What Are Options?

This is a beginner’s guide to investing in options.

As a day trader, this is something I believe I will be using so I need a complete understanding of everything to do with options.

However, it’s quite a big topic so we need to start from the beginning.

Again, this is an introduction to options and will be very beginner friendly.

An Introduction to Options

Options are contracts that give the buyer the right, but not the obligation, to buy or sell a certain asset at a specified price before a certain date.

They are used in various markets, including stocks, commodities, and ETFs

The contract is based on the current and future price of the underlying.

You will often come across this term “underlying”. It refers to the asset in the contract. So for example purposes, we will be discussing options with stocks.

So think of how a contract works. There will be someone who writes the contract, and someone who buys the contract. You can be either.

Buying a Stock vs. Buying an Option

When you buy a stock, it’s yours to keep. You actually own a piece of the company.

Now, imagine instead of buying the stock right away, you pay a smaller amount of money for a special ticket. This ticket lets you decide later if you want to buy the stock at today’s price, no matter if the price goes up or down in the future.

This is like buying an options contract. You don’t own the stock yet – you just have the right to buy or sell it later at a set price.

Buying these contracts gives you the right but not the obligation to buy or sell the stock in the future.

Key Terms

• Strike Price: The set price at which the asset can be bought or sold.
• Expiration Date: The date by which the option must be exercised or becomes worthless.
• Premium: The cost of the option, paid by the buyer to the option writer (seller)
• Intrinsic Value: The difference between the current price of the underlying asset and the strike price, if the option is profitable.
• Time Value: The part of the option’s premium that reflects the time remaining until expiration.

Types of Options and Pricing

• Call Options: Give the buyer the right to buy a stock at a predetermined price (strike price) within a set time frame.
• Put Options: Give the buyer the right to sell a stock at a predetermined price within a set time frame.

Buying a Call: If you’re bullish on a stock, you can buy a call option, giving you the right to buy the stock at the strike price. If the stock price rises above the strike price, you can profit by either exercising the option or selling it.

Buying a Put: If you’re bearish on a stock, you can buy a put option, giving you the right to sell the stock at the strike price. If the stock price falls below the strike price, you can profit by either exercising the option or selling it.

In the options market, one standard contract typically represents the right to buy or sell 100 shares of the underlying asset (a stock in our examples). This standardization makes the trading process more efficient and easier to understand.

When you see an option’s price quoted, it’s usually the price per share. However, since one contract covers 100 shares, you need to multiply the quoted price by 100 to get the total cost of the contract. For example:

• If a call option is quoted at $2 per share, the cost to buy one contract (which covers 100 shares) is $2 x 100 = $200.

Example 1: Buying a Call Option

Imagine you believe that Stock XYZ, currently trading at $50 per share, will increase in price in the next month. You decide to buy a call option with a strike price of $52, expiring in one month. The premium (cost) for this option is $2 per share.

So, it will cost you $200 ($2 x 100 shares) to have the right to buy 100 shares of Stock XYZ at $52. This right to buy will expire in 1 month.

• Scenario if Stock XYZ Rises: Suppose Stock XYZ rises to $60 before the expiration. Your call option gives you the right to buy shares at $52, even though they’re now worth $60. You could exercise the option, buying the shares at $52 and immediately selling them at $60, making a profit of $8 per share (minus the $2 premium, so a net gain of $6 per share).
• Scenario if Stock XYZ Falls or Remains Unchanged: If Stock XYZ remains below $52 or falls in price, your option will be worthless at expiration. Your loss is limited to the premium paid, which is $2 per share.

Example 2: Buying a Put Option

Suppose you believe Company ABC’s stock which is currently trading at $100 per share might decline in the next three months. So you decide to buy a put option with a strike price of $95, expiring in three months. The premium for this option is $3 per share.

• Scenario if Company ABC Falls: If Company ABC’s stock falls to $80, your put option allows you to sell the shares at $95, despite the market price being $80. You can exercise the option and make a profit of $15 per share (minus the $3 premium, so a net gain of $12 per share).
• Scenario if Company ABC Rises or Remains Unchanged: If Company ABC’s stock remains above $95 or rises, your put option will be worthless at expiration. Your loss is limited to the $3 premium per share.

In the Money (ITM)

Call Options

• A call option is in the money when the strike price is below the current market price of the underlying asset.
• For example, if a call option’s strike price is $52 and the current market price of the stock is $60, the call option is in the money.
• Intrinsic Value: The option has intrinsic value, which is the difference between the market price and the strike price ($60 – $52 = $8 in this case).

Put Options

• A put option is in the money when the strike price is above the current market price of the underlying asset.
• For example, if a put option’s strike price is $95 and the current market price of the stock is $80, the put option is in the money.
• Intrinsic Value: The option has intrinsic value, equal to the difference between the strike price and the market price ($95 – $80 = $15 in this case).

Out of the Money (OTM)

Call Options

• A call option is out of the money when the strike price is above the current market price of the underlying asset.
• For example, if a call option’s strike price is $52 and the current market price of the stock is $50, the call option is out of the money.
• Intrinsic Value: The option has no intrinsic value, as exercising it would not be profitable.

Put Options

• A put option is out of the money when the strike price is below the current market price of the underlying asset.
• For example, if a put option’s strike price is $95 and the current market price of the stock is $98, the put option is out of the money.
• Intrinsic Value: The option has no intrinsic value, as exercising it would not be profitable.

At the Money (ATM)

• An option is considered “at the money” when the strike price is equal to or very close to the current market price of the underlying asset. At the money options have no intrinsic value but may still have time value.

Significance

• ITM Options: More expensive due to their intrinsic value but have a higher probability of being profitable if exercised.
• OTM Options: Cheaper since they lack intrinsic value but are considered riskier as they require the underlying asset’s price to move more significantly to become profitable.

Traders often choose between ITM and OTM options based on their risk tolerance, market outlook, and strategy objectives. ITM options are preferred for more conservative strategies, while OTM options are chosen for more speculative approaches, hoping for larger price movements in the underlying asset.

Exercising an Option

When you exercise an option, you are utilizing your right to buy (in the case of a call option) or sell (in the case of a put option) the underlying asset at the option’s strike price.

Exercising a Call Option

• If you exercise a call option, you have the right to buy 100 shares of the underlying stock at the strike price.
• You need sufficient funds in your account to purchase all 100 shares at the strike price. For instance, if the strike price is $50 and you exercise a call option, you need $50 x 100 = $5,000 (excluding any commissions or fees).

Exercising a Put Option

• If you exercise a put option, you have the right to sell 100 shares of the underlying stock at the strike price.
• You need to own or have access to the 100 shares you are selling. If you don’t already own them, you’ll have to buy them at the current market price to fulfill the contract.

Key Points When Exercising Options

• Timing: You can exercise your option any time before its expiration date (if it’s an American-style option; European-style options can only be exercised on the expiration date).
• Profitability: Before exercising, it’s crucial to consider whether doing so is profitable. For a call option, the current market price should be higher than the strike price plus the premium paid. For a put option, the market price should be lower than the strike price minus the premium paid.
• Alternatives to Exercising: Many traders choose not to exercise their options but instead sell the option contract itself for a profit if it’s in a favorable position. This approach can be more efficient and avoids the need for a large capital outlay.

In summary, the pricing of options involves multiplying the per-share premium by 100 due to the standard contract size of 100 shares. When exercising an option, you need to be prepared to buy or sell all 100 shares at the strike price, which requires having sufficient funds or shares available. However, in practice, many traders opt to trade the options themselves rather than exercise them.

Selling Options Before Expiry

Most traders typically don’t plan to actually exercise their options contracts.

• Realizing Profit or Limiting Loss: Day traders often buy options with the intention of selling them for a profit before they expire. If the value of the option increases (due to favorable movements in the underlying asset’s price, changes in volatility, etc.), they can sell the option at a higher price than they paid, thereby making a profit. Conversely, they might sell an option at a loss to avoid further losses if they believe the option’s value will continue to decline.

Who Buys These Options?

• Speculators and Hedgers: Other traders may be willing to buy these options for various reasons. Some are speculators who believe that the price of the underlying asset will move favorably before the option expires. Others are hedgers who might use the option to protect against adverse price movements in the underlying asset.
• Market Makers: Market makers play a crucial role in providing liquidity. They are often on the other side of the trade, willing to buy and sell options to ensure that there’s always a market for them.

What Happens at Expiration?

• In the Money Options: If an option is “in the money” at expiration (meaning it has intrinsic value), the holder can exercise the option to realize its value. For a call option, they can buy the underlying asset below market price; for a put option, they can sell it above market price.
• Out of the Money Options: If an option is “out of the money” (has no intrinsic value), it becomes worthless at expiration. The holder cannot make a profit by exercising the option.

Does Someone Always Lose Money?

• Not necessarily. The outcome depends on the price movement of the underlying asset and the strategy used:
  • Exercised Options: If an option is exercised, the buyer may profit if the intrinsic value exceeds the premium paid. The seller (writer) of the option might incur a loss, especially if they don’t own the underlying asset (in case of a naked call).
  • Expired Worthless: If an option expires worthless, the buyer loses the premium paid, but the seller gains it.
  • Traded Options: If the option is sold before expiry, the original buyer might make a profit or limit a loss, and the new buyer then assumes the risk/reward potential of the option.
  • Hedging: Some traders use options for hedging. Their gain or loss on the option is offset by changes in the value of their other investments. The option serves as insurance, so a loss on the option might be acceptable because it protected against a greater loss elsewhere.

Key Takeaway

The options market involves various players with different strategies and expectations. Options can be traded several times before they expire. Not everyone in the options market ends up losing money; some profit by accurately predicting market movements, while others use options to hedge against other investments. The value of an option can fluctuate significantly before expiration, creating opportunities for both buyers and sellers to achieve their financial goals.

What We Didn’t Cover

While this guide offers a beginner-friendly introduction to options trading, it’s important to be aware that there’s much more to learn in this complex field. To avoid getting overwhelmed, we focused on the fundamentals, but as we continue our journey towards becoming a full-time day trader, we will explore these additional areas:

• The Greeks: Understanding Delta, Gamma, Theta, Vega, and Rho is crucial for advanced options trading, as they measure risks related to price changes, time decay, and volatility. Learn about the option greeks here.
• Options Spreads: An option spread involves buying and selling multiple options simultaneously and can help manage risk and target specific market scenarios.
• Volatility Trading: Advanced traders often focus on market volatility, using options to profit from expected changes in volatility rather than just price direction.
• Portfolio Hedging: Options can be used to protect other investments in a portfolio, acting as insurance against adverse price movements.
• Options on Futures and Other Derivatives: Options are also available for futures and other financial instruments, adding another dimension to trading.
• Risks: Options trading involves significant risks, including the potential for rapid financial loss. Understanding these risks and how to manage them is critical for any trader.
• Options Pricing Factors: Several factors influence options pricing, including the underlying asset’s price, volatility, time to expiration, and interest rates. A deeper understanding of these factors is essential for advanced trading.
• Selling Options and Other Strategies: Writing or selling options, like covered calls or cash-secured puts, involves different risks and strategies than buying options. It’s important to understand these before venturing into options selling.
• Regulatory and Brokerage Requirements: Trading options requires knowledge of specific regulatory and brokerage requirements, including margin and trading level prerequisites.

As we wrap up this introduction to options trading, it’s important to remember that we are just at the beginning stages of our journey to becoming a proficient day trader. This introduction should help us understand the basics of options, but there’s still much more to explore and learn.

In the future we will study the nuances of options trading and publish practical video tutorials demonstrating the process of buying and selling options using our brokerage account. These hands-on demonstrations will make it easier to grasp these concepts and apply them in real trading scenarios. So make sure you subscribe to our YouTube channel.