What is Options Trading?
Options trading gives investors the right, not the obligation, to buy or sell an underlying asset at a predetermined price, known as the strike price, before a set expiration date. An option is a contract between two parties: the buyer and the seller. The buyer pays the seller a premium for the rights granted by the contract.
Options come in two main types: calls and puts. Here’s an easier way to understand how they work. Call options give the buyer the right to buy the underlying asset at the strike price. Put options give the buyer the right to sell the underlying asset at the strike price. These derivatives can be traded on securities like stocks, indexes, commodities, and currencies.
Options are called “derivatives“ as their value is ‘derived’ from that of the underlying asset – this is the financial instrument whose price and volatility are used to determine the value of the option contract.
In most cases, each option contract covers 100 units of the underlying security.
How Does Options Trading Work?
When you buy or sell an option contract, you are buying or selling the right to exercise the terms of that contract at the expiration date – for the European version. As the buyer, you pay a premium to acquire these rights but have no obligation to exercise the option.
If the option expires either worthless or out-of-the-money (OTM), the holder may just let the contract expire without exercising their right.
The seller of the option collects the premium and is obligated to fulfill the terms if the buyer chooses to exercise.
The price of an option, known as the premium, comprises intrinsic and extrinsic value. Intrinsic value is the difference between the strike and current asset prices. Extrinsic value, or time value, is the amount investors are willing to pay for the possibility that the option may become profitable (‘in-the-money’) by expiration due to a favorable move in the underlying asset price.
As the expiration date approaches, time decay accelerates and causes the extrinsic value component of an option’s premium to erode. Once an option reaches expiration, it no longer has any extrinsic value and only the intrinsic value remains. This is why picking the right expiration date is critical to succeed at trading stock options.
The main factors determining an option’s premium include:
- Price of the Underlying Asset: It affects its intrinsic value.
- Strike Price: The value of the premium will be affected based on how far or close the strike price is to the price of the underlying asset when the contract is purchased. A strike price quite distant from the underlying price, if volatility is low and the expiration date is not that far away, will result in a low premium.
- Time to Expiration: The lengthier the period between the purchase date and the expiration date, the higher the odds that the underlying asset can experience a favorable price move.
- Volatility: Higher volatility means a higher premium as the odds that the strike price can be reached are considered higher.
Strategies Used in Options Trading
The most common strategies used in options trading for beginners include:
- Buying calls or puts for speculation.
- Writing covered calls against stock you already own.
- Using spreads to offset risk.
The benefits of trading these derivatives include immediate access to leverage, risk management, and income generation. Some risks include complexity and potentially unlimited losses when writing a contract.
Types of Options
Calls vs. Puts
|They give the holder the right, not the obligation, to buy the underlying asset. Speculators buy calls when they expect that the underlying asset’s price will rise in the future.
|They give the holder the right, not the obligation, to sell the underlying asset. Speculators buy puts when they expect that the underlying asset’s price will decline in the future.
Understanding calls and puts meaning for options trading is critical to achieving successful outcomes.
- Call Buyer: Pays a premium upfront for the right to buy the asset at the strike price. They are considered a bullish position as the trader expects that the asset price will rise in the future. The risk is limited to the premium paid. The maximum profit is unlimited.
- Call Seller (Writer): Receives the premium upfront. If the contract is exercised, the writer must sell the underlying asset to the buyer at the strike price. The writer’s gains are capped at the premium he received, but the risk is unlimited if the price of the underlying asset rises dramatically.
- Put Buyer: Pays the premium for the right to sell the asset at the strike price. This is considered a bearish position as the underlying asset’s value is expected to decline in the future. The risk is limited to the premium paid.
- Put Seller (Writer): Receives the premium upfront. The writer must buy the underlying asset from the buyer at the strike price if the contract is exercised. The writer’s gains are capped at the premium he received. The risk is quite high, as losses can skyrocket if the underlying asset’s price declines substantially. However, it is limited because an asset’s price cannot drop below 0.
Note that buyers have defined risk, whereas sellers/writers have undefined risk. Due to the uncapped downside, writing options are only recommended for highly experienced investors.
American vs. European Options
- American: American options can be exercised at any given point of the contract’s lifetime. They provide greater flexibility for traders and increase the risks for writers.
- European: European options can only be exercised on the expiration date. They are less flexible, but their risks are limited to those who write the contract.
Most stock options are American. Meanwhile, index options tend to be European.
In the Money vs. Out of The Money
In-the-money (ITM) contracts can produce a profitable outcome at a given point in time. If they were exercised on that day, the result would be positive for the holder.
Out-of-the-money (OTM) options are contracts currently producing a negative outcome for the holder. If they were to be exercised at that moment, they would produce a loss to the trader.
Options Trading Strategies for Beginners
- Long Calls & Puts: Buy single calls or put options. The risk is limited to the premium paid.
- Bull Call Spread: Buy in-the-money call. Sell out-of-the-money call. Caps upside and downside risk. This is considered a bullish position.
- Bear Put Spread: Buy out-of-money put. Sell in-the-money put. Caps upside and downside risk. This is considered a bearish position.
- Covered Calls: This strategy can be implemented when the investor holds 100 shares or multiples of a hundred of a specific stock. It consists of selling calls on these shares. The premium collected generates income for the investor, and the risk is capped as the investor would only risk having to give up the shares at a profit in case the option contract is exercised.
Short-Term Options vs. Long-Term Options
Options contracts expire after a set period of time. Short-term option contracts typically expire in a few weeks or months, while long-term option contracts can expire in years. There are some key similarities and differences between each type.
- They allow investors to trade the underlying assets with leverage.
- They provide the potential for premium collection to generate income.
- They can be used to speculate on price moves.
- They both have well-defined maximum risks.
- Time decay impact: Short-term contracts experience accelerated time decay as expiration approaches. This quick erosion of their extrinsic value can lead to rapidly declining premium values. Meanwhile, long-term options have plenty of time value, so decay occurs slower.
- Liquidity profiles: Generally, short-term contracts tend to be much more liquid with tighter bid/ask spreads. There are some exceptions, like quarterly options, which receive extra demand. Meanwhile, long-term contracts tend to be less liquid, resulting in wider bid/ask spreads, difficulties in closing large positions, and high price volatility.
- Income-generation capacity: Collecting premiums by writing short-term options allows traders to collect income more frequently thanks to their quicker expirations. Locking in profits and rolling to new contracts occurs more often. Meanwhile, long-term premium selling ties up capital for extended periods but typically allows investors to capture larger premiums due to the added time value.
Are Short-Term Options Better than Long-Term Options?
Short-term contracts favor active traders focused on quick turnaround while long-term appeal to investors with longer time horizons willing to endure near-term volatility. Investors should determine their intended holding period and strategy before selecting the appropriate expiration dates based on their adopted strategy.
What are LEAPS?
The term LEAPS stands for Long-Term Equity Anticipation Securities. They are simply long-term stock or index option contracts with expiration dates farther out in the future compared to most other alternatives.
While standard equity options have expirations of up to about 9 months, LEAPS can have expirations of 2, 3, or even 5 years into the future. Their extended time horizon allows investors to be right on market direction before time decay accelerates.
The added time value of LEAPS means that their premiums are substantially higher than short-term contracts. However, the extra extrinsic value also provides a bigger profit potential if the underlying stock keeps trending favorably.
LEAPS function identically to regular calls and puts – they give holders fixed upside and downside price protection for extended time periods. LEAPS can be effective instruments for hedging longer-term portfolio risks or speculating on stock forecasts spanning years rather than months. However, investors must be ready to pay bigger premiums for the added time value component.
Pros and Cons of Options Trading
Now that we have provided a wide options trading definition, here’s a summary of the benefits and disadvantages of using these derivatives.
|Options give traders the possibility of controlling sizable positions despite having a limited account balance, as each contract provides exposure to 100 units of the underlying asset.
|Most trading strategies have a well-defined maximum loss potential. In addition, these derivatives can be used to mitigate portfolio risks.
|Investors can sell options on the shares they own to earn additional income.
|These derivatives can be used to speculate and earn on predicted price movements for stocks, indexes, etc.
|Options have more moving parts compared to stocks. Their price tends to be susceptible to changes not just in the underlying asset’s value but also in the market’s implied volatility and the Greeks.
|Writing uncovered or ‘naked’ calls and puts can result in unlimited losses for investors.
|Options contracts have a pre-defined expiration date. If the option is worthless at that time, the buyer loses the premium paid on the contract.
How to Start Options Trading?
Up to this point, we have learned a broad definition of options trading. Now, it is time to provide you with a step-by-step guide on how to trade options.
1. Open an Account With an Online Broker That Allows Options Trading
Look for brokers that offer educational materials along with an easy-to-use interface that allows you to quickly find the contract you would like to purchase for different underlying assets.
Many online brokers nowadays offer zero-commission trading for these instruments. In addition to this, look for a provider that also makes available advanced tools to analyze different scenarios for your prospective trades, such as the maximum loss, maximum gains, and how the price of the option will be affected in different scenarios – i.e., higher or lower IV or changes in the underlying asset’s price, etc.
2. Get Approved for Higher Options Trading Levels
Most brokers use approval levels to dictate what strategies traders can utilize based on their experience level, net worth, and other similar factors. Higher approval levels give investors access to more complex strategies with higher risk.
These tiers are:
Covered calls and cash-secured puts only.
Long calls and puts are allowed.
Spreads and combinations permitted.
Naked call and put writing approved.
Naked options can be sold with this approval level. These are options contracts where the writer does not own the underlying asset.
Ensure you fully understand the risks involved in any of these strategies.
3. Learn the Basics by Using a Demo Account
Use a practice trading account. Nearly all brokers offer paper trading functionality. Paper trading allows you to use virtual money to test strategies in real market conditions without assuming an actual risk. Take advantage of paper trading to refine your trading skills before committing real money to this activity.
4. Start Small
Start with small position sizes. When moving to real-money options trading, use only a small percentage of your capital for each trade. Losses can grow exponentially with options. This is why position sizing is key to preserving capital. Only allocate additional funds as your skills further advance.
5. Trade Liquid Options
Stick to highly liquid contracts. The most liquid options are those with high volume and open interest in large-cap stocks and exchange-traded funds (ETFs). Avoid illiquid contracts since entering and exiting trades becomes increasingly difficult and may result in higher price volatility and losses. Check the volume and open interest figures before selecting specific contracts.
What are the Greeks?
The Greeks are options trading terms named after letters of the Greek alphabet. They measure how option prices are expected to change based on various inputs. Traders rely on the Greeks to understand their risk exposure and how sensitive the options contract is to changes in certain variables.
- Delta: This is the rate of change of the option’s contract value compared to the price of the underlying asset. Calls are delta positive, while puts are delta negative. A Delta value of 1 means that for every 1% change in the underlying asset’s price, the value of the contract will change by 1%.
- Gamma: This is the rate of change for Delta. It accelerates when the contract moves closer to the expiration date. In practice, a Gamma value of 1 means that for every 1% change in the underlying asset value, the value of Delta will change by 1%.
- Theta: This is the rate at which the time decay will cause the option’s extrinsic value to erode. It is usually expressed as a negative value. The value of Theta indicates the percentage that the option’s value will decline every day the contract moves closer to the expiration date.
- Vega: It measures the options contract sensitivity to changes in the asset’s implied volatility (IV). A high Vega reading means that the price of the contract is highly sensitive to changes in the underlying asset’s implied volatility.
Understanding how the Greeks impact option valuations is vital for success. Traders use the Greeks to project future scenarios for profits and losses based on different assumptions.
Options Trading Example
Below are some examples of popular options trading strategies. These help demonstrate how options work in real market situations.
Covered Call Example
You own 100 shares of XYZ stock, which is currently trading at $50 per share. To generate income from your long stock position, you write 1 covered call contract with a strike price of $55 expiring in 60 days. You collect a total of $200 for selling the call ($2 premium x 100 shares).
Scenario 1: XYZ stock price stays below $55. The option expires worthless, and you keep the full $200 premium.
Scenario 2: XYZ stock rallies to $65 per share. Your shares get called away at $55, but you still gain the premium plus the price appreciation of the shares up to the strike price. This is $200 plus $500, resulting in a $700 profit.
Married Put Example
You think that shares of ABC stock, currently trading at $100 apiece, will rise over the next 2 months but would like to hedge your positions (100 shares) against unexpected declines. You pay $300 ($3 per share premium x 100 shares) for 1 put contract with a $90 strike price expiring in 60 days.
Scenario 1: ABC stock drops to $80 per share. You exercise the put to sell your shares at $90 strike and cut your losses. The overall loss is the premium paid plus the $10 loss on each share, meaning you lost $1,300. Without this derivative contract, you would have lost $2,000. Your losses were cut by 35%.
Scenario 2: ABC stock rises to $120 per share. The put option expires worthless, but you gain a profit of $2,000 on your original stock purchase minus the $300 premium paid, resulting in a $1,700 total profit.