14/11/2023

Options for beginners

How options work – examples with explanations

This article is about options for beginners. We will try to explain in simple terms the idea of such a complex financial instrument as exchange-traded options and their applications in trading.

Read more:

What are Options
Key Concepts
Types of Option Strategies
How Option Trading Works
FAQ

Please note! The ATAS platform is not designed for options trading, so there will be no platform screenshots in the article. Nevertheless, it is beneficial for every trader to understand how options work, as it can help to reduce risks.

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Options are specialized contracts that grant the holder the right (but not the obligation) to buy a financial asset in the future on a specific date and at a predetermined price.

Example. How options work

Suppose you have bought an option:

its duration is 1 month,
it gives you a right to buy 1 Bitcoin
at the price of $30,000.

If one month later you see that the price of Bitcoin is $35,000, you can use your option to buy the coin at a price lower than the market value.

Our profit in this case will be $5,000 minus the cost of purchasing the option.

But there is another scenario to consider. Let’s say the price of Bitcoin drops to $25,000. In that case, you can simply say, “I’ll pass” and not exercise your right to purchase.

In this scenario, your loss is limited to the cost of buying the option.

It is very beneficial because the cost of the option (known as the “premium”) is a fixed amount. This is how options help you limit your losses. For instance, you have bought an option for $200 and Bitcoin has dropped by $5,000. Your loss is only $200, not the full $5,000 that you could have lost in the futures or spot markets.

Options are more complex in comparison to stocks, cryptocurrencies, or futures, as they have specific nature which is unique to these markets. However, this complexity allows for risk reduction, the creation of new trading strategies, and the optimization of existing ones.

An Underlying Asset — a financial asset whose right to buy or sell is determined by the option. Typically, this is a futures contract. Options can also exist for stocks, currency, or any other asset traded on the exchange.
A Call Option— an option that grants the right to buy an asset at a specified price in the future.
A Put Option — an option that grants the right to sell an asset at a specified price in the future.
The Strike Price — the price at which the option buyer can buy or sell the asset in the future.
The Premium — the amount the option buyer pays to the option seller.
The Expiration Date — the period during which the option can be used.

Here are some of the basic types of option trading strategies:

Call Strategy: buying a call option in anticipation of profiting from an increase in the asset’s price.
Put Strategy: buying a put option in anticipation of earning from a decline in the asset’s price.
Insurance Strategy: buying a call option on an asset you already own to protect against a drop in the asset’s price.
Hedging Strategy: buying a call option on an asset you plan to acquire in the future to protect against an increase in the asset’s price.
Combination Strategy: simultaneously using two or more options.

The choice of option trading strategy depends on your goals and risk tolerance.

For more detailed descriptions of these strategies and their applications, check out our article on the 9 Popular Option Trading Strategies in our blog. The article also includes screenshots of the options board for trading oil futures.

Here is how an options board for trading looks like:

This is a screenshot from the Binance Exchange.

The board displays quotes for buying/selling Bitcoin options. Calls are on the left, puts on the right. Options with an expiration period of ‘in 2 days and 15 hours’ are selected.

For instance, let’s say you believe Bitcoin has risen to a crucial resistance level at $35,000, and the chances of breaking this resistance in 2 days and 15 hours are minimal. In this scenario, you sell a CALL option for $105. And expect a profit upon the expiration of the specified period Tempting? Not really. If Bitcoin unexpectedly surpasses the $35,000 resistance and surges to $40,000, then your loss will be = 40 000 – 36 500 = $3 500.

What are the advantages of options then?

There are several of them. One advantage is the absence of stop-loss orders. If a sharp price fluctuation on the futures market knocks you out of a position with a loss, in the options market, you can remain profitable.

Here are additional reasons why you should consider options:

Options offer the opportunity to profit from price movements of the underlying asset in any direction.
Options can be used to hedge existing positions (to protect against losses and limit risks). For example, if an investor owns stocks that they believe are overvalued, they can buy a put option to shield themselves from a decline in the stock price.
Application of various strategies involving 2 options. For example, to profit from market volatility.

Options provide more flexibility, allow you to hedge against risks, and pave the way for potential trading income increases. For instance, if an investor buys a call option and the price of the underlying asset significantly surpasses the option’s strike price, they can get profits several times higher than the premium cost.

What are futures and options?

Both financial instruments are derivatives. Their value depends on the underlying asset.

What is the difference between a future and an option?

In a nutshell, a future is an obligation, while an option is a right.

How do options differ from stocks?

Stocks represent the underlying asset, while options are derived from the underlying asset.

What types of options are there?

There are two main types: a Call Option (CALL) allows the purchase of an asset at a predetermined price in the future. A Put Option (PUT) grants the right to sell an asset at a predetermined price in the future.

Which is better – futures or options?

Each of these financial instruments has its own advantages and disadvantages. There is no one-size-fits-all answer. However, futures may be more preferable as they are easier to understand and learn to trade, for instance, through the Market Replay simulator.

Options are a financial instrument with significant advantages but are also quite complex. They are more suitable for developing sophisticated strategies by advanced traders.

Futures trading is easier. Moreover, futures traders have an opportunity to analyze cluster charts to have a better understanding of market conditions. Cluster charts are not available for the options market.

The ATAS platform provides you with a powerful toolkit for cluster analysis of futures, stocks, and cryptocurrency markets:

clusters can be created on regular timeframes as well as on range charts or charts of other types;
the list of available indicators and special features is constantly expanding with each ATAS platform update;
ATAS enables you to load tick data history from futures, stocks, and cryptocurrency markets, providing you with a comprehensive foundation for studying cluster charts;

The platform offers many other advantages for traders who combine professional-level cluster charts with useful indicators and other features.

Download ATAS. It is free. During the trial period, you will get full access to the platform’s tools to experiment with the DOM and footprint charts. Moreover, you can continue using the program for free even after the 14-day trial period is over, whether it is for cryptocurrency trading or volume analysis.

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Information in this article cannot be perceived as a call for investing or buying/selling of any asset on the exchange. All situations, discussed in the article, are provided with the purpose of getting acquainted with the functionality and advantages of the ATAS platform.