What is options trading?

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There are several basic trading strategies, but in order to execute any of them successfully an investor new to options will need to know some elementary concepts.

The most basic are the call and the put. Buying a call confers the right, but not the obligation, to buy at a pre-set price. Puts grant the buyer the right to sell at a pre-set price. But options are sold as well as bought. That seller grants the buyer the right, and takes on an obligation to fulfill the other side of the trade.

There are several basic variations.

Long Calls

The most basic, and easiest to understand, is the (long) call. MSFT (Microsoft), currently trading at $28, have June 31 options that expire on the third Friday of June, with a strike price (pre-set, ‘if exercised, must-be-bought-at-price’) of $31.

Short (’Naked’) Calls

When the option seller (the ‘writer’) doesn’t own the underlying stock he’s obligated to sell (if the option is exercised), he is said to be selling a ‘naked’ call. Since he’s on the selling side of the contract, his position is said to be ’short’.

If the market price of the underlying asset decreases, the short call position will profit by the amount of the premium. The price rises above the strike price by more than the premium, the short position incurs a loss.

Long Put

Traders who anticipate that the future market price of an asset, say a stock, will fall prior to expiration can buy the right to sell the stock at a fixed price. The put buyer has no obligation to sell the stock, but simply the right.

If, in fact, the market price does fall below the strike price (prior to expiration of the option) by more than the premium paid, he profits. If the price increases, or doesn’t fall enough to cover the premium, the trader lets the contract ‘expire worthless’.

Short Put

Traders who speculate that the future market price will increase, can sell the right to sell an asset at a pre-determined price.

If the asset’s market price rises, the short put position makes a profit equal to the amount of the premium. (Excluding any transaction costs, such as commissions.) If the price falls below the strike price by more than the premium, the ‘writer’ loses money.

Several basic trading strategies utilize the characteristics of these four basic positions. These strategies are either pure profit plays - speculating on coming out on the plus side of the equation - or combinations of speculation and hedging.

Hedging involves taking positions that tend to move in opposite directions. They profit less than pure speculation, but make up for it by offloading some risk.

‘Bull spreads’, for example, use a long call with a low strike price in combination with a short call at a higher strike price and a short put with a higher strike price.

‘Bear spreads’, by contrast, involve a short call with a low strike price and a long call with a higher strike price. An alternative method uses a short put with low strike price and a long put with a higher strike price.

Options trading software can demonstrate several concrete examples of how any of these - under different assumptions about future prices, volume, etc in combination with different expiration dates and strike prices - can result in profit (or loss).

 

Bid - The highest offered price at a specified time.
Black-Scholes Model – A theoretical method of pricing using strike price, market price, interest rates, expiration date and other factors.
Butterfly Spread – A trading strategy consisting of the purchase of two identical options, together with the sale of one option with a higher strike price, and one option with an lower strike price.

(All options are of the same type, have the same underlying asset and the same expiration date.)
Calendar Spread – A trading strategy consisting of one long and one short option of the same type with the same exercise price, but which expire in different months.
Call – An options contract conferring the right to buy an underlying asset, such as 100 shares of stock, at a pre-set price, by a specified date.
Condor – A trading strategy consisting of the sale (or purchase) of two options with consecutive exercise prices, together with the sale (or purchase) of one option with a lower exercise price and one option with a higher exercise price.
Covered Call – A trading strategy which consists of holding a long position in an asset and selling call options on that same asset.
Delta - A ratio comparing the change in the price of an option to that of a change in the underlying asset.
Exercise Price – See Strike Price
Hedge – A technique of reducing risk by taking positions which tend to move in opposite directions.
Historic Volatility – (See Volatility) Calculated by using the standard deviation of underlying asset price changes from close to close trading for the prior 21 days.
Holder – The buyer of an option. (See Writer)
In-the-Money - A (call/put) option is in-the-money if the strike price is (less/more) than the market price of the underlying security.
Intrinsic Value - The difference between the underlying asset’s price and the strike price. (For both puts and calls, if the difference is negative, the value is given as zero.)
Naked Option - An option written (sold) without a position in the underlying asset.
Option – A contract to buy (call) or sell (put) an underlying asset at a pre-set price by (’American style’) or on (’European style’) a specified date.
Open Interest - The total number of options contracts not closed or delivered on a given day.
Out-of-the-Money - An option whose exercise price has no intrinsic value.
Premium - The price an option buyer pays to an option seller.
Put - An option contract granting the right to sell an asset at a pre-set price within a specified time.
Straddle - A trading strategy consisting of a long (short) call and a long (short) put, in which both options have the same strike price and expiration date.
Strangle - A trading strategy consisting of a long (short) call and a long (short) put in which both options have the same expiration date, but different strike prices.
Strike Price - The price at which an underlying asset must be bought (call) or sold (put), if an option is exercised.
Time Value - The amount by which the current market price of a option exceeds its intrinsic value.
Volatility - A measurement of degree of change in price over a specified period of time.
Writer - The seller of either a call or put option.

 

Options trading can become very complicated very quickly. There are LEAPS (long-term contracts), choosers, barriers, compounds (exotics) and a host of technical parameters to measure volatility and predict price movements.

Thankfully, some of these complications can be simplified into a number of simpler trading strategies. Most revolve around using the fact that options have a contractually specified expiration date and strike price. This makes trading in them subject to some techniques not available in regular stock investing.

Calendar

The ‘calendar spread’ or ‘time spread’ strategy involves simultaneously buying and selling two options of the same type, with the same strike price, but different expiration dates.

For example, purchase two calls of MSFT (Microsoft) at a strike price of $27, but one set to expire on April 15, the other on June 17. The idea is to attempt to gain from the difference in price as each contract advances closer to maturity.

Straddle

In a ’straddle’ strategy the investor holds both a call and a put (on the same underlying asset, of course) with the same strike price and expiration date.

At first blush, this seems like betting against oneself. No matter which way the price goes, the investor loses. But, it’s also true that no matter which way the price goes the investor gains.

It’s this feature that makes a straddle a kind of hedging strategy. Since price direction and amount can only be predicted to some degree of probability, the investor is ‘hedging his bets’.

While risky, the strategy can produce profits when price movements are large. Offsetting those potential profits is the fact that, where others are also betting on a large price movement, these options contracts tend to be priced higher.

Strangle

Yet another variation is the ’strangle’. The investor holds both call and put options with the same maturity, but with different strike prices.

These contracts are purchased ‘out of the money’ and therefore cost less to buy. (’Out of the money’ means the strike price of the underlying asset is – higher (for a call) or lower (for a put) – than the market price.) Their purchase price (premium) is lower since if the option were exercised immediately the investor would experience an immediate loss.

Suppose Microsoft (MSFT) is currently trading at $30 per share. Buy one call at $3 and one put at $2 with the call having a strike price of $35, the put $25. (Total Investment = ($3 x 100) + ($2 x 100) = $500.)

If the price over the length of the contracts stays between $25 and $35 the total possible loss = $500, the cost of the options.

Suppose the price drops, though, to $15. The call is worthless, but the put is worth ($25-$15) x 100 = $1000 - ($2 x 100) = $800. Subtract the cost of the call, $800 - $300 = $500. This represents the net profit (ignoring commissions and taxes) on the trades.

Definitely do try this at home, but wear a safety helmet… in the form of following carefully the movements of both the options and the underlying assets.

 

Stock and Bond trading strategies run the gamut from the simple ‘buy and hold forever’ to the most advanced use of technical analysis. Options trading has a similar spectrum.

Options are a contract conferring the right to buy (a call option) or sell (a put option) some underlying instrument, such as a stock or bond, at a predetermined price (the strike price) on or before a preset date (the expiration date).

So-called ‘American’ options can be exercised anytime before expiration, ‘European’ options are exercised on the expiration date. Though the history of the terms may lie in geography, the association has been lost over time. American-style options are written for stocks and bonds. The European are often written on indexes.

Options officially expire on the Saturday after the third Friday of the contract’s expiration month. Few brokers are available to the average investor on Saturday and the US exchanges are closed, making the effective expiration day the prior Friday.

With some basic terminology and mechanics out of the way, on to some basic strategies.

There are one of two choices made when selling any option. Since all have a set expiration date, the holder can keep the option until maturity or sell before then. (We’ll consider American-style only, and for simplicity focus on stocks.)

A great many investors do in fact hold until maturity and then exercise the option to trade the underlying asset. Assume the buyer purchased a call option at $2 on a stock with a strike price of $25. (Typically, options contracts are on 100 share lots.) To purchase the stock the total investment is:

($2 + $25) x 100 = $2700 (Ignoring commissions.)

This strategy makes sense provided the market price is anything above $27.

But suppose the investor speculates that the price has peaked prior to the end of the life of the option. If the price has risen above $27 but looks to be on the way down without recovering, selling now is preferred.

Now suppose the market price is below the strike price, but the option is soon to expire or the price is likely to continue downward. Under these circumstances, it may be wise to sell before the price goes even lower in order to curtail further loss. The investor can, at least, minimize the loss by using it to offset capital gains taxes.

The final basic alternative is to simply let the contract expire. Unlike futures, there’s no obligation to buy or sell the asset - only the right to do so. Depending on the premium, strike price and current market price it may represent a smaller loss to just ‘eat the premium’.

Observe that options carry the usual uncertainties associated with stocks: prices can rise or fall by unknown amounts over unpredictable time frames. But, added to that is the fact that options have - like bonds - an expiration date.

One consequence of that fact is: as time passes, the price of the option itself can change (the contracts are traded just like stocks or bonds). How much they change is influenced by both the price of the underlying stock and the amount of time left on the option.

Selling the option, not the underlying asset, is one way to offset that premium loss or even profit.

 

 

 

 

You often see the phrase ‘options and futures’, as if the two were financial Siamese twins. But, though similar, there are important differences the savvy investor should keep in mind.

Both are so-called derivatives, since they have no independent worth as an asset, but derive their value from the instrument they are related to. However, there is an essential difference between the pair. Both are contracts binding two parties, but the terms of that contract define the difference.

A futures contract gives its buyer the obligation to purchase the underlying asset and the seller to sell (and deliver) it at a preset date. (If the futures holder liquidates his position prior to expiration, the delivery clause is voided, obviously.)

By contrast, an options contract, whether a call (buy an asset) or put (sell an asset), grants the holder the right - but not the obligation - to exercise the option. The holder is entitled to simply let the option expire without investing further.

Investors can enter futures contracts without inputing any funds (ignoring any commission), but an option always carries a cost - the ‘premium’. (Note: This is only partially accurate since, in practice, futures contract buyers typically put down a deposit of around 10% of the price of the underlying asset. But the futures contract itself doesn’t cost anything but a small commission.)

Futures contracts typically represent a larger investment in the underlying asset. (At least from the standpoint of a legal obligation, if not actual money laid out.)

The contract requires the buyer to either purchase the ‘goods’ by the deadline (which is rare), or sell the contract to another party. So, the financial obligation is, at least in principle, potentially very large.

The risk in options is therefore lower, with the amount limited to the premium cost.

Nevertheless, few traders actually take delivery of several tons of wheat or a few thousand barrels of oil. The contracts typically are actively traded until just before settlement time, at which time a buyer - one appropriate to that commodity - purchases the actual goods and re-sells them.

(Of course, futures contracts exist on non-physical ‘goods’ as well - such as index futures, bond futures, even futures on options!)

Similarly, only a small percentage of options traders actually take delivery of the underlying shares of stock, bond certificates, commodity or other instrument. (Some do, such as employees of companies granting options as part of employment compensation packages. And a small percentage of a very large number is still a substantial number of individuals.)

There are also important differences in the way profits (or losses) are realized from the two contracts.

A call option, for example, that is ‘in the money’ can be purchased and exercised immediately. ‘In the money’ means the ’strike price’ - the price at which the underlying asset must be bought or sold via the option - is lower than the current market price.

For example, in April a June 17 call on Microsoft might have a strike price of $25, with a current market price of $27 per share. Assuming the cost of the option (and commissions) averages less than $2 per share the investor can realize an immediate profit by selling the call or exercising the option.

Futures gains, on the other hand, are automatically ‘marked to market’ daily. I.e. the any change in the value of the position is adjusted in the accounts of the contracting parties at the end of every trading day.

Like stock prices, of course, the gain or loss is ‘only on paper’. Unlike stocks however, that ‘paper loss’ can become very real when the contract expires and the holder is forced to liquidate.

Both instruments carry risk, but are valuable for the leverage they offer - the ability to control more funds than you invest.

Trading shares of stock has become as common as surfing the Internet. But, like any financial investment, trading stock is risky. The price can fall unexpectedly and stay down for lengthy periods. To offset that risk, and to trade with more funds than you have without borrowing, options are… well, an option.

An option is a contract giving the investor the right to buy or sell some instrument at a given price on or before a stated date.

Options contracts are written on all sorts of underlying assets: real property, stocks, bonds, even movie screenplays. (Though the latter trade on a rather different sort of exchange…)

The basic idea is simple. Invest a (relatively) small sum today, to control something worth a larger amount today. Bet that the price will move in a given direction before a certain date, then sell and pocket the difference.

For example, suppose Google shares are selling at $400 per share. But buying 1,000 shares of GOOG (the symbol for Google stock) at $400 each would cost $400,000. That’s a substantial investment of cash, one beyond the means of the average investor.

Even buying on margin (borrowing) would typically get you only half the way there. Most stock brokers will lend their clients only up to 50% of the total cost. (There are laws restricting them, in any case.)

But, you can still ‘own’ 1,000 shares of GOOG. Simply buy an option at, say, $20 per share (the ‘premium’). Now your investment is $20,000 - hefty, but within reach. (That’s called ‘leverage’ - controlling more than you own.)

Every option has an expiration date - the date by which the investor must ‘exercise his option’, i.e. execute a decision to buy/sell the instrument or lose his invested money. Depending on the underlying asset, and other factors, the date can be anywhere from a day to several months hence.

Options also have a strike price - the price at which the underlying instrument has to be bought or sold when exercising the option.

Continuing the example, suppose the option for GOOG expires in 30 days and has a strike price of $410. The break-even price would be $410 + $20 = $430 per share. At this point, you are ‘under water’ by $30 per share x 1,000 shares = $30,000. Ouch!

(Note: ‘Under water’ is - obviously - not the same amount as your investment. It’s the amount you have to rise to reach break-even.)

But, three weeks pass and Google announces some good news about earnings. The price per share rises to $440. Now you can exercise your option (’close your position’) and sell.

The options contract price has increased as well, to $25. Your profit is: ($25-$20) x 1,000 = $5,000. (Ignoring broker fees.) Not bad. That’s a 25% profit on a $20,000 investment. (Of course, prices fall as well. More on risk and hedging strategies later.)

Options aren’t for everyone. They’re more complicated (though not too much), riskier, and generally involve shorter term trades and the requirement to watch the market more closely.

But note that purchasing the options contract did NOT involve investing 5% ($20/$400 x 100%) and borrowing 95% of the funds. Options contracts are a straight investment of funds, not a broker loan.

If the price goes in the predicted direction before expiration, you make money. Otherwise, you lose (some or all of) your investment.

As with any investment, do your homework. Make sure you understand how options work and what the relative risks are. In particular, study the market for that type of underlying instrument. Throwing darts blindly is the least successful options trading strategy.

Good luck… or should we say, good research.