Options are financial instruments based on the value of underlying securities. The buyer of an options contract has the ability (but not an obligation) to sell or buy the underlying security at a later date.
Options contracts are often bought through an online brokerage. They each have an expiration date, which is the date by which the holder must exercise the option.
Sometimes, an options buyer can choose to buy the underlying security. In other cases, they can choose to sell the underlying security. This is determined by the specific type of options contract at hand. In all cases, buyers purchase options at a slight premium for the rights given by the contract.
Key Takeaways
Options are complex financial instruments that give buyers the right (but not the obligation) to sell or buy an asset at a certain price and on a certain date.
Calls entitle you to buy the option at a certain price, while puts entitle you to sell an option at a certain price.
Depending on your investing goals, options strategies can help you speculate on the market, hedge your investments, or generate income.
Understanding Options
Options are versatile tools that can be used by traders for a variety of purposes. At its core, every option is a contract between a buyer, who pays a premium for the rights granted by the contract, and a seller. The Options Clearing Corporations offers a helpful document that discusses the characteristics and risks of options, which can be found on their website.
Did you know: Options are sometimes referred to as “derivative products” because their value is derived from that of the underlying asset.
Writing and Buying Options
Creating and selling options is also referred to as “writing” the options. The trader who creates and sells an option is known as the “writer” while the individual who purchases it from them is known as the “buyer.” The buyer, subsequently, can choose whether to exercise the option within the options expiration date.
Paying for Options
The price of the underlying premium is set in the contract at what is known as a “strike price.” The buyer, meanwhile, pays for the option at a given premium per share. They may later decide to buy or sell the underlying asset at the strike price. They may also not exercise the option to buy or sell, in which case they lose the money they have paid on the option’s premium. In that case, the writer of the option walks away with the premium they have been paid.
Types of Options Exercise
When it comes to exercising options, there are two main ways they can be structured: American-style and European-style.
European-style: Options can only be exercised at expiration. These options stop trading on the Thursday preceding the third Friday of the expiration month.
American-style: Options can be exercised at any time prior to expiration. Most stop trading on the third Friday of the expiration month. All stocks with options and ETFs have American-style options.
Did you know: American-style and European-style do not refer to regional distinctions. Many major US-based indices, including the S&P 500, have actively traded European-style options.
Calls vs. Puts
There are two sides of options trading: call options and put options.
1. Call Options
The buyer of a call option is entitled to buy the underlying security. Importantly, they are under no obligation to do so—their purchase of the underlying security is their choice, provided they decide to do it on or before the call option’s expiration date.
If they decide to buy the security, they will do so at the strike price, which is set when they buy the option. This means that the option gains value when the underlying security increases in value.
Call options are often used for speculative investing, especially if they have long expiration dates. They’re also popular with bullish buyers.
2. Put Options
The buyer of a put option is entitled to sell the underlying security. They, similarly, do not have to sell these securities, and can decide whether or not to exercise their right to sell, as long as they do so on or before the option’s expiration date.
Put options increase in value when the underlying assets drop in value. This means that puts are useful for hedging, protecting the buyer’s portfolio. As a result, put options are popular with bearish buyers.
Approaches to Options Trading
There are three main approaches to trading options:
Speculation
When a trader speculates, they are making a bet that the underlying asset in a given option will go up in value. An investor can use speculation to reap a profit, leveraging their underlying shares in the increasingly valuable asset.
The speculative buyer first purchases an option at the price of the set premium. Then they buy the underlying asset at its lower, already-set price (which is known as its strike price). This is true even if the value of those shares has risen during the time they hold the option.
In other words, through successful speculation, an options trader locks in a lower-cost price tag for a valuable stock.
Hedging
Alternatively, an investor can use hedging to decrease their risk. They do so by purchasing put options, which allow them to sell their options at a given, unmoving price (the “strike price”)—even if the value of those underlying shares decreases.
Through hedging, the trader is making a bet that the value of a given stock will fall rather than rise—they purchase the shares at a locked-in strike price assuming that their market value will fall, and then sell those shares at the strike price.
With hedging, the put option offsets another investment. If the investor has shares in a company that decrease in value, they can benefit from that falling value through exercising a put option.
Income Generation
Some traders use call options independently as a means of generating income.
Income can also be generated through writing (that is, selling) options. The writer pockets buyers’ premiums when they buy an option. Then, if the buyer never exercises the option, the writer walks away with that premium.
However, sellers often face greater risk than buyers, particularly when it comes to calls. Buyers of calls only stand to lose the premium, while writers face infinite risk.
Example of an option
Let’s say that Company ABC is trading at $100 and you believe that the shares will increase in value. You decide to buy a call option, with a share in the company as the underlying asset. You purchase one call option with a strike price of $110 for one month in the future. The price of the option contract is $0.50 per share (for 100 shares) so your total cash payment is $50 ($0.50 x 100).
If Company ABC increases to $112, your option is worth $2 because you can now exercise the option at $110 and resell it at $112. That means you’ll make a profit of $150, since you bought the contract for $50 and sold your stocks for a net profit of $200 ($2 x 100).
However, you may have made the wrong call. If the company’s share value drops to $90, the contract would expire and be worth nothing. In that case, you’d be out the $50 you spent on the options contract.
Options Trading Strategies to Know
There are a host of different options trading strategies, each with their own goals. Some of the most popular approaches include:
Cash-secured put:
A cash-secured put involves writing an at-the-money or out-of-the-money put option and simultaneously setting aside enough cash to buy the stock at the strike price. The goal is to either have the put expire worthless and keep the premium or be assigned and acquire the stock below the current price.
Covered Calls:
This strategy is useful for income generation as well as risk protection. It involves purchasing an underlying stock while simultaneously writing a call option based on that stock. This can offset a decline in the value of the underlying stock while also helping the investor earn money from buyer premiums. A buyer of the call could lose the premium they paid to purchase the options if not exercised. While a seller (writer) of a covered call forgoes upside stock appreciation above the strike price if assigned.
Bull Call Spread:
In this strategy, the investor buys call options at a given strike and expiration date—and, at the same time, sells an equal number of call options with the same underlying asset and expiration date, but with a higher strike price. This strategy is a bullish one in which investors guess that the underlying stock will appreciate in value. There is a risk that an investor could lose the premium they paid to purchase the options if not exercised.
Bear Put Spread:
This strategy is the mirror image of the Bull Call Spread. Here, an investor purchases put options for a given underlying asset at a certain strike price and with a certain expiration date. At the same time, they sell an equal number of put options with the same underlying asset and expiration date, but a lower strike price. Investors using this strategy are bearish and predict a depreciation in the underlying asset’s value. There is a risk that an investor could lose the premium they paid to purchase the options if not exercised.
How to Read Stock Option Ticker Symbols
Since 2010, it has been possible to read any stock option by looking at the ticker symbol. Stock option tickers have four components:
The Stock Symbol
The stock symbol is shared with the symbol for the underlying asset that forms the basis of the option. For example, stocks in the company Apple are symbolized with the letters AAPL, regardless of whether a trader is purchasing Apple stock directly, or is purchasing an option with Apple shares as the underlying asset.
The Expiration Date
The next component is the expiration date, which is written in YYMMDD format. A stock option expiring on November 19, 2023 would be written as 231119. This means that by November 19th 2023, the buyer has to assess the value of the underlying asset and decide whether to buy (in the case of a call option), sell (in the case of a put option), or let the option expire without exercising it.
The Option Type
This tells buyers whether they are dealing with a call or a put option. The type is indicated with a “C” for call or a “P” for put.
The Strike Price
The last component is the strike price, which is 8 digits. This is the price at which the option can be exercised. A strike price of $30 is written as 00030000. To read a strike price, just move the decimal point three digits to the left.
What are the Benefits of Options?
Options can be particularly helpful as a tool for leverage and hedging against risk. Here are a few of the main benefits:
Risk/Reward Ratio:
The strategy of hedging helps traders to manage risk. Through buying and selling put options, traders can protect themselves from large losses by offsetting other investments with covered options. And, for those buying options, risk is generally limited to the amount spent on the premium.
Low Capital Requirements:
Initially, traders only need to pay the relatively low premium.
Spreads:
Options spread strategies involve buying and selling a number of different options for a certain stock in order to optimize returns and lower risk. For instance, a trader may choose to buy one option while simultaneously selling another option with the same underlying asset but a higher strike price, thus benefiting from the best elements of both options.
What are the main risks of options?
Options are complex financial instruments that carry several major risks. These include:
Unlimited Losses:
Traders can face unlimited liability by writing “naked” calls—that is, call options sold by themselves—as opposed to “hedged” or “covered” options, in which they own the underlying security.
Margin Requirements:
Investors are required to deposit a certain value, in the form of either cash or securities, to a broker as collateral prior to trading options. Some options like long calls and puts don’t have margin requirements, but for the most part, this collateral is needed for options trading.
Lower Liquidity:
Liquidity for options can vary vastly depending on the individual option—and some options are illiquid, meaning they have an extremely low level of liquidity. Liquidity in options trading is also extremely complex relative to options trading, and determining the liquidity of an option requires skill.
Expiration risk:
Because options have a firm expiration date, trading on or close to the expiration date is associated with risk. If the market is volatile, or if a mishap occurs close to the expiration, traders may find that they cannot exercise their option as desired or that they face an unexpected outcome.
Conclusion
Options trading can offer traders an opportunity for risk management, speculation, and income generation. However, options do come with risk, and can be complicated to navigate. That’s why it can be helpful to understand how options trading works and research the individual option you’re trading before you dive in.
How do options differ from futures?
When a buyer purchases an option, they have the ability to but not the obligation to buy or sell the underlying asset on or before the option expires. When a buyer purchases futures, however, they are obligated to purchase the underlying asset on a set date.
Is an options contract an asset?
An options contract is a derivatives security, which is a type of asset. It’s an agreement between a buyer and a seller that establishes the potential for the future buying and selling of an asset at a given price and within a given period.
What are options used for?
Options are generally used for one of three approaches: speculation, hedging, and income generation. This range of uses means that options can be an advantage in situations where an asset’s value goes down, in addition to those in which the asset’s value goes up.
What are the requirements for options trading?
Before trading options, investors must register with a broker. Then they must fund their account with the minimum required amount, including whatever the margin requirement may be.
How can I start trading options?
After opening an options trading account with a broker, you’ll need to decide which options you’re interested in trading. Next, you need to predict the value of the underlying asset at expiration relative to the strike price. Finally, you’ll need to decide on the time frame and expiration.
What should I understand before trading options?
Before trading options, it’s important to understand your own objectives as a trader, and then to select options that suit those objectives. Then determine your risk tolerance and compare it to the risk/reward of the given option. Evaluate the option’s volatility, consider how external events might affect the asset, decide on your strategy, and lay out parameters like the strike price and expiration.
