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What Is an Option?
Options are financial instruments that are derivatives based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset. Unlike futures, the holder is not required to buy or sell the asset if they choose not to.
- Call options allow the holder to buy the asset at a stated price within a specific timeframe.
- Put options allow the holder to sell the asset at a stated price within a specific timeframe.
Each option contract will have a specific expiration date by which the holder must exercise their option. The stated price on an option is known as the strike price. Options are typically bought and sold through online or retail brokers.
- Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.
- Call options and put options form the basis for a wide range of option strategies designed for hedging, income, or speculation.
- Although there are many opportunities to profit with options, investors should carefully weigh the risks.
How Options Work
Options are a versatile financial product. These contracts involve a buyer and a seller, where the buyer pays an options premium for the rights granted by the contract. Each call option has a bullish buyer and a bearish seller, while put options have a bearish buyer and a bullish seller.
Options contracts usually represent 100 shares of the underlying security, and the buyer will pay a premium fee for each contract. For example, if an option has a premium of 35 cents per contract, buying one option would cost $35 ($0.35 x 100 = $35). The premium is partially based on the strike price—the price for buying or selling the security until the expiration date. Another factor in the premium price is the expiration date. Just like with that carton of milk in the refrigerator, the expiration date indicates the day the option contract must be used. The underlying asset will determine the use-by date. For stocks, it is usually the third Friday of the contract’s month.
Traders and investors will buy and sell options for several reasons. Options speculation allows a trader to hold a leveraged position in an asset at a lower cost than buying shares of the asset. Investors will use options to hedge or reduce the risk exposure of their portfolio. In some cases, the option holder can generate income when they buy call options or become an options writer.
American options can be exercised any time before the expiration date of the option, while European options can only be exercised on the expiration date or the exercise date. Exercising means utilizing the right to buy or sell the underlying security.
Options Risk Metrics: The Greeks
The “Greeks” is a term used in the options market to describe the different dimensions of risk involved in taking an options position, either in a particular option or a portfolio of options. These variables are called Greeks because they are typically associated with Greek symbols. Each risk variable is a result of an imperfect assumption or relationship of the option with another underlying variable. Traders use different Greek values, such as delta, theta, and others, to assess options risk and manage option portfolios.
Delta (Δ) represents the rate of change between the option’s price and a $1 change in the underlying asset’s price. In other words, the price sensitivity of the option relative to the underlying. Delta of a call option has a range between zero and one, while the delta of a put option has a range between zero and negative one. For example, assume an investor is long a call option with a delta of 0.50. Therefore, if the underlying stock increases by $1, the option’s price would theoretically increase by 50 cents.
For options traders, delta also represents the hedge ratio for creating a delta-neutral position. For example if you purchase a standard American call option with a 0.40 delta, you will need to sell 40 shares of stock to be fully hedged. Net delta for a portfolio of options can also be used to obtain the portfolio’s hedge ration.
A less common usage of an option’s delta is it’s current probability that it will expire in-the-money. For instance, a 0.40 delta call option today has an implied 40% probability of finishing in-the-money. (For more on the delta, see our article: Going Beyond Simple Delta: Understanding Position Delta.)
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Theta (Θ) represents the rate of change between the option price and time, or time sensitivity – sometimes known as an option’s time decay. Theta indicates the amount an option’s price would decrease as the time to expiration decreases, all else equal. For example, assume an investor is long an option with a theta of -0.50. The option’s price would decrease by 50 cents every day that passes, all else being equal. If three trading days pass, the option’s value would theoretically decrease by $1.50.
Theta increases when options are at-the-money, and decreases when options are in- and out-of-the money. Options closer to expiration also have accelerating time decay. Long calls and long puts will usually have negative Theta; short calls and short puts will have positive Theta. By comparison, an instrument whose value is not eroded by time, such as a stock, would have zero Theta.
Gamma (Γ) represents the rate of change between an option’s delta and the underlying asset’s price. This is called second-order (second-derivative) price sensitivity. Gamma indicates the amount the delta would change given a $1 move in the underlying security. For example, assume an investor is long one call option on hypothetical stock XYZ. The call option has a delta of 0.50 and a gamma of 0.10. Therefore, if stock XYZ increases or decreases by $1, the call option’s delta would increase or decrease by 0.10.
Gamma is used to determine how stable an option’s delta is: higher gamma values indicate that delta could change dramatically in response to even small movements in the underlying’s price.Gamma is higher for options that are at-the-money and lower for options that are in- and out-of-the-money, and accelerates in magnitude as expiration approaches. Gamma values are generally smaller the further away from the date of expiration; options with longer expirations are less sensitive to delta changes. As expiration approaches, gamma values are typically larger, as price changes have more impact on gamma.
Options traders may opt to not only hedge delta but also gamma in order to be delta-gamma neutral, meaning that as the underlying price moves, the delta will remain close to zero.
Vega (V) represents the rate of change between an option’s value and the underlying asset’s implied volatility. This is the option’s sensitivity to volatility. Vega indicates the amount an option’s price changes given a 1% change in implied volatility. For example, an option with a Vega of 0.10 indicates the option’s value is expected to change by 10 cents if the implied volatility changes by 1%.
Because increased volatility implies that the underlying instrument is more likely to experience extreme values, a rise in volatility will correspondingly increase the value of an option. Conversely, a decrease in volatility will negatively affect the value of the option. Vega is at its maximum for at-the-money options that have longer times until expiration.
Those familiar with the Greek language will point out that there is no actual Greek letter named vega. There are various theories about how this symbol, which resembles the Greek letter nu, found its way into stock-trading lingo.
Rho (p) represents the rate of change between an option’s value and a 1% change in the interest rate. This measures sensitivity to the interest rate. For example, assume a call option has a rho of 0.05 and a price of $1.25. If interest rates rise by 1%, the value of the call option would increase to $1.30, all else being equal. The opposite is true for put options. Rho is greatest for at-the-money options with long times until expiration.
Some other Greeks, with aren’t discussed as often, are lambda, epsilon, vomma, vera, speed, zomma, color, ultima.
These Greeks are second- or third-derivatives of the pricing model and affect things such as the change in delta with a change in volatility and so on. They are increasingly used in options trading strategies as computer software can quickly compute and account for these complex and sometimes esoteric risk factors.
Risk and Profits From Buying Call Options
As mentioned earlier, the call options let the holder buy an underlying security at the stated strike price by the expiration date called the expiry. The holder has no obligation to buy the asset if they do not want to purchase the asset. The risk to the call option buyer is limited to the premium paid. Fluctuations of the underlying stock have no impact.
Call options buyers are bullish on a stock and believe the share price will rise above the strike price before the option’s expiry. If the investor’s bullish outlook is realized and the stock price increases above the strike price, the investor can exercise the option, buy the stock at the strike price, and immediately sell the stock at the current market price for a profit.
Their profit on this trade is the market share price less the strike share price plus the expense of the option—the premium and any brokerage commission to place the orders. The result would be multiplied by the number of option contracts purchased, then multiplied by 100—assuming each contract represents 100 shares.
However, if the underlying stock price does not move above the strike price by the expiration date, the option expires worthlessly. The holder is not required to buy the shares but will lose the premium paid for the call.
Risk and Profits From Selling Call Options
Selling call options is known as writing a contract. The writer receives the premium fee. In other words, an option buyer will pay the premium to the writer—or seller—of an option. The maximum profit is the premium received when selling the option. An investor who sells a call option is bearish and believes the underlying stock’s price will fall or remain relatively close to the option’s strike price during the life of the option.
If the prevailing market share price is at or below the strike price by expiry, the option expires worthlessly for the call buyer. The option seller pockets the premium as their profit. The option is not exercised because the option buyer would not buy the stock at the strike price higher than or equal to the prevailing market price.
However, if the market share price is more than the strike price at expiry, the seller of the option must sell the shares to an option buyer at that lower strike price. In other words, the seller must either sell shares from their portfolio holdings or buy the stock at the prevailing market price to sell to the call option buyer. The contract writer incurs a loss. How large of a loss depends on the cost basis of the shares they must use to cover the option order, plus any brokerage order expenses, but less any premium they received.
As you can see, the risk to the call writers is far greater than the risk exposure of call buyers. The call buyer only loses the premium. The writer faces infinite risk because the stock price could continue to rise increasing losses significantly.
Risk and Profits From Buying Put Options
Put options are investments where the buyer believes the underlying stock’s market price will fall below the strike price on or before the expiration date of the option. Once again, the holder can sell shares without the obligation to sell at the stated strike per share price by the stated date.
Since buyers of put options want the stock price to decrease, the put option is profitable when the underlying stock’s price is below the strike price. If the prevailing market price is less than the strike price at expiry, the investor can exercise the put. They will sell shares at the option’s higher strike price. Should they wish to replace their holding of these shares they may buy them on the open market.
Their profit on this trade is the strike price less the current market price, plus expenses—the premium and any brokerage commission to place the orders. The result would be multiplied by the number of option contracts purchased, then multiplied by 100—assuming each contract represents 100 shares.
The value of holding a put option will increase as the underlying stock price decreases. Conversely, the value of the put option declines as the stock price increases. The risk of buying put options is limited to the loss of the premium if the option expires worthlessly.
Risk and Profits From Selling Put Options
Selling put options is also known as writing a contract. A put option writer believes the underlying stock’s price will stay the same or increase over the life of the option—making them bullish on the shares. Here, the option buyer has the right to make the seller, buy shares of the underlying asset at the strike price on expiry.
If the underlying stock’s price closes above the strike price by the expiration date, the put option expires worthlessly. The writer’s maximum profit is the premium. The option isn’t exercised because the option buyer would not sell the stock at the lower strike share price when the market price is more.
However, if the stock’s market value falls below the option strike price, the put option writer is obligated to buy shares of the underlying stock at the strike price. In other words, the put option will be exercised by the option buyer. The buyer will sell their shares at the strike price since it is higher than the stock’s market value.
The risk for the put option writer happens when the market’s price falls below the strike price. Now, at expiration, the seller is forced to purchase shares at the strike price. Depending on how much the shares have appreciated, the put writer’s loss can be significant.
The put writer—the seller—can either hold on to the shares and hope the stock price rises back above the purchase price or sell the shares and take the loss. However, any loss is offset somewhat by the premium received.
Sometimes an investor will write put options at a strike price that is where they see the shares being a good value and would be willing to buy at that price. When the price falls, and the option buyer exercises their option, they get the stock at the price they want, with the added benefit of receiving the option premium.
A call option buyer has the right to buy assets at a price that is lower than the market when the stock’s price is rising.
The put option buyer can profit by selling stock at the strike price when the market price is below the strike price.
Option sellers receive a premium fee from the buyer for writing an option.
In a falling market, the put option seller may be forced to buy the asset at the higher strike price than they would normally pay in the market
The call option writer faces infinite risk if the stock’s price rises significantly and they are forced to buy shares at a high price.
Option buyers must pay an upfront premium to the writers of the option.
Real World Example of an Option
Suppose that Microsoft (MFST) shares are trading at $108 per share and you believe that they are going to increase in value. You decide to buy a call option to benefit from an increase in the stock’s price.
You purchase one call option with a strike price of $115 for one month in the future for 37 cents per contact. Your total cash outlay is $37 for the position, plus fees and commissions (0.37 x 100 = $37).
If the stock rises to $116, your option will be worth $1, since you could exercise the option to acquire the stock for $115 per share and immediately resell it for $116 per share. The profit on the option position would be 170.3% since you paid 37 cents and earned $1—that’s much higher than the 7.4% increase in the underlying stock price from $108 to $116 at the time of expiry.
In other words, the profit in dollar terms would be a net of 63 cents or $63 since one option contract represents 100 shares ($1 – 0.37 x 100 = $63).
If the stock fell to $100, your option would expire worthlessly, and you would be out $37 premium. The upside is that you didn’t buy 100 shares at $108, which would have resulted in an $8 per share, or $800, total loss. As you can see, options can help limit your downside risk.
Options spreads are strategies that use various combinations of buying and selling different options for a desired risk-return profile. Spreads are constructed using vanilla options, and can take advantage of various scenarios such as high- or low-volatility environments, up- or down-moves, or anything in-between.
Spread strategies, can be characterized by their payoff or visualizations of their profit-loss profile, such as bull call spreads or iron condors. See our piece on 10 common options spread strategies to learn more about things like covered calls, straddles, and calendar spreads.
Essential Options Trading Guide
Options trading may seem overwhelming at first, but it’s easy to understand if you know a few key points. Investor portfolios are usually constructed with several asset classes. These may be stocks, bonds, ETFs, and even mutual funds. Options are another asset class, and when used correctly, they offer many advantages that trading stocks and ETFs alone cannot.
- An option is a contract giving the buyer the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) the underlying asset at a specific price on or before a certain date.
- People use options for income, to speculate, and to hedge risk.
- Options are known as derivatives because they derive their value from an underlying asset.
- A stock option contract typically represents 100 shares of the underlying stock, but options may be written on any sort of underlying asset from bonds to currencies to commodities.
What Are Options?
Options are contracts that give the bearer the right, but not the obligation, to either buy or sell an amount of some underlying asset at a pre-determined price at or before the contract expires. Options can be purchased like most other asset classes with brokerage investment accounts.
Options are powerful because they can enhance an individual’s portfolio. They do this through added income, protection, and even leverage. Depending on the situation, there is usually an option scenario appropriate for an investor’s goal. A popular example would be using options as an effective hedge against a declining stock market to limit downside losses. Options can also be used to generate recurring income. Additionally, they are often used for speculative purposes such as wagering on the direction of a stock.
There is no free lunch with stocks and bonds. Options are no different. Options trading involves certain risks that the investor must be aware of before making a trade. This is why, when trading options with a broker, you usually see a disclaimer similar to the following:
Options involve risks and are not suitable for everyone. Options trading can be speculative in nature and carry substantial risk of loss.
Options as Derivatives
Options belong to the larger group of securities known as derivatives. A derivative’s price is dependent on or derived from the price of something else. As an example, wine is a derivative of grapes ketchup is a derivative of tomatoes, and a stock option is a derivative of a stock. Options are derivatives of financial securities—their value depends on the price of some other asset. Examples of derivatives include calls, puts, futures, forwards, swaps, and mortgage-backed securities, among others.
Call and Put Options
Options are a type of derivative security. An option is a derivative because its price is intrinsically linked to the price of something else. If you buy an options contract, it grants you the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date.
A call option gives the holder the right to buy a stock and a put option gives the holder the right to sell a stock. Think of a call option as a down-payment for a future purpose.
Call Option Example
A potential homeowner sees a new development going up. That person may want the right to purchase a home in the future, but will only want to exercise that right once certain developments around the area are built.
The potential home buyer would benefit from the option of buying or not. Imagine they can buy a call option from the developer to buy the home at say $400,000 at any point in the next three years. Well, they can—you know it as a non-refundable deposit. Naturally, the developer wouldn’t grant such an option for free. The potential home buyer needs to contribute a down-payment to lock in that right.
With respect to an option, this cost is known as the premium. It is the price of the option contract. In our home example, the deposit might be $20,000 that the buyer pays the developer. Let’s say two years have passed, and now the developments are built and zoning has been approved. The home buyer exercises the option and buys the home for $400,000 because that is the contract purchased.
The market value of that home may have doubled to $800,000. But because the down payment locked in a pre-determined price, the buyer pays $400,000. Now, in an alternate scenario, say the zoning approval doesn’t come through until year four. This is one year past the expiration of this option. Now the home buyer must pay the market price because the contract has expired. In either case, the developer keeps the original $20,000 collected.
Call Option Basics
Put Option Example
Now, think of a put option as an insurance policy. If you own your home, you are likely familiar with purchasing homeowner’s insurance. A homeowner buys a homeowner’s policy to protect their home from damage. They pay an amount called the premium, for some amount of time, let’s say a year. The policy has a face value and gives the insurance holder protection in the event the home is damaged.
What if, instead of a home, your asset was a stock or index investment? Similarly, if an investor wants insurance on his/her S&P 500 index portfolio, they can purchase put options. An investor may fear that a bear market is near and may be unwilling to lose more than 10% of their long position in the S&P 500 index. If the S&P 500 is currently trading at $2500, he/she can purchase a put option giving the right to sell the index at $2250, for example, at any point in the next two years.
If in six months the market crashes by 20% (500 points on the index), he or she has made 250 points by being able to sell the index at $2250 when it is trading at $2000—a combined loss of just 10%. In fact, even if the market drops to zero, the loss would only be 10% if this put option is held. Again, purchasing the option will carry a cost (the premium), and if the market doesn’t drop during that period, the maximum loss on the option is just the premium spent.
Put Option Basics
Buying, Selling Calls/Puts
There are four things you can do with options:
- Buy calls
- Sell calls
- Buy puts
- Sell puts
Buying stock gives you a long position. Buying a call option gives you a potential long position in the underlying stock. Short-selling a stock gives you a short position. Selling a naked or uncovered call gives you a potential short position in the underlying stock.
Buying a put option gives you a potential short position in the underlying stock. Selling a naked, or unmarried, put gives you a potential long position in the underlying stock. Keeping these four scenarios straight is crucial.
People who buy options are called holders and those who sell options are called writers of options. Here is the important distinction between holders and writers:
- Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights. This limits the risk of buyers of options to only the premium spent.
- Call writers and put writers (sellers), however, are obligated to buy or sell if the option expires in-the-money (more on that below). This means that a seller may be required to make good on a promise to buy or sell. It also implies that option sellers have exposure to more, and in some cases, unlimited, risks. This means writers can lose much more than the price of the options premium.
Why Use Options
Speculation is a wager on future price direction. A speculator might think the price of a stock will go up, perhaps based on fundamental analysis or technical analysis. A speculator might buy the stock or buy a call option on the stock. Speculating with a call option—instead of buying the stock outright—is attractive to some traders since options provide leverage. An out-of-the-money call option may only cost a few dollars or even cents compared to the full price of a $100 stock.
Options were really invented for hedging purposes. Hedging with options is meant to reduce risk at a reasonable cost. Here, we can think of using options like an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn.
Imagine that you want to buy technology stocks. But you also want to limit losses. By using put options, you could limit your downside risk and enjoy all the upside in a cost-effective way. For short sellers, call options can be used to limit losses if wrong—especially during a short squeeze.
How Options Work
In terms of valuing option contracts, it is essentially all about determining the probabilities of future price events. The more likely something is to occur, the more expensive an option would be that profits from that event. For instance, a call value goes up as the stock (underlying) goes up. This is the key to understanding the relative value of options.
The less time there is until expiry, the less value an option will have. This is because the chances of a price move in the underlying stock diminish as we draw closer to expiry. This is why an option is a wasting asset. If you buy a one-month option that is out of the money, and the stock doesn’t move, the option becomes less valuable with each passing day. Since time is a component to the price of an option, a one-month option is going to be less valuable than a three-month option. This is because with more time available, the probability of a price move in your favor increases, and vice versa.
Accordingly, the same option strike that expires in a year will cost more than the same strike for one month. This wasting feature of options is a result of time decay. The same option will be worth less tomorrow than it is today if the price of the stock doesn’t move.
Volatility also increases the price of an option. This is because uncertainty pushes the odds of an outcome higher. If the volatility of the underlying asset increases, larger price swings increase the possibilities of substantial moves both up and down. Greater price swings will increase the chances of an event occurring. Therefore, the greater the volatility, the greater the price of the option. Options trading and volatility are intrinsically linked to each other in this way.
On most U.S. exchanges, a stock option contract is the option to buy or sell 100 shares; that’s why you must multiply the contract premium by 100 to get the total amount you’ll have to spend to buy the call.
|What happened to our option investment|
|May 1||May 21||Expiry Date|
The majority of the time, holders choose to take their profits by trading out (closing out) their position. This means that option holders sell their options in the market, and writers buy their positions back to close. Only about 10% of options are exercised, 60% are traded (closed) out, and 30% expire worthlessly.
Fluctuations in option prices can be explained by intrinsic value and extrinsic value, which is also known as time value. An option’s premium is the combination of its intrinsic value and time value. Intrinsic value is the in-the-money amount of an options contract, which, for a call option, is the amount above the strike price that the stock is trading. Time value represents the added value an investor has to pay for an option above the intrinsic value. This is the extrinsic value or time value. So, the price of the option in our example can be thought of as the following:
|Premium =||Intrinsic Value +||Time Value|
In real life, options almost always trade at some level above their intrinsic value, because the probability of an event occurring is never absolutely zero, even if it is highly unlikely.
Types of Options
American and European Options
American options can be exercised at any time between the date of purchase and the expiration date. European options are different from American options in that they can only be exercised at the end of their lives on their expiration date. The distinction between American and European options has nothing to do with geography, only with early exercise. Many options on stock indexes are of the European type. Because the right to exercise early has some value, an American option typically carries a higher premium than an otherwise identical European option. This is because the early exercise feature is desirable and commands a premium.
There are also exotic options, which are exotic because there might be a variation on the payoff profiles from the plain vanilla options. Or they can become totally different products all together with “optionality” embedded in them. For example, binary options have a simple payoff structure that is determined if the payoff event happens regardless of the degree. Other types of exotic options include knock-out, knock-in, barrier options, lookback options, Asian options, and Bermudan options. Again, exotic options are typically for professional derivatives traders.
Options Expiration & Liquidity
Options can also be categorized by their duration. Short-term options are those that expire generally within a year. Long-term options with expirations greater than a year are classified as long-term equity anticipation securities or LEAPs. LEAPS are identical to regular options, they just have longer durations.
Options can also be distinguished by when their expiration date falls. Sets of options now expire weekly on each Friday, at the end of the month, or even on a daily basis. Index and ETF options also sometimes offer quarterly expiries.
Reading Options Tables
More and more traders are finding option data through online sources. (For related reading, see “Best Online Stock Brokers for Options Trading 2020”) While each source has its own format for presenting the data, the key components generally include the following variables:
- Volume (VLM) simply tells you how many contracts of a particular option were traded during the latest session.
- The “bid” price is the latest price level at which a market participant wishes to buy a particular option.
- The “ask” price is the latest price offered by a market participant to sell a particular option.
- Implied Bid Volatility (IMPL BID VOL) can be thought of as the future uncertainty of price direction and speed. This value is calculated by an option-pricing model such as the Black-Scholes model and represents the level of expected future volatility based on the current price of the option.
- Open Interest (OPTN OP) number indicates the total number of contracts of a particular option that have been opened. Open interest decreases as open trades are closed.
- Delta can be thought of as a probability. For instance, a 30-delta option has roughly a 30% chance of expiring in-the-money.
- Gamma (GMM) is the speed the option is moving in or out-of-the-money. Gamma can also be thought of as the movement of the delta.
- Vega is a Greek value that indicates the amount by which the price of the option would be expected to change based on a one-point change in implied volatility.
- Theta is the Greek value that indicates how much value an option will lose with the passage of one day’s time.
- The “strike price” is the price at which the buyer of the option can buy or sell the underlying security if he/she chooses to exercise the option.
Buying at the bid and selling at the ask is how market makers make their living.
The simplest options position is a long call (or put) by itself. This position profits if the price of the underlying rises (falls), and your downside is limited to loss of the option premium spent. If you simultaneously buy a call and put option with the same strike and expiration, you’ve created a straddle.
This position pays off if the underlying price rises or falls dramatically; however, if the price remains relatively stable, you lose premium on both the call and the put. You would enter this strategy if you expect a large move in the stock but are not sure which direction.
Basically, you need the stock to have a move outside of a range. A similar strategy betting on an outsized move in the securities when you expect high volatility (uncertainty) is to buy a call and buy a put with different strikes and the same expiration—known as a strangle. A strangle requires larger price moves in either direction to profit but is also less expensive than a straddle. On the other hand, being short either a straddle or a strangle (selling both options) would profit from a market that doesn’t move much.
Below is an explanation of straddles from my Options for Beginners course:
And here’s a description of strangles:
How to use Straddle Strategies
Spreads & Combinations
Spreads use two or more options positions of the same class. They combine having a market opinion (speculation) with limiting losses (hedging). Spreads often limit potential upside as well. Yet these strategies can still be desirable since they usually cost less when compared to a single options leg. Vertical spreads involve selling one option to buy another. Generally, the second option is the same type and same expiration, but a different strike.
A bull call spread, or bull call vertical spread, is created by buying a call and simultaneously selling another call with a higher strike price and the same expiration. The spread is profitable if the underlying asset increases in price, but the upside is limited due to the short call strike. The benefit, however, is that selling the higher strike call reduces the cost of buying the lower one. Similarly, a bear put spread, or bear put vertical spread, involves buying a put and selling a second put with a lower strike and the same expiration. If you buy and sell options with different expirations, it is known as a calendar spread or time spread.
Combinations are trades constructed with both a call and a put. There is a special type of combination known as a “synthetic.” The point of a synthetic is to create an options position that behaves like an underlying asset, but without actually controlling the asset. Why not just buy the stock? Maybe some legal or regulatory reason restricts you from owning it. But you may be allowed to create a synthetic position using options.
A butterfly consists of options at three strikes, equally spaced apart, where all options are of the same type (either all calls or all puts) and have the same expiration. In a long butterfly, the middle strike option is sold and the outside strikes are bought in a ratio of 1:2:1 (buy one, sell two, buy one).
If this ratio does not hold, it is not a butterfly. The outside strikes are commonly referred to as the wings of the butterfly, and the inside strike as the body. The value of a butterfly can never fall below zero. Closely related to the butterfly is the condor – the difference is that the middle options are not at the same strike price.
Because options prices can be modeled mathematically with a model such as the Black-Scholes, many of the risks associated with options can also be modeled and understood. This particular feature of options actually makes them arguably less risky than other asset classes, or at least allows the risks associated with options to be understood and evaluated. Individual risks have been assigned Greek letter names, and are sometimes referred to simply as “the Greeks.”
Below is a very basic way to begin thinking about the concepts of Greeks:
What are Options?
How to Trade Options
An option is exactly that — it’s a choice (or option) an investor has when playing the stock market. It’s a securities contract, a “call” or a “put,” that gives you the right to buy (call) or sell (put) the underlying equity, index, or ETF at a predetermined price (strike price) during a preset time period (expiration date).
You’ve already seen how options strategies work every day without realizing it. In fact, you probably have purchased the right to protect yourself against risk in some area of your life, such as home, health or car insurance. Those same principles can be applied to options trading.
|HOW TO TRADE OPTIONS:|
|– What Are Options?|
|– What Are Options Contracts?|
|– Price of Options|
|– How to Read Options Symbols|
|– How to Price Options|
|– How to Read Options Quotes|
|– Understanding Options Risk|
|– Common Mistakes to Avoid|
|– Options Trading Strategies|
|– Choosing an Options Broker|
Let’s use car insurance as an example. You purchase a new car after taking time to decide which model you want based on safety ratings, how smooth the ride feels and how well it will accommodate your needs. But would you drive that shiny new car off the lot without taking precautions in the event that something happens to your investment? Probably not (and not just because car insurance is required by law).
When you buy an insurance policy — be it automobile, health, life or homeowner’s insurance — you pay a monthly or yearly premium for the protection it provides. The policy ultimately might be valued at several times more than what you actually pay for it, but the nominal amount you’re charged for this security net is a small price to pay in comparison.
At the end of the year, when your car insurance needs to be renewed and you haven’t been involved in any accidents that required you to file a claim, you still come out a winner because you didn’t lose any more than your initial investment (your premium) and you drove for a whole year with peace of mind because you had the insurance in the first place.
That’s the same principle used for options trading, but replace that well-researched vehicle purchase with a favorite stock holding. For example, let’s say you think Allstate (NYSE:ALL), which is trading at roughly $30 a share, will rise to $35 within the next few months, but you don’t want to tie up thousands of dollars of your hard-earned cash. By instead purchasing one options contract (which controls 100 shares) at $1.50 per contract, only $150 would be tied up, as opposed to the $3,000 required if you bought 100 shares of the stock outright.
Options pricing will be covered in more detail a bit later.
What are Options: Two Basic Types
There are two basic types of options: calls and puts. Every options strategy, no matter how complex, uses one or both of these option types as its building blocks.
Call options are derivatives that give the buyer the right, but not the obligation, to buy a security (i.e., to “call” it away from its owner) at a specified price during a specified period of time. Typically, you buy calls when you’re bullish about the direction of the market and/or about a particular stock’s prospects.
Put options give you the right, but not the obligation, to sell a security (or “put” it to someone else) at a specified price during a specified period of time. Put buyers are generally bearish on the market and/or a stock’s potential, so they purchase puts to try and profit from an expected downside move.
Put buying is similar in theory to shorting stock because the trader is motivated by expectations that the shares will fall below a certain price. The put buyer actually incurs less risk than the short seller, however, because the maximum potential loss when buying options is the premium paid to enter the trade. Investors who short stocks must come up with a lot of capital to buy shares of the stock (aka “cover their shorts”) if the price rallies higher.
For all options, there are always two parties involved — someone buying and someone selling. There are also pros and cons for each strategy. The key to successful options trading is determining which choice is right for you at which time. Hopefully this introductory guide helps you understand the terminology and strategies so you can make informed and confident decisions when you’re ready to trade!
The chart below is a quick review of what calls and puts allow you to do.
When you trade an option, you are actually buying (or selling) an options contract. One options contract controls 100 shares of the underlying stock. For example, if Allstate (ALL) is selling for $30 per share, it would cost you $3,000 to own 100 shares. But by purchasing the call option, you can control those 100 shares for a fraction of the cost — $1.50x 100 (representing 100 shares) = $150 per contract. The variables behind option pricing will be discussed later.
Each options contract controls 100 shares of stock, so when you hear people talk about one contract, they are effectively talking about 100 shares. Two contracts would be the equivalent of 200 shares, five contracts would be 500 shares, and so on.
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