How Options Trading Works: The Ultimate Guide [2021]

Posted On December 26, 2020

Options Trading

An option is essentially a contract that gives an investor the right, but not the obligation, to buy or sell an underlying asset at a predetermined set price in the future, even if the value of the asset moves beyond that price within a set timeframe. Buying and selling options, i.e. ‘options trading’, is done on the options market, which trades contracts based on securities. 

The two types of options trading allow investors to use options for a variety of different reasons. The first, a call option, which is a contract that gives an investor the right to buy a stock, ETF, commodity or other assets, at a set price for a certain period of time. Some investors will buy calls when they anticipate the value of the asset to increase. In the same vein, others might sell calls when they expect the price of a stock to trade flat.

The second type are put options, which represent the right to sell a security at a predetermined set price – known as the strike price – for a specified period of time. One might invest in a put option if they expect the value of an asset to move lower than the price they will sell for. Put options, therefore, are great protective tools, since should the asset retain its value, the holder of the put is under no obligation to sell. 

Options trading vs. Stock trading

The buying and selling of these contracts appear, at first glance, a lot like trading stock. However, there are some stark differences. 

Unlike stocks, options contracts have an expiration date. This can vary from weeks, months to years; depending on the regulations and type of options an investor wishes to hold. When trading stocks, investors needn’t think about when the stock will expire.

Options fall into the derivatives category, as their value is ‘derived’ from somewhere else. The value of stocks is calculated using the economic principle of supply and demand and is decided by the market on which they are traded. In the same vein, options are not definite by numbers in the way stocks are. 

One of the starkest differences is that options holders have no rights, including voting rights or rights to company dividends, unlike stock owners. Investors have no ownership of a company when they hold options.

The most distinguishing feature of buying and selling options is that the investor has the right to exercise that option at any point up until the expiration date. The act of buying or selling an option doesn’t mean you have to exercise the right at the point of purchase. Because of this unique feature, options are considered derivative securities. Meaning, their price is derived from something other than the forces of supply and demand in the market. It’s for this reason, options are more often than not, considered less risky than stocks.

What is options trading and how does it work?

Investing in options is equivalent to betting on stocks to go up, down or to hedge a trading position in the market. The price at which an investor agrees to buy the underlying security via the option is called the ‘strike price’. The fee paid for buying that option contract is the ‘premium’.

The very notion of determining the strike price is essentially betting that the asset will go up or down in price. In short, the price you pay to take that bet is the premium; which is a percentage of the value of the asset. Options trading is typically carried out with securities on the stock or bond market, as well as ETFs. Investors buy and sell options through a brokerage like E*Trade (ETFC) or Fidelity (FNF). 

How are strike prices determined?

When buying a call option, the strike price of an option for a stock is determined based on the current price of that stock. So, if a share of any given stock is, for example, $1,748 – if the strike price of the call option is above that share price, it is considered to be “out of the money”. On the other hand, if the strike price is under the current share price of the stock, it’s considered to be “in the money”. 

The opposite is true of the strike prices for put options (right to sell). Strike prices below the current share price are considered to be “out of the money”. If the strike price at which the holder can sell is higher than the share price, it’s considered “in the money”. 

The key here is to remember that any “out of the money” options, both call and put, are worthless at expiration. The aim of the options trading game, in general, is to be in the money. 

In – at – out of the money

Buying an option that is already “in the money” means that it will be profitable with immediate effect. Its premium, however, will be a little steeper for its profitability. On the other hand, buying an option that is “at the money” will mean that the option is equal to the current stock price. Should this stock increase in price in the future; the option holder will be able to purchase it at its old, lower price as agreed in the options contract. 

For call options, “in the money” contracts will be those of underlying asset’s priced above the strike price. Put options will be “in the money” when the strike price is below the current price of the underlying asset. 

The time value of an asset, also known as the extrinsic value, is the value of the option above the intrinsic value (above the “in the money” range). Irrespective of whether it’s a call or put option, if it is “out of the money” by its expiration date, they can be sold in order to collect a time premium.

What drives premium prices?

The longer an option has before its expiration date, the more time it has to make a profit – its time value is higher, meaning its premium price is going to be higher too. On the other hand, the less time an options contract has before it meets its expiration date, the less its time value will be –  this less additional time value drives down the price of the premium.

Generally speaking, options typically expire on a Friday within different time frames. These can be monthly, bi-monthly, or quarterly, and many options contracts are six months. 

Trading Call vs. Put Options

Investing in a call option is basically betting that the price of the share will go up over the course of the options contract. At which point, you will have access to a high-value stock at a lower predetermined price. For instance, if you buy a call option at $1500, feeling bullish about the stock, you are predicting that the share price will increase. 

Long Call

(Call option payoff. Image: Wikipedia)

As for put options, an investor should be expecting the price of the underlying asset to go down over time. At which point, they can sell them at a price above their depreciated value. Options trading, therefore – especially in the stock market – is affected most by the price of the underlying asset, time until the expiration of the option, and the volatility of the underlying security.

Short Put

(Option put payoff. Image: Wikipedia)

Options trading strategies you need to know

Options contracts will typically take the following form: Stock ticker (name of stock), expiration date, the strike price, call or put, and the premium price. An example of a call option for Apple could look something like this: APPL 10/15/2020 200 Call @ 3.

It’s not uncommon for investors to try to jump into trading options before acquiring a good understanding of the options trading strategies that are available to them. Having a strategy behind you can help to minimise risk and maximise return. Investors should learn how to take advantage of the flexibility and power that options contracts can provide. To get you started, here are a few options trading strategies to know. 

Strangles and Straddles

A straddle strategy will be taken up by an investor who is expecting the asset to be highly volatile, but cannot say which direction in which it will go. When using a straddle strategy, an investor will buy call and put options at the same strike price, underlying price and expiration date. This particular strategy is often used when an investor is expecting the price of the stock to either hit new lows or new highs, usually following an event like an earnings report.

For perspective, consider a company like Apple is getting ready to release its quarterly earnings on 25th January. An options trader might use a straddle strategy to buy call options to expire on that date at the current Apple stock price, and also put options to expire on the day for the same price. It’s a useful protection tool against losses.

Long Straddle

(Straddle and strangle strategies for options trading. Image: Ticker Tape)

A strangle strategy will see an investor buy an “out of the money” call and an “out of the money” put at the same time for the same expiration date on the same underlying asset. The idea here is that the investor who uses this strategy is assuming the asset will have a significant price movement, but again, cannot say in which direction. The safety measure here is that the investor only needs the stock to move greater than the total premium paid – regardless of its direction.

This is a cost-effective strategy too since the premiums are less expensive due to the fact the options are “out of the money” –  they cost less to buy, meaning the risk is reduced.

Covered call

This strategy is ideal for investors who are neutral or only slightly bullish on a stock. A covered call works by buying 100 shares of regular stock and selling one call option per 100 shares. This helps to reduce the overall risk of an investor’s current stock investments and also provides an opportunity to make a profit with the option.

Covered Call

(Covered call options trading strategy. Image: OptionsBro)

The investor’s long position in the asset is the “cover” since it means he can deliver the shares if the buyer of the call option chooses to exercise their right. Covered calls can help to generate income when the stock price increases or stays the same over the time of the options contract.

The risk is in the stock price falling too much. But it’s generally a safe strategy since you’re protecting your investment from decreases in share price while taking advantage of the opportunity to make money while the stock price is flat. 

Iron Condors

This strategy is dependent on the investors’ appetite for risk. Traders can either be conservative or risky depending on their preferences. That’s what makes this strategy so adaptable and useful. To deploy this strategy, the position of the trade has no direction, meaning the asset can go up or down. There is potential for profit over a fairly wide range.

Iron Condor

(Iron Condor options trading strategy. Image: OptionsBro)

An investor will sell a put and buy another put at a lower strike price (this is also known as a put spread) and combine it by buying a call and selling a call at a higher strike price (known as a call spread). The goal is to profit from low volatility in the underlying asset. Iron Condors strategy earns the most profit when the underlying asset closes between the middle strike prices at expiration.

Options trading as a hedging strategy

Hedging strategies are used by investors to reduce their exposure to risk. Should an asset in an investors portfolio fall subject to a sudden price decline, it can be offset with a hedging strategy. When done effectively, hedging can reduce uncertainty, and limit loss without reducing the potential for high returns. 

Typically, investors will buy securities inversely correlated with a vulnerable asset in their portfolio. If the price of the vulnerable asset declines, the inversely correlated security should move in the opposite direction – ‘hedging’ against any losses. 

Derivatives can help to limit an investors’ losses to a fixed, and so, anticipated amount. Put options are classic hedging instruments. With a put option, investors can sell a stock at the specified price over the duration of the contract. Should the price of the put options underlying asset rise above the initial contract price, an investor will simply not exercise the option and lose the premium paid.

Options trading mistakes

Even seasoned investors can make mistakes when trading options, and there are plenty to be made. Perhaps the most common mistakes traders make when dealing with options is that they believe they should hold onto their call or put options until the expiration date. There is no need to wait. If your options underlying stock skyrockets overnight, increasing the value of your option – you can exercise the contract immediately to reap the gains. This is true even if you have weeks before the expiry date on your options contract.

Another mistake is to neglect your exit plan. Failing to create a strategic exit strategy for your option will increase the risk. Investors should plan to exit their options when they either incur a loss or when they’ve reached a profit goal.

Thinking cheaper is better is another poor decision to make when trading in options. The cheaper an option’s premium is, the more “out of the money” the option generally is. An “out of the money” option carries slightly more risk than “in the money”. 

Risks and rewards

One for the main attractions of options trading revolves around their relative safety. They’re often more resilient to changes in market prices, they can help generate income on current and future investments and can often open up doors to better deals on a variety of equities. But arguably the biggest pro is that options trading can help investors capitalise on the rise and fall of securities without having to invest in it directly. 

Options are unique and attractive trading instruments because they offer high returns. The holder has the ‘option’ to exercise his rights, and the ‘option’ not to. As such, investors can restrict their losses and multiply returns.

Since one options contract is for 100 shares, it becomes less risky to pay the premium and not risk the total amount which would have been spent to buy the shares instead. Risk exposure is reduced, therefore. 

Whilst these arguments all add up in theory, in practice, options trading is complex and gives rise to some risks in options trading. Interpreting risks associated with options trading is largely done on individual bases. However, the primary risk revolves around the levels of volatility and uncertainty of the market. Options with high premiums are those whose uncertainty is high. This, combined with a volatile market makes it difficult for investors to navigate their strategy, and increases risk. 

Should you trade in options?

Most people, at this point, would probably be sold on the idea of trading in options. After all, investing in options is flexible and has a long history of being profitable. The ideal options trader would be one looking for a more tactical approach to investing. Options trading is a sophisticated and complex endeavour – one in which should be undertaken by an investor with a willingness to explore the complex options strategies. 

Options trading is a good choice for those with a smaller initial investment requirement. One options contract is 100 shares. “In the money” options are immediately profitable but should you expect the value of the options underlying securities to increase, a call option is valuable in accessing future profitable stock at a discounted price. 

The associated time period of an options investment is inherently shorter; making them attractive investments for those who buy and sell regularly. All options have expiration dates, meaning an investor can carefully assess the future of his portfolio by considering the dates at which he will no longer hold certain investments. 

Many investors appreciate the flexibility afforded by options, namely the time to see how a trade plays out and the ability to lock in a price without being obliged to buy. However, they do add complexity to the investment process. Anyone considering trading in options should be prepared to keep a closer eye on the market and make more decisions, like: 

  • The direction the stock is likely to go 
  • The velocity at which the price will move 
  • The time frame in which this will happen 

Prospective options traders should expect to learn a whole new vocabulary of terms of which could be avoided should an investor stick to trading stock on major exchanges. The complexity of options trading makes it a semi-exclusive investment vehicle, and one not for the faint-hearted. There’s a lot to learn and requires patience, time and practice. 

In a nutshell, options trading can be exciting, safe and lucrative. The good thing behind the complexity of options trading is that investors can let an option expire and incur no further financial obligation other than the premium paid.

Written by Daglar Cizmeci
Investor, Founder and CEO with over 20 years’ industry experience in aviation, logistics, finance and tech. Chairman at ACT Airlines, myTechnic and Mesmerise VR. CEO at Red Carpet Capital and Eastern Harmony. Co-Founder of Marsfields, ARQ and Repeat App.

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