Part 4 Learn Institutional Trading

1. Uses of Options

Options trading is not just speculation; it serves multiple purposes:

Hedging (Risk Management):

Investors use options to protect against unfavorable price movements.

Example: A stock investor buys a put option to limit losses if the stock price drops.

Speculation:

Traders use options to bet on price direction with limited capital and potentially high returns.

Income Generation:

Selling options (writing calls or puts) can generate consistent income through premiums.

Covered calls are a popular income strategy where you hold the stock and sell a call option against it.

Arbitrage Opportunities:

Advanced traders exploit mispricing between options and underlying assets to make risk-free profits.

2. Option Strategies

Options provide flexibility through a variety of strategies, which range from simple to highly complex:

Basic Strategies

Long Call: Buy call option anticipating price increase.

Long Put: Buy put option anticipating price decrease.

Covered Call: Hold stock and sell a call to earn premium.

Protective Put: Buy a put for stock you own to limit downside risk.

Intermediate Strategies

Straddle: Buy call and put at the same strike and expiry to profit from volatility.

Strangle: Buy call and put with different strikes to benefit from large price moves.

Bull Spread: Combine two calls (different strikes) to profit from moderate upward movement.

Bear Spread: Combine two puts to profit from moderate downward movement.

Advanced Strategies

Butterfly Spread: Limit risk and reward for minimal cost, suitable for low volatility expectations.

Iron Condor: Sell an out-of-the-money call and put while buying further out-of-the-money options to cap risk.

Calendar Spread: Exploit differences in time decay by trading options with the same strike but different expiries.

3. Greeks in Options Trading

Options traders use Greeks to measure sensitivity of option prices to different variables:

Delta: Measures price change in option relative to underlying asset.

Gamma: Measures change in delta as asset price changes.

Theta: Measures time decay of the option’s premium.

Vega: Measures sensitivity to volatility.

Rho: Measures sensitivity to interest rates.

Understanding Greeks helps traders manage risk, hedge positions, and optimize strategies.

4. Risks in Options Trading

Options trading carries significant risk, especially for sellers/writers:

For Buyers:

Risk limited to premium paid.

Potential for total loss if option expires worthless.

For Sellers:

Risk can be unlimited for uncovered (naked) options.

Margin requirements can be high.

Time Decay Risk:

Options lose value as expiry approaches, especially OTM options.

Volatility Risk:

Unexpected changes in market volatility can affect option premiums dramatically.

Proper risk management, position sizing, and understanding of market conditions are crucial.

5. Practical Tips for Options Trading

Start Small: Begin with a few contracts until you understand mechanics and risk.

Focus on Liquid Options: Trade options with high volume to ensure tight spreads and easy entry/exit.

Use Stop-Loss: Protect capital by predefining risk limits.

Understand Time Decay: Avoid holding OTM options for too long without movement in underlying.

Diversify Strategies: Combine hedging, speculation, and income strategies.