Options Basics: What You Need to Know

Thu Oct 7, 2021, 05:38 pm | by Dan Schmidt | No comments

Stock options are the first type of derivative most traders encounter. Unlike actual stocks themselves, options don’t represent an equity stake in a publicly traded company. Options are called derivatives because they derive value from the underlying stock, but they trade separately and don’t always move in tandem. Options can be used to hedge equity positions, create income streams, or simply add leverage to trades. In this article, we’ll discuss the basics of trading options without getting overly technical. Options can turn small trades into big winners, but they also carry risks that stocks do not.

What Are Options? 

An option is simply a contract that entitles the owner to buy or sell a particular stock at a predetermined price. An option contract is an agreement between two traders regarding the future price of an asset. Each contract allows the holder to control 100 shares with a single security and there’s no obligation to cash in the contract for the shares (known as ‘exercising’ the option).

Options can be traded on public exchanges and most traders simply buy and sell them without ever intending to exercise. Pricing options is a complicated endeavor and depends on a variety of factors. Here are a few key terms to understand if you want to grasp the basics of options trading.

Strike Price – The strike is the predetermined price on the contract that allows the holder to buy (or sell) 100 shares of the underlying stock. Until an option reaches its strike price, it has no intrinsic value and will expire worthless if the strike isn’t hit before expiration.

Expiration Date – All options contracts have an expiration date, which makes buying and selling more difficult than owning stocks. Your investment thesis must not only get the direction of the stock move right, but also the time frame in which it will occur. The further an option is from expiration, the more expensive it will be. Options decay in value as they move closer to expiration, especially if the strike price remains out of reach.

Premium – The price of the option is known as the premium. The option buyer pays the premium to the seller for the right to exercise the contract at a future date should the strike price be reached. The seller pockets the premium as profit should the option expire worthless.

Open Interest – Often confused with volume, open interest is a good way to gauge the activity in a particular options market. Open interest refers to the number of contracts that have been opened at a certain strike price and expiration date. Volume is how often these contracts are traded. High open interest is usually a bullish sign for that particular market.

“In The Money (ITM)” – When the underlying equity reaches the option’s strike price, that contract is “in the money” meaning it can be exercised for discounted shares or sold for profit. ITM options have intrinsic value since they can be used to acquire actual shares of the underlying company.

“Out of The Money (OTM)” – An option that’s yet to see its strike price reached is known as “out of the money.” OTM options have no intrinsic value, but that doesn’t mean that they can’t be sold for profit. A popular strategy amongst meme stock traders involves buying far out of the money options for cheap and selling immediately on a price increase. However, OTM options will expire worthless if the strike isn’t reached and you’ll lose your entire investment.

Option Writer – We’ve mostly discussed buying options here, but every option contract must have a buyer AND a seller. Unlike a stock which is issued by the company offering equity, options are ‘written’ by a trader who then sells to a buyer and pockets the premium. Writing options can be risky since losses are potentially infinite, but a strategy of writing options while buying stock (or other options) can provide an upfront income stream through premiums.

Puts and Calls 

Options can be used to profit from stock moves to the downside or upside depending on the type of contract you purchase. You have two choices when buying (or selling) stock options – call options and put options.

A call option is a contract that grants the owner the right to purchase 100 shares of the underlying stock at the strike price. If your trade thesis is bullish, you might consider buying a call option. If the stock advances past the strike price, the call option will increase in value.

A put option is the opposite of a call. A put grants the owner the right to sell 100 shares of the underlying stock at the strike price. It’s called a put because when the strike price is reached, the owner of the option can ‘put’ the 100 shares on the option seller and pocket the difference as profit.

Benefits of Options 

Options have some benefits over traditional stocks. Here are the main reasons traders purchase options in their portfolios:

  • Leverage – An option allows a trader to control a position worth 100 shares for a fraction of the price. Getting this type of leverage with traditional investments usually means using margin (ie. borrowing money). Buying a call option entitles you to 100 shares of underlying stock, but you only pay a premium for your trouble.
  • Less Upfront Money – Leverage means less money upfront when executing your trades. Buying and selling options can create opportunities for outsized profits while controlling them from a small account.
  • Hedging – Options can be used to hedge equity positions or create revenue streams. For example, a popular trade is known as a covered call in which a trader sells a call option while buying shares of the underlying stock. The trader pockets the option premium and offsets their risk by owning the shares of the underlying company.

Risks of Options 

  • Volatility – Since an option entitles the owner to 100 shares, the volatility swings in option contracts can be fierce. If you don’t grasp how options are valued, you might see volatility you can’t handle and sell at the worst possible time.
  • Time Restrictions – Options are tricky because the clock is working against you. As expiration approaches, options shed value rapidly so you must not only guess the directional move properly, but the time frame in which it happens.
  • Loss of Entire Investment – If you own options in a particular stock and an unexpected event sends the share price in the opposite direction of your thesis, you could be facing a 100% loss. Unlike stocks which never go to zero, options expire worthless frequently. Be prepared to experience at least one heavy loss if you’re speculating with options.

How to Trade Options for Beginners 

If you’ve weighed the pros and cons and still want to try your hand at options, you can follow this simple plan to get started:

  1. Open your trading account. You’ll usually need to request permission to trade options and beginners aren’t often granted the ability to write (ie. sell) options. To start off, you’ll be restricted to buying calls or puts.
  2. Choose your options. If you’re bullish on the underlying stock, you’ll want to look at call options. If bearish, take a look at the put options.
  3. Have a trading thesis. It’s not enough just to predict up or down, you need to get the timing right with options also. Are there any upcoming catalysts that would spike volatility in the shares? How about regulatory headwinds? You don’t need to be precise, but have an idea of where you think the stock is headed and how long it will take to get there.
  4. Pick your timeframe. If you have the cash to pony up for a long-dated option, you’ll have more time for your thesis to be proven correct. Shorter dated options will face more volatility.
  5. Know your strategy. Are you speculating on equities with leverage? Using calls and puts in tandem to create income streams? Hedging already open equity positions? The strategy you employ will determine your holding period and profit goals.

Final Thoughts 

Options can be exciting tools for turning small bets into big wins, but it’s crucial to understand the risks involved with these types of derivatives. Options contracts are extremely volatile and require a certain risk appetite when used for speculation. Utilizing complex options trades can be a way to earn current income and long-term profits, but one misstep could create a catastrophic loss. If you’re just starting out with options, practice with small trades and don’t risk any capital you can’t afford to lose.