracts, the lower “strike prices,” the lower the cost/premium of these options. The more “out of money” we go on the “options chain,” the premium of the options contracts goes down, as we would expect. So if we look at the corresponding “call option” that has the same “strike price,” the only difference between the “call” and the “put” is that one of them got “intrinsic value.” One is deeply “in the money,” while the other is “out of the money.” However, the $570 “time value” of this “put option” is also the “time value” of this “in-the-money” call. You can see that the price of the “In the money” call option is just the “intrinsic value” of the “in the money” call option, which would be the difference between the spot price ($30023) minus the strike price (2500) 30023 − 25000 = 5023 And then we add the price of the “put option,” and that’s what roughly the cost of the call option will be 5023 + 1264.90 = 6287.9 As you can see, the price of the “call option” with a “strike price” of 2500 is ~$6293 We can see a slight difference, and that difference is due to the “forward” and the fact that we are pricing options of the “forward,” which might be slightly less or more due to the interest rate (rho). For stocks, It can be due to dividends and factors like that. However, I am trying to explain that these “deep in the money” call option contracts contain a lot of “intrinsic value” and are thus quite valuable. In addition, they received a small amount of “time value” due to their distance from “at the money” strikes, but a substantial amount of premium. You can also see columns for “Delta,” which is a topic for part 2 of a new article. Disclaimer: Use limit orders when trading options. Don’t use market orders! The spread can be wide and unfair. Check the implied volatility too before making irrational decisions How to read expirations on the option chain (ByBit example) This section will examine the various expiry dates and maturities. Since the ByBit exchange has introduced options trading, we will review their options and options chain. You can see this short-dated “at the money” calls are around $1500 Now, if we check the option contracts with longer expiry, let’s select the July options and see the price/premium for an “at the money” call option contract with that same “strike price.” The price has gone from $1500 to $4120 for that same “strike price,” but two months later. You can see that the longer maturity by around two months makes the premium of that same “strike price” option much higher. Why? Because there’s more “time value.” As the maturity is further in the future, the value of the options goes up because they have more “time value.” Should I trade on ByBit? Yes, there’s some opportunity. I will try to explain this simply. If you’re familiar with ByBit, those traders are crazy high risk-taking gamblers. Crazy ByBit “ape” uses his savings to buy worthless short-term far “Out the money” options because he saw bullish tweets from 3AC (hedge fund). The market's implied volatility might be high, but you can analyze the “realized volatility” and decide to sell him a “call option” and collect the premium. Usually, the options market is fairly efficient, more efficient than you think, but there’s always a chance. For example, I sold bitcoin “call options” with these fantasy “strike prices” of 100k expiring in June on Deribit. You may wonder, who would ever take such a gamble? Exactly. There’s always a gambler somewhere. We provide him the liquidity to buy a “call option” for his gambling by selling that “call option” to him. We buy the underlying (spot) to hedge our position. Sometimes there can be a win-win. ByBit Options (Discount on fees and $100 deposit bonus): [https://www.bybit.com/register?affiliate\_id=6776&group\_id=1653&group\_type=1](https://www.bybit.com/register?affiliate_id=6776&group_id=1653&group_type=1) Trading platform: Delta exchange Another new exchange called “Delta exchange” has options trading for multiple altcoins. You could use these options to hedge your portfolio for altcoins. Here we can see the options chain for Avax. Delta exchange If you’re seeking to signup and want a 10% discount You can use my referral link [https://delta.exchange/?code=rnr](https://delta.exchange/?code=rnr) I haven’t fully tested out their exchange yet, but they provide a lot of options for different altcoins, move contracts, and some exciting derivates contracts (which I need to study more) Trading platform HXRO (Gamified option trading) Another exchange called “HXRO” gives a bit of feeling like trading on Robinhood, which might be helpful for beginners to get a feel or introduction to options trading. I’m not here to make judgments about putting “options trading” at people’s fingertips in a “fun,” and gamified format with practically no other market maker than “Alameda Research” (The guys behind FTX exchange) is a good thing. You can try it out yourself. You choose a prediction for a price if it will hit yes or no, and request a quote. You can’t place limit orders, and it’s most likely Alameda Research giving you a quote after you request it. They give you a quote. The market makers (Alameda Research) most likely charge you a higher unfair premium. They will take your trade agast them and hedge it out somewhere else. Most won't notice since it’s a fun gamified way aimed at retail traders, most won’t see. The probability seems somewhat equal to Deribit, which shows a similar delta for that same strike which is 0.3 (Sometimes, I use the “delta” in a practical sense to estimate the likelihood of an option expiring “in the money.”) The probability estimations seem at least fair. You could try it out if you're a beginner and gamble with $10–$100, but I don’t recommend it if you're a serious trader. Suppose you want to try it out to get a feeling for a start and do some practice in a “fun” gamified way. Well, I’m not here to make judgments. I started playing with HXRO 2 years ago to test out and play. Since I give HXRO exposure, I might as well just put my referral link in HXRO Hxro is trading, simplified. Trade your favorite markets... hxro.trade I promise they don’t sponsor me or ask me to write this. HXRO, if you guys are reading this, for the right price you can call me ;) DeFi These DeFi protocols also use options like this protocol built on Solana. Stay away from trading options contracts on these DeFi protocols. They falsely advertise themselves and appear like it’s “free money” and “risk-free.” Also, the market makers for these options are most likely hedge funds like 3AC, who will happily give you a terrible price and hedge that away on an actual options exchange like Deribit. Use an actual exchange to trade options contracts and receive better prices. These DeFi option protocols are predatory, and I won’t recommend using them. It comes close to robbing people with its false advertisements. Sign-up for an actual exchange. I know KYC might be a pain, but it’s worth it. Final words, announcements, and more Congratulations, you finished reading this article which is just the first part. Please leave a clap for the algorithm on medium if you enjoyed it. I highly recommend you create a medium account and follow me. Turn on email notifications. As I’ve mentioned before You have learned in school, on television, or YouTube how to visualize atoms, protons, neutrons, electrons, etc. This model is entirely inaccurate, yet we use it because it helps us visualize the specifics of these abstract subjects. Consider everything in this article to be an oversimplification to assist you with more advanced reading about options trading This article was part 1 of my article series about options contract trading. I will publish as a part 2, and I will cover “option Greeks.” What they are and how to use them when evaluating option trades. Also, I will attempt to explain how “Gamma hedging” from market makers impacts markets. So you will understand what I mean with The tail that wags the dog If you scroll down the article, you can see a “Todo” list for parts 2, 3, and 4 of the following articles about options trading. More medium articles? If you are looking for more medium articles like this written by me, you can find them here. [https://romanornr.medium.com](https://romanornr.medium.com) Twitter: [https://twitter.com/RNR\_0](https://twitter.com/RNR_0) If you liked this article, you will probably also love this article about FTX MOVE contracts. [FTX.com](http://FTX.com) MOVE contracts MOVE contracts are a straddle where the strike price is determined at the first hour of the day and expires at the last… [romanornr.medium.com](http://romanornr.medium.com) Scroll down from what you can expect from the following articles about options contract trading Part 2, 3, and 4 of the options trading article (coming sooner or later) Options Greeks (advanced) Delta * Delta hedging Gamma Vega greeks combined Term structure Contango Backwardation Weighted Vega Forward implied volatility Forward volatility in VIX futures Skew Skew Dynamic greeks Implied skew Trading strategies volatility strategies spread/ratios risk reversal/colar Advanced strategies Butterflies and condors Calander spreads Gamma levels Call walls Vol Put walls Second-order Greeks Vanna Charm Dealer positions Gamma Squeeze A useful tool for trading options: [https://tools.deribit.com/options-discovery?index=BTC](https://tools.deribit.com/options-discovery?index=BTC) Source: [https://romanornr.medium.com/options-trading-fd4d0bffb2c5?source=social.tw](https://romanornr.medium.com/options-trading-fd4d0bffb2c5?source=social.tw) --- *Originally published on [Nemoe](https://paragraph.com/@nemoe/option)*