Fundamentals of option trading is our concept that strives to draw a complete picture for the aspiring option trader, traditional portfolio manager, curious student or anyone who wants to have more knowledge about this increasingly popular financial topic.

You will find that articles on this website starts with ample amount of history and theory as well as basic option knowledge and then evolves to a more practical option trading strategy guide. This approach is necessary when it comes to explaining options as they may seem more complicated than they actually are without the fundamental base required to understand them. Nevertheless, lots of effort has been spent on making the subject understandable and useful for the reader rather than being a challenging math obscurity.

Although this post is not intended to be the “ultimate get rich with trading guide” you can find lots of practical knowledge and financial wisdom that’s actually practiced and implemented by the finance professionals at prestigious finance hubs around the world.

Finally, understanding the “wild” nature of options is very crucial in the pursuit of trying to tame them. We included a bold part in the end that tries to explain the risks and outcomes that can be associated with options and structured derivative products. But sometimes, with the lack of experience, such disclaimers can go unnoticed easily. I’d like to emphasize the importance of gradually warming up with options and the way they behave before making any serious decisions that involves option trading. If you treat it as a powerful tool that takes lots and lots of knowledge and practice to master in a considerably long journey there is no reason why you shouldn’t benefit from the potential opportunities that options offer. Just as insane profit outcomes such as 10000% or more returns are possible with option trading, If you treat it as a quick road to riches scheme that should be attacked as an emotion ball, losing the whole portfolio in a span of days is also possible.

So, kindly be advised to always keep the risks involved in mind, enjoy the knowledge building process that this article will enable you and more importantly enjoy and own your own financial wisdom journey.

# Option Basics:

Although roots of future contracts can be traced back to the late 17th century when elite class of Japan, known as “Samurai”, traded and brokered rice for future deals. Derivatives however, and particularly options, as we know in modern day, started much more recently.

Figure 1: Dojima River Rice Exchange by Utagawa Hiroshige (17th century)

In 1973, two academicians with extremely prestigious academic background progressively came up with an idea on what would become a historical breakthrough in finance and economics. The formula inherits its name from those two men: Black and Scholes (Merton would be added later with his dividend effect contributions to the formula).

They came up with an option price calculation, in which they combined underlying asset’s current price, option’s strike price, volatility of the underlying, time to expiry and the risk-free interest rates in the market. They blended these values (that can potentially affect the underlying price in future) with a complex mathematical formula (not so complex in today’s world and basically consisted of a lengthy normal distribution calculation) and they ended up with an accurate estimation of the value of an option. Full technical details of option pricing, Black and Scholes Formula and a glossary explaining the finance lingo that you may come across will be included in the upcoming posts of this website.

Believe it or not Black and Scholes had great difficulty having their paper published by prestigious journals. Clearly using differential equations and distribution models was unexpected and confusing initially. After a slight intervention by Mr. Merton their paper would be published, and they were later awarded Nobel prize for their contributions in field of economics in 1990 probably with a huge lag.

### Black & Scholes Formula

Black and Scholes Formula multiplies the stock price by the cumulative standard normal probability distribution function (C is the Call Option pricing and P is the Put Option pricing).

- And then net present value (NPV) of the strike price multiplied by the cumulative standard normal distribution is subtracted from the first part.

C = S*N(d1) – Ke^(-r*T)*N(d2)

P = Ke^(-r*T)*N(-d2) – S*N(-d1)

d1 = (ln(S/K) + (r + (annualized volatility) ^2 / 2)*T) / (annualized volatility * (T^(0.5))).

d2 = d1 – (annualized volatility) * (T^(0.5)).

(S is the stock price, K is the strike price, r is the risk-free interest rate and T is the time to maturity.)

If you are not savvy with mathematical notations here is an easy way to grasp the big picture. Don’t worry about the normal distribution part (d1 and d2) for a moment. C = S*N(d1) – Ke^(-r*T)*N(d2). In this call formula just realize that the Stock price – Strike Price (and the effects of time to expiry and interest rate) are the main theme. Normal Distribution adds the volatility and probability model to the picture with respect to the time left to expiry. This can help you see the big picture and genius behind the oeuvre of these academicians without necessarily diving in advanced mathematics.

So, what’s all the fuss about? Well, thanks to the Black and Scholes Formula we have options to buy and sell almost any asset at any price level to be exercised at any future date. Let’s take a closer look at how options work.

At the very basic level we have two types of options: call and put. When the option gives you the right to buy an underlying security it means it’s a call option and when it gives you the right to sell the underlying security it means it’s a put option. This can have a profound effect on the outcomes of your trade. Normally, if you buy a call option, its value is expected to rise as the underlying price increases but when you buy a put option its value is expected to fall as the underlying price decreases. You might want to take a moment and internalize this sentence since it’s the fundamental logic of option trading.

### Call Option Example

__Call Options__: Options have certain characteristic parameters such as: strike price, exercise date (or strike date or maturity) and underlying asset its based on.

Let’s look at an example of a Tesla call option trading at $41.50 while Tesla is trading at $344.60 with a strike price of $350 and maturity date of June 19, 2020.

Here is the breakdown of all the parameters given.

Option type: Call

Underlying asset: Tesla

Strike price: $350

Maturity date: June 19, 2020

Figure 2: Tesla stock price movement for last 5 days on 12.12.2019. (Source: WSJ)

This particular option gives you the right to purchase Tesla stock at $350 on June 19, 2020. You might see more clearly now that, if the underlying asset price increases, option price will increase with it and let you incur profits from your trade since you own the option. Let’s say Tesla came up with a new vehicle that everybody fell in love with and they don’t have any problems matching the demand. Hypothetically stock price increased to $525. The option you’re holding gives the owner the right to purchase the Tesla stock at $350 and that’s why it makes you profit.

### Put Option Example

__Put Options:__ A put option will have similar characteristic parameters such as: strike price, exercise date (or strike date or maturity) and underlying asset its based on.

Let’s look at an example of a Tesla put option trading at $41.50 while Tesla is trading at $344.60 with a strike price of $335 and maturity date of June 19, 2020.

Here is the breakdown of all the parameters given.

Option type: Put

Underlying asset: Tesla

Strike price: $350

Maturity date: June 19, 2020

This particular option gives you the right to sell Tesla stock at $350 on June 19, 2020. And if the underlying asset price decreases, option price will increase and become profitable. If the stock price falls to $200 in the stock market since your option gives the owner the right to sell the Tesla stock at $350 it will make you profits.

Figure 3: A snapshot of Tesla (TSLA) option chain showing some of the call and put options with their market prices and strike prices for maturity: 06.19.2020. (Source: NASDAQ)

# Moneyness

Option’s also have a characteristic called moneyness. Based on the relation between option’s type, strike price and underlying asset’s price an option can be: in the money, at the money or out of the money.

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#### In the money (ITM):

A call option will be in the money if its strike price is lower than the market price of the underlying asset.

A put option will be in the money if its strike price is higher than the market price of the underlying asset.

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#### At the money (ATM):

Sometimes an option’s underlying asset price can flirt with the level of its strike price. (Right on it or slightly above or below) Usually, a call or a put option will be called at the money if its strike price is right around the market price of the underlying asset.

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#### Out of the money (OTM):

A call option will be out the money if its strike price is higher than the market price of the underlying asset since no one will be interested in purchasing an asset at a higher strike price than its current spot market value.

A put option will be out of the money if its strike price is lower than the market price of the underlying asset since no one will be interested in selling an asset at a lower price than its current spot market value.

An option’s value is consisted of two types of values: Intrinsic Value and Time Value. The value that arises from an option’s relation between its strike price and underlying asset price is called its **Intrinsic Value**. It’s rather easy to calculate and it’s the value that is being discussed during the moneyness subject.

However, another critical component of an option’s value, which is harder to calculate and comprehend, is **Time Value. **Don’t worry, we will take a closer look to this concept in its individual post which will help you understand all the critical aspects of time value, its dynamics and its impacts on an option’s price. You can understand the implications of an options time value without being a mathematics wizard and trade options successfully.

Now, although options can be in other complex structures (vertical spreads, iron condors etc.) to obtain more specific outcomes, Black & Scholes Formula, plain vanilla call options and plain vanilla put options lay out the most fundamental basics of the option world and it’s crucial that they are internalized by option traders.

If you could bare with me through the Nobel Prize winning Black & Scholes formula, you probably know more about options than most Wall Street professionals do at this point. Computers handle most of the calculations with regards to option pricing today. Even in the professional world that’s usually the case. At hedge funds and prop shops with highly skilled traders you will see simple excel formulas punched into the computer to calculate the option price with a few variables. (By now, you already know these variables: stock price, strike price, volatility, time to maturity and interest rate)

One thing professional trader knows very well is how options work: how they behave, when to use which option, their risks and benefits and option behaviors that can be unexpected for the average investors.

In the upcoming posts we will look into some of those variables in detail as it is the key to understanding how options work and successful options investing.