In the previous lecture we covered what a derivative contract is. To recap briefly a derivative contract is a legal agreement between two parties. The contract derives its value from an underlying asset, according to the rules set out in the contract.
An option contract is a specific type of derivative contract. It gives the buyer of the option contract, the right to trade the underlying asset at a certain price on a certain date. The buyer is not obligated to exercise their right, but they have the option to, hence the name ‘option contract’.
When looking at an option contract there will be 5 main parameters to consider:
- The underlying asset – The asset that the option contract derives its value from. In the example in the previous lecture, this would be silver, but this can just as easily be bitcoin, another currency, or stocks.
- The option type – The two types of options are call options, and put options. A call option gives the buyer of the option the right to buy the asset at a given price, and a put option gives the buyer of the option the right to sell the asset at a given price.
- The expiry date – This is the date the option will expire and be exercised if it has any value. Exercising an option means the buyer exercises their right to buy or sell the asset.
- The strike price – The price at which the buyer has the right to trade the asset on the expiry date. For a call option the buyer has a right to buy the asset at the strike price, and for a put option the buyer has the right to sell the asset at the strike price.
- The option price (aka the option premium) – This is the price the buyer pays to the seller to purchase the option. In other words it is the premium the buyer pays the seller for the right to trade the asset at a specific price.
It’s important to understand the two different types of options, call options and put options. We will cover each in great detail in their own sections later in the course, but for now it is useful to know the main difference between the two.
The buyer of a call option, is purchasing the right (or option) to buy the asset at the strike price, on the expiry date.
On the other side of this trade of course is the trader who is selling this call option to the buyer. The seller of the call option, has an obligation to sell the asset to the call option buyer at the strike price, on the expiry date.
The buyer of a put option, is purchasing the right (or option) to sell the asset at the strike price, on the expiry date.
On the other side of this trade, is the trader who is selling this put option to the buyer. The seller of the put option, has an obligation to buy the asset from the put option buyer at the strike price, on the expiry date.
It is usually put options that confuse new option traders. This is because the buyer of a put option is actually betting on the price of the asset decreasing. Put options increase in value when the price of the asset goes down. Don’t worry if you don’t fully understand this yet, because there are two entire sections on call options and put options and exactly how each works.
For now just remember that a call option buyer has the right to buy the asset, and a put option buyer has the right to sell the asset.
Let’s look at how you may see an option written
On the Deribit platform you will see option instruments written in the following format:
Underlying Asset – Expiry Date – Strike Price – Option Type
For example if you see an option written as:
BTC – 30OCT20 – 13000 – C
This means the underlying asset is bitcoin (BTC), the expiry date is 30th October 2020, the strike price is $13,000, and the option type is a call. The buyer of this call option then, is purchasing the right to buy bitcoin at a price of $13,000 on 30th October 2020.
If you see an option written as:
BTC – 26MAR21 – 11000 – P
This means the underlying asset is bitcoin (BTC), the expiry date is 26th March 2021, the strike price is $11,000, and the option type is a put. The buyer of this put option, is purchasing the right to sell bitcoin at a price of $11,000 on 26th March 2021.
The final of the five parameters, the option price, will be displayed in the option chain and in the order book for each option. More on this later.