Options Trading
Options Trading
Options are financial contracts that grant the holder the right to buy or sell a financial instrument at a specified price during a certain period. They are available for a variety of assets, including stocks, funds, commodities, and indexes. Like other assets, options can be purchased through brokerage investment accounts. Although options trading might seem complex initially, understanding a few key points makes it manageable. Investor portfolios often include multiple asset classes such as stocks, bonds, exchange-traded funds (ETFs), and mutual funds. Options constitute another asset class; when used effectively, they provide benefits that trading stocks and ETFs alone cannot offer. Additionally, options are a type of asset (or contingent liability), with valuation influenced by factors like the underlying asset price, time to expiration, market volatility, the risk-free interest rate, and the option’s strike price.
Options can be traded either through private agreements between parties in over-the-counter (OTC) deals or via exchange-traded markets as standardized contracts. Generally, owning an option does not give the holder rights related to the underlying asset, like voting rights or income such as dividends.
History of Options
Contracts akin to options have existed since ancient times. The earliest known option buyer was Thales of Miletus, an ancient Greek mathematician and philosopher. In London, puts and “refusals” (calls) emerged as prominent trading instruments in the 1690s during William and Mary’s reign. Privileges, which were over-the-counter options, appeared in nineteenth-century America, with specialized dealers offering both puts and calls on shares.
The Chicago Board Options Exchange was founded in 1973, creating a system with standardized forms and terms, clearing trades through a guaranteed house. Since then, trading and academic interest have grown. Today, many options remain standardized and traded via clearing houses on regulated exchanges. In contrast, some over-the-counter options are negotiated bilaterally as customized contracts between a buyer and seller, where one or both may be dealers or market-makers.
Objectives of Options Trading
Options are influential because they can improve an investor’s portfolio by providing income, protection, and leverage. Typically, there is an option strategy suited to an investor’s specific goal, depending on the situation.
Options serve as a hedge against declining stocks, aiming to limit losses and reduce risk cost-effectively—similar to insurance. Investors buy puts to cap losses when purchasing tech stocks, for instance, while short sellers use call options to minimize risks during adverse price moves, especially in short squeezes.
Options can be used for speculation, which is a wager on future price direction. A speculator might think a stock’s price will rise due to fundamental or technical analysis. They could buy the stock or a call option. Using a call option instead of buying stock outright offers leverage, as out-of-the-money options may cost only a few dollars compared to a $100 stock.
Notable Terms in Options Trading
Buyer of an Option: The individual who, through the payment of the premium, acquires the right to exercise his option with the seller/writer.
Writer/Seller of an Option: The party who receives the premium of the option and consequently is obliged to sell or purchase the asset if the option purchaser exercises it.
Call Options: Purchasing a call option grants the holder the right, but not the obligation, to purchase an underlying asset at a predetermined price—the ‘strike’ price—on or before a specified date. As the market value appreciates, the potential for profit correspondingly increases. Additionally, one may sell call options. In the capacity of a call option seller, one assumes the obligation to sell the underlying at the strike price should the option be exercised by the buyer at expiration.
Put Options: Purchasing a put option grants the holder the right, but not the obligation, to sell an asset at the strike price on or before a specified date. As the market value declines, the potential for profit correspondingly increases. Additionally, one may sell put options. As the seller of a put option, you assume the obligation to purchase the asset at the strike price should the buyer choose to exercise their option at expiry.
Premium: The amount paid by the option purchaser to the option seller is known as the option premium.
Expiry Date: The expiry date (or expiration date) is the last day a contract remains valid; after this date, it becomes worthless if it is not exercised.
Strike/Exercise Price: The strike price in options trading is the set, predetermined price at which the option holder can buy (for a call) or sell (for a put) the underlying asset (such as a stock) if they decide to exercise the contract before it expires.
American Options: The option can be exercised at any time until its expiry date.
European Options: The option can be exercised only on the expiration date.
Index Options: These are the options whose underlying is an index such as the S&P 500 (SPX), the Nasdaq-100 (NDX), and the VIX (Cboe Volatility Index).
Stock Options: These options are based on individual stocks, with the stock serving as the underlying asset.
In-the-Money Option: An in-the-money (ITM) option results in positive cash flow for the holder if exercised immediately. For instance, with a call option on an index, if the current index value exceeds the strike price (spot price > strike price), the option is considered to be in-the-money.
At-the-Money Option: An at-the-money (ATM) option is one that results in zero cash flow if exercised immediately, meaning no profit or loss. For example, if the current index value equals the strike price (spot price = strike price), the option is considered ATM.
Out-of-the-Money Option: An out-of-the-money (OTM) option is one that would result in negative cash flow if exercised now. For example, in the previous case, if the index value is below the strike price (spot price < strike price), the option is considered OTM.
Options Contract specifications
A financial option is a contract between two parties, with the terms outlined in a term sheet. While option contracts can be complex, they generally include the following key details:
- Whether the option holder has the right to buy (a call option) or to sell (a put option).
- The quantity and class of the underlying asset(s) (for example, 100 shares of TBS Co. B stock).
- The strike price, also called the exercise price, is the price at which the underlying transaction takes place when exercised.
- The expiration date, or expiry, refers to the final date on which the option can be exercised.
- The settlement terms, for example, whether the writer is required to deliver the actual asset upon exercise or may merely tender the equivalent cash amount.
- The terms under which the option is quoted in the market, facilitating the conversion of the quoted price into the actual premium, the total amount remitted by the holder to the writer.
Options Price or Premium
Valuing option contracts primarily involves assessing the probabilities of future price movements—the more likely an event, the pricier an option benefiting from it. For example, a call’s value increases as the underlying stock rises, crucial for understanding options’ relative value.
As expiry approaches, an option’s value declines because the probability of a price move decreases, thereby wasting assets. For example, if you buy a one-month out-of-the-money option and the stock doesn’t move, its value declines daily.
Since time influences option valuation, a one-month option possesses less value compared to a three-month option. Extended durations enhance the probability of advantageous price movements. A one-year option strike incurs higher costs than a one-month strike owing to time decay, which results in a decline in option value if stock prices remain static. Consequently, the same option will diminish in worth by tomorrow if prices do not fluctuate.
Volatility raises option prices by increasing uncertainty and the likelihood of large swings, both up and down, because higher volatility implies larger potential price moves. Greater volatility increases the chance of an event and the option’s price. Options trading and volatility are inherently connected.
Option price fluctuations are due to intrinsic and extrinsic (time) value. An option’s premium combines these. Intrinsic value is the in-the-money amount; for a call, it’s how much the stock trades above the strike price. Time value is the extra an investor pays above an option’s intrinsic value, known as extrinsic or time value. The option’s price can be summarized as follows:
Premium ($10) = Intrinsic Value ($9.5) + Time Value ($0.5)
In real life, options usually trade above their intrinsic value because the probability of an event, though often unlikely, is never zero.
Options Trading Example
For example, imagine you expect US crude oil prices to increase from $60 to $70 per barrel in the coming weeks. You choose to buy a call option that grants you the right to purchase the oil at $65 per barrel anytime within the next month. The $2 fee paid for the option is called the ‘premium’.
If US crude oil exceeds $70 (the ‘strike’ price) before your option expires, you can purchase at a lower cost. Your profit from this trade will be $3 per barrel, calculated as $(70-65-2). If the price remains below $65, you are not obligated to exercise the option and can let it expire. In that case, your only loss will be the premium paid to establish the position.
Hedge with Options
Using options for hedging helps traders cap potential losses on other holdings. For example, if you own stock and fear its price might drop soon, you can purchase a put option with a strike price near the current stock price. If the stock price falls below this strike at the option’s expiration, your losses are offset by the gains from the put. Conversely, if the stock price rises, your maximum loss is limited to the initial cost of the option.
Leverage in Options Trading
Options are leveraged products similar to CFDs, enabling speculation on market movements without owning the actual asset. This can amplify your profits, but also your losses if you’re selling options. For traders seeking higher leverage, options trading is appealing. You can select your strike price and trade size, giving you more control over leverage compared to spot market trading.
Options Trading Strategies
Long Calls: Trading options provides benefits for making directional bets. If you anticipate a price increase, purchase a call option, which requires less capital than buying the asset outright. If prices decline, your losses are limited to the premium paid. This approach is suitable for specific types of traders who meet certain conditions:
They are “bullish” or confident in a specific stock, ETF, or index, and aim to limit their risk.
They aim to leverage their position to benefit from increasing prices.
Options are leveraged instruments that let traders amplify potential gains by using less capital. Instead of $10,000 to buy 100 shares at $100, you could spend $2,000 on a call with a 10% higher strike price.
The maximum loss from a long call is limited to the premium paid, while the potential profit is unlimited, as the option payoff increases with the underlying asset’s price until expiration, and there is no theoretical cap on how high it can rise.
Long Puts: While a call option grants the holder the right to purchase the underlying at a specified price before the contract’s expiration, a put option allows the holder to sell the underlying at a set price. This strategy is favored by traders who meet certain conditions:
They hold a bearish (pessimistic) outlook on a specific stock, ETF, or index but prefer to assume less risk than a short-selling approach.
They aim to use leverage to profit from declining prices.
A put option functions oppositely to a call option, increasing in value when the underlying asset’s price drops. While short-selling also enables profits from falling prices, it carries unlimited risk since there’s no upper limit to how high the price can go. With a put, if the underlying ends above the strike price, the option just expires worthless.
The potential loss on a long put is limited to the premium paid for the options. The maximum profit from this position is capped since the underlying price cannot fall below zero. However, similar to a long call, the put option amplifies the trader’s return.
Short Calls: A trader expecting a stock price to fall might sell the stock short or alternatively sell, or “write”, a call. When selling a call, the trader commits to selling the stock to the call buyer at a set price (the “strike price”). If they do not own the stock when the call is exercised, they must buy it from the market at the current price. When the stock price drops, the call seller profits by the amount of the premium. However, if the stock rises above the strike price by more than the premium, the seller incurs a loss, which can be unlimited.
Short Puts: In a short put, the trader sells an option anticipating a price rise, earning the premium from buyers. The maximum profit is limited to this premium, but the potential loss can be unlimited if the trader has to purchase the underlying asset to meet her obligations when buyers exercise the option. Although the risk is high, a short put can be effective if the trader reasonably believes the price will go up. The trader can also buy back the option when its value is near the money, earning income from the premium.
Covered Calls: Unlike long calls or puts, a covered call is an options strategy added on top of an existing long position in the underlying asset, meaning you already own the stock. It involves selling a call option that covers the quantity of the stock you hold. This allows the writer to earn the option premium as income but also restricts the potential upside of the stock. This approach is favored by traders who meet specific circumstances:
They anticipate either no change or a small rise in the underlying’s price, securing the entire option premium.
They are prepared to accept limited upside gains in return for some downside protection.
A covered call strategy entails purchasing 100 shares of the underlying asset and selling a call option on those shares. The trader collects the option premium, which reduces the shares’ cost basis and offers limited downside protection. In exchange, the trader agrees to sell the shares at the option’s strike price if exercised, limiting the upside potential.
A trader purchases 1,000 shares at $34 each and writes 10 call options (one per 100 shares) with a $36 strike price, expiring in a month. The options cost $0.25 per share, totaling $25 per contract and $250 for all 10. This premium reduces the effective share cost to $33.75, providing limited downside protection since any decline to this level is offset by the premium received. If the share price exceeds $36 before expiry, the trader’s short call is exercised, requiring delivery of the shares at $36. This results in a profit of $2.25 per share ($36 minus $33.75). The strategy is based on expecting the share price to stay near or below $36, avoiding significant drops below $34. As long as the shares aren’t called away before expiration, the trader retains the premium and can sell additional calls if desired.
If the share price exceeds the strike price before expiration, the short call option may be exercised, requiring the trader to deliver shares of the underlying at the strike price, even if it’s lower than the current market price. In return for this risk, a covered call strategy offers limited downside protection through the premium received from selling the call option.
Protective Puts: A protective put involves buying a downside put to cover an existing position, effectively setting a floor on losses. You pay a premium, acting as insurance against losses. It’s preferred by traders owning the asset who want downside protection.
A protective put is a long put, similar to the strategy mentioned earlier; however, its primary aim, as the name suggests, is to provide downside protection rather than to profit from a downward move. If a trader holds shares and has a long-term bullish outlook but wants to guard against short-term declines, they might buy a protective put.
If the underlying’s price rises above the put’s strike price at maturity, the option becomes worthless, resulting in a loss of the premium for the trader, but they benefit from the increased underlying value. Conversely, if the underlying’s price falls, the trader’s portfolio loses value, but this loss is mostly offset by the gain from the put option. Therefore, this position can be viewed as a form of insurance strategy.
With this strategy, the trader can choose a strike price below the current market price to lower premium costs, though it reduces downside protection. This approach is analogous to deductible insurance. For instance, if an investor purchases 1,000 shares at $54 each and aims to protect their investment from negative price shifts over the next two months, the following put options are available:
June 2025 options | Premium |
$54 put | $1.23 |
$52 put | $0.47 |
$50 put | $0.20 |
To protect against a potential price decline, the trader can buy 10 at-the-money (ATM) put options with a $54 strike price, at $1.23 per share, or $123 per contract, totaling $1,230. Alternatively, if the trader is comfortable with some downside risk, opting for a cheaper out-of-the-money (OTM) option, such as the $50 put, could be effective. This approach would significantly reduce the cost to just $200.
If the underlying asset’s price remains unchanged or increases, the maximum loss is limited to the option premium paid, thereby providing insurance. Conversely, if the asset’s price falls, the capital loss is offset by an increase in the option’s value and is capped at the difference between the initial stock price and the strike price, plus the premium paid. For example, at a $50 strike price, the loss is limited to $4.20 per share ($54 – $50 + $0.20).
Long Straddles: Buying a straddle allows you to profit from future volatility without predicting the direction of the move—whether up or down, either will generate a profit. In this strategy, an investor buys both a call and a put option at the same strike price and expiration date on the same underlying asset. Since it involves purchasing two at-the-money options, it tends to be costlier than some alternative strategies.
Suppose someone expects a certain stock to undergo significant price swings after an earnings report on June 25. The current stock price is $200. The investor establishes a straddle by buying a $5 put and a $5 call, both with a $200 strike price and expiring on June 30. The total cost for this straddle is $10. The trader will profit if the stock price exceeds $210 (the strike plus the total premium) or falls below $190 (the strike minus the total premium) at expiration.
A long straddle’s maximum loss is limited to the premium paid. Because it includes two options, it costs more than buying just a call or a put alone. The potential upside is unlimited, while the downside is limited to the strike price. For example, with a $20 straddle, if the stock drops to zero, the maximum profit is $20.
Married Put Strategy: Similar to a protective put, the married put entails purchasing an ATM put option to hedge an existing long stock position. This strategy effectively replicates a call option, often referred to as a synthetic call.
Protective Collar Strategy: With a protective collar, an investor holding a long position in the underlying asset purchases an out-of-the-money (OTM) put option to limit downside risk, while simultaneously writing an out-of-the-money (OTM) call option to generate income from potential upside.
Long Strangle Strategy: Similar to a straddle, a strangle involves buying both an OTM call and an OTM put option simultaneously. Both options share the same expiration date but have different strike prices, with the put strike below the call strike. This strategy requires less premium than a straddle but depends on the stock moving significantly higher or lower to realize profits.
Vertical Spreads: A vertical spread involves simultaneously buying and selling options of the same type (either puts or calls) and expiration date, but at different strike prices. These can be set up as either bull or bear spreads, which profit when the market moves upward or downward, respectively. Spreads tend to be less expensive than a long call or long put because you also collect the premium from the option you sell. However, this strategy restricts your maximum gains to outcomes between the strike prices.
Levels of Options Trading
Brokers implement access control systems to prevent traders from executing unsuitable options strategies, thereby limiting risk. Typically, they offer around four or five approval levels, ranging from the lowest—indicating minimal risk—to the highest, which involves greater risk. The exact number of levels and the specific strategies allowed at each level differ among brokers. Each broker may have their own vetting criteria, usually considering factors like annual salary, net worth, trading experience, and investment objectives such as capital preservation, income, growth, or speculation. For instance, traders with low earnings, limited experience, and a focus on capital preservation are generally not authorized to engage in high-risk strategies like naked calls and naked puts. Traders can update their details when requesting permission to advance to a higher approval level.
- Level 1: Covered calls and protective puts, used when an investor owns the underlying asset.
- Level 2: Long calls and puts, including straddles and strangles.
- Level 3: Options spreads involve purchasing one or more options while simultaneously selling different options on the same underlying asset.
- Level 4: Selling (writing) naked options, meaning unhedged, which involves the potential for unlimited losses.
Advantages & Disadvantages of Options Trading
One significant advantage of purchasing options is the potential for high gains while risks are limited to the premium paid. Nonetheless, this can also be a disadvantage because options may expire worthless if the stock doesn’t move enough to become in-the-money. Therefore, acquiring many OTM options can become expensive.
Options are useful for leverage and risk hedging. For example, a bullish investor wanting to invest $1,000 in a company could earn more using call options instead of shares, as they increase buying power. If the investor already has exposure and wants to reduce it, they can hedge by selling put options.
The primary drawback of options contracts is their complexity and the challenge in pricing them accurately. This complexity often makes options a more advanced financial instrument, typically suited for experienced investors. However, in recent years, their popularity among retail investors has been growing.
Investors should thoroughly understand the risks and potential outcomes before engaging in any options trades, given the possibility of significant gains or losses. Ignoring this can result in severe losses.
| Maximum Gain | Maximum Loss |
Call Buyer | Unlimited | Premium |
Put Buyer | Limited | Premium |
Call Seller | Premium | Unlimited |
Put Seller | Premium | Limited |
There’s also a significant risk in selling options since you take on theoretically unlimited risk with profits limited to the premium (price) received for the option.
Options trading often involves greater complexity and risk compared to stock trading. It demands a solid understanding of market trends, the skill to analyze data and indicators, and a grasp of volatility. It’s important to be honest about your risk appetite, investment objectives, and the time you can commit to this activity.
Conclusion
Options trading enables investors and traders to buy or sell stocks, ETFs, and other securities at specified prices and dates. This form of trading provides flexibility, allowing participants not to execute the transaction at the set date or price. When an investor or trader buys or sells options, they gain the right to exercise that option at any moment before it expires. However, exercising the option at expiration is not mandatory. As a result, options are considered derivative securities.
Options provide alternative methods for investors to profit from trading underlying securities. They offer benefits such as downside protection and leveraged returns but also have drawbacks, including the need to pay an upfront premium.
Options trading frequently entails increased complexity and risk relative to stock trading. It necessitates a comprehensive understanding of market trends, proficiency in analyzing data and indicators, and an awareness of volatility. It is crucial to be candid about one’s risk appetite, investment goals, and the time available to dedicate to this activity.