Understanding Options Trading

Posted on Monday, January 28th, 2019 MarketBeat Staff

Summary - Traders have many ways to invest in stocks. In addition to looking for stocks to sell on the open market, they can look to trade options. The options market has become immensely popular as online options brokers have been able to provide investors with a better understanding of the options market and provide them with strategies to help them identify and analyze profitable options trades.

Options trading is based on price movement and volatility. There are two standardized options in options trading known as calls and puts. A call option is a contract that gives the buyer the right to buy shares for an agreed upon price, known as the strike price at or before a certain date. A put option is a contract that gives the buyer the right to sell shares for an agreed upon price on or before a certain date.

Trading options is a form of hedging because options traders profit when the price of the underlying security moves in the direction they anticipate. For example, if they are buying a call option on the stock of ABC company at a strike price of $30, they are speculating that the price of the stock will rise above $30 and since the strike price of the contract will probably be set above $30, the underlying stock price will have to rise above the strike price for the trade to have profit potential.

However, the buyer of the contract does not have to exercise the contract. If the price of the underlying security moves in the opposite direction they can simply choose to allow the contract to expire worthless. In this case, the only cost to the buyer will be the premium they paid to the seller. The premium gives the seller a small measure of protection since they are assuming the risk of an options trade.

Introduction

Options trading has become one of the more popular investing strategies. The primary reason for this is a lower risk – at least for the investor who is on the buying side of the trade. In this article, we’ll take a closer look at options trading. We’ll define and give examples of what options are. After providing a thorough review of the mechanics and terminology behind options trading, we’ll look at a couple of option strategies that traders may use. We’ll also explain how options contracts are different from futures contracts and we’ll provide examples. And although options trading is considered less risky than trading stocks, we’ll look at ways to avoid some of the common mistakes that can add to the risk associated with options trading.

What is options trading?

Options trading is the sale of a contract between a buyer and a seller in which the buyer of the contract is purchasing the right, but not the obligation, to buy or sell a quantity of a security at a specified price on or before a specified date. Options can be traded on virtually any kind of security (stocks, bonds, commodities, indexes, ETF’s, etc.). The options contract covers a specific period of time that can be a month, quarter or even six months.

Unlike trading individual stocks that self-directed investors can trade on the stock market, an options trade must be conducted through a broker. In fact, one of the reasons options trading has exploded in popularity for individual investors since the early 2000s is that online options brokers have increased their ability to provide education about investing in options and now offer tools that help options traders assess a trade’s profit potential. When purchasing an options contract, the investor will generally have to pay a base fee plus a commission which can make trading options contracts a little more expensive than conventional stock trades. 

Understanding options

When an investor purchases an option, they are not taking ownership of the underlying security. This is an important difference between trading securities and trading options. The options investor is purchasing the right, call it an opportunity, to purchase that security at a later date. Because the investor is not taking possession of the actual security (and may never actually do so – that’s why it’s called an option), they pay what is called a “premium” for the option. Option trades can either be on the buy side (call options) or sell side (put options). In either case, they are considered long trades.

Let’s look at some of the key terms that will help explain options.

Call Option– This is an option in which the buyer of the option believes that the price of the underlying security will rise before the option’s expiration date. They will agree to a strike price that is below the price they believe the security will rise to. If they are correct, then they will make a profit because the seller of the contract will have to allow them to buy shares at a price that is lower than where the stock is currently trading.

  • Example: The ABC Company has a stock price of $30 per share. Amy believes that the stock will rise in the next quarter. She buys a call option from a seller for $31 per share. The seller charges a $3 premium. Since option contracts are generally for 100 shares, Amy is paying $300 (3 x 100) for the option. This premium is the only money Amy is putting at risk.

    If Amy is correct and the stock rises past $31 per share, she can “call” in her option and the seller would have to sell her shares for the strike price of $31 per share. If the stock is has increased to $38, Amy would stand to make a $400 profit. Her shares would be worth $3,800 which is a $700 profit. However, she would have to factor in her $300 premium (700 – 300 = 400). If Amy is not correct, and the stock of ABC Company declines, she would simply allow the option to decline worthless, leaving her with only a $300 loss from the premium.

Put Option– This is an option in which the buyer of the option believes that the price of the underlying security will decline before the option’s expiration date. They will agree to a strike price that is above the price they believe the security will fall too. If they are correct, they will make a profit because the seller of the contract will have to buy John’s shares at a higher price than the current price per share.

  • Example: The stock of the XYZ Company is currently selling at $40 per share. John believes, based on a weak earnings report, the stock will fall in the next quarter. He buys a put option from a seller for $38 a share. The seller charges a $2 premium. Since option contracts are generally for 100 shares, John will be paying $200 (2 x 100) for the option. The premium is the only money John is putting at risk.

    If John is correct, and the XYZ company stock drops below $38 per share, he can “put” the option to the seller and receive 100 shares of the company stock for $3,800. If the stock is trading at $33 per share, John will have made a $300 profit ($500 - $200 premium). If John is incorrect and the stock increases in price, he can simply allow the contract to expire worthless. In this case, he is only out the $200 premium he paid for the contract.

Strike Price – This is the price that the buyer and seller of the option agree to as part of the contract. In the case of a stock, the strike price is usually based on the current price per share. However, the strike price does not necessarily need to be at that price. For example, if a stock is currently trading at $50 per share, a seller may be offering a call option with a strike price of $51.50 or a put option with a strike price of $49. It is up to the buyer to decide if they believe the price of the underlying security will go above or below the strike price.

Expiration Date– This is the date that the contract will expire. On or before the expiration date, the buyer of the contract can choose to exercise the option. If the buyer does not exercise the option, the contract will expire worthless. In the event a contract expires worthless, the buyer will only be out the premium they paid to purchase the contract.

Premium– This could also be called the "risk premium" and it is paid to the seller of the contract. In the case of options trading, the seller is the only one that is assuming a risk since they will be the one who either needs to sell shares at a discount (in the case of a call option) or buy shares at a premium (in the case of a put option). To offset this risk, they charge the buyer of the option a premium that they receive regardless of whether the contract is redeemed. In fact, a trading strategy for the seller is to offer options contracts that will expire worthless (i.e. the buyer will not exercise their option).  In this case, the buyer pockets the premium. 

At the Money– This is a term used to describe an options contract that is currently at the strike price.

In the Money– This is a term used to describe an options contract that is currently above the strike price (in the case of a call option) or below the strike price (in the case of a put option). The term means that the contract is at a level where the buyer of the option can make a profit.

Out of the Money– This is a term used to describe an option contract that is currently trading below the strike price (in the case of a call option) or above the strike price (in the case of a put option). The term means that the contract is at a level where the buyer would take a loss if they were to exercise the contract. Out of the money contracts will generally expire worthless, or could be rolled over into a new contract with a new expiration date.

Understanding different options strategies for trading

There are a variety of strategies for trading options. Too many, in fact, for the scope of this article. However, two of the most common strategies, particularly for those new to options trading are straddles and strangles. The primary difference between straddles and strangles has to with the option trader’s opinion regarding the movement and the implied volatility of the underlying stock or security.

  • Straddles – In this strategy, an investor is expecting a security to have volatility, but is unsure of what direction the security will move. For this reason, they take out both a call option and a put option at the same strike price and the same expiration date. A key point is that the contracts should be taken out at the same time so the price of the underlying security is the same. The investor will exercise the option that puts them “in the money” and allows the contract to expire worthless.
  • Strangles – This strategy is similar to a straddle strategy, but in the case of a strangle strategy, the options trader is intentionally buying call and put options that are “out of the money”. Once again, this strategy is used when the investor anticipates significant price movement but is unsure of in which direction. A benefit to this strategy is that the buyer will generally pay a lower premium because they are assuming a bit more risk of the contract expiring worthless because they are allowing the strike price to be set further from the current price of the underlying stock.

How an investor can profit from options trading

Now that you understand the mechanics of an options contract, let’s look at how an options trader can profit from their contract. There is really no “best” way. Any of the following methods can, and are, used.

  1. The buyer exercises the option – If the price of the security rises above the strike price (call option) or falls below the strike price (put option), the buyer can exercise the option at any time – even before expiration – and collect the profit.
  2. The buyer can take out a contract in the opposite direction (such as a straddle or strangle). This is a little more sophisticated strategy, but it can be profitable for a stock that an investor sees trading in a tight range. In this case, an investor who bought a call option for $41 on a stock trading at $40 may also buy a put option at $41 with the same expiration date. If the price begins to fall below $41, they can exercise the put option and make a profit, plus recover the lost premium from the call option which they will allow to expire worthless. This is different from a covered call in which a buyer buys a call option and then sells a call option of the same value.
  3. The buyer can let the contract expire and collect the difference between the stock price and the strike price (this only works if the contract is “in the money” at the time of expiration).

How futures and options trading are different

The difference between futures and options trading is found in the word “option”. As the name implies, an options contract is a contract between a buyer and a seller in which the holder of the option has the right, but not the obligation, to execute the contract. In this way, the options trader has little risk as they can allow the options contract to expire “worthless”, leaving their loss confined to the premium they paid to buy the contract.

By contrast, a futures contract is a contract in which the buyer is obligated to execute the contract at the time of expiration regardless of the price of the underlying asset. This means if a buyer enters into a futures contract that calls for them to purchase a stock at $50, but the stock is "out of the money" with a value of $40, they would still have to buy the stock at the agreed upon price.

The lack of an obligation for an options contract means that only the seller has a true financial liability. However, in the case of a futures contract, the risk is spread equally between the buyer and the seller.

The final word on options trading

Options trading can seem complicated, but it's actually one of the simpler trading strategies that have the advantage of not exposing an investor to significant risk. That's because options trading gives the buyer the option, but not the obligation, to purchase or sell a particular security at an agreed upon price, called the strike price on or before the expiration date.

Call options give investors the opportunity to buy shares at a lower price than the current market price. Put options, by contrast, give investors the opportunity to sell shares at a higher price than the current market price. The optional nature of an options contract puts the risk on the seller of the contract. Should the price of the underlying security not move in the direction for the buyer to make a profit, they can simply allow the contract to expire worthless. In this case, their only loss is in the premium they paid to enter into the contract.

To be successful at options trading, the buyer of the option should have a clearly defined profit expectation and be prepared to exercise the option once the underlying security reaches their exercise price. This can be before the expiration date.

Enter your email address below to receive a concise daily summary of analysts' upgrades, downgrades and new coverage with MarketBeat.com's FREE daily email newsletter.

Yahoo Gemini Pixel