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Option Trading Basics
By Lawrence G. McMillan

In today's ever-changing markets, you want to ensure that your investments will work for you no matter what scenario the markets may bring. When trading only stocks or futures, this can sometimes be a difficult task to accomplish. However, option trading offers many solutions to such problems. Options are financial instruments that can provide you, the individual investor, with tremendous profit potential, limited risk, and the flexibility you need to take advantage of almost any investment situation you might encounter. Whether your market outlook is bullish, bearish, choppy, or quiet, option trading can significantly increase your trading opportunities for profit.

Options Basics

There are two types of option contracts: calls and puts. A call option is a contract which conveys to its holder the right, but not the obligation, to buy a fixed number of shares or future contracts of the underlying security at a specified price, on or before a specific date. A put works in a similar manner to a call except that it gives the holder the right to sell a fixed number of shares or contracts of the underlying asset. So if you think the market is going up, you would look at buying calls, and if you think the market will decline, you would look at buying puts.

As an option trader, you can play the role of either the buyer or the seller of the option contract, and in many strategies the position will be made up of both contracts that you are buying and contracts you are selling.

As the seller of an option, you are taking on an obligation to deliver the stock or future to the buyer of the option at the specified price upon the buyer's request. For taking this obligation, you are paid a premium that you collect at the time the option is sold.

Options give you options. You're not just limited to buying, selling short or staying out of the market. With options, you can tailor your position to your own situation and market outlook.

Following are some examples that illustrate the wide array of possibilities option trading offers:

  • Prepare to buy a stock at a fixed price when you think the market will go up by purchasing a call option to buy the stock at the strike price. Here, for only the option's premium, you can profit from an increase in the stock price above the strike price, saving the unused capital for other investment opportunities.
  • Leverage your gains by controlling more stock or futures contracts with your initial investment. When the market moves favorably, you benefit by getting a greater return on your investment.
  • Protect your investments from a market decline by purchasing a put option to sell your stock or futures contract at a certain level. This limits your risk below the strike of the put to only the cost of the put option.
  • Make money above and beyond what your current investments are bringing in by selling covered calls. The money you receive from selling the calls will also provide some protection from a price decline in the underlying investment.
  • Profit from a big market move - even if you're not sure which way it will be - by purchasing a straddle, which consists of buying a put and a call.
  • Make money if the market goes nowhere by purchasing a butterfly spread or writing a straddle. You benefit by profiting from the time decay factor of the options.

All of this can be a reality when you add options to your trading arsenal. And aside from just giving you a long list of choices when it comes to how you manage your investment risks and rewards, options trading also offers a long list of benefits over other types of strategies. Here are just a few...

  • Trade in more markets
  • Combine strategies to make money under virtually any market conditions
  • Leverage your investment for a greater potential reward
  • Use options activity to forecast where the market is going
  • Know exactly what your risk is
  • And much more...

Benefits Of Exchange-Traded Options

Orderly, Efficient, and Liquid Markets... Flexibility... Leverage... Limited Risk. These are the major benefits of options traded on securities exchanges today.

Although the history of options spans several centuries, it was not until 1973 that standardized, exchange-listed and government regulated options became available. In only a few years, these options virtually displaced the limited trading in over-the-counter options and became an indispensable tool for the securities industry.

Orderly Efficient and Liquid Markets

Standardized option contracts provide orderly, efficient and liquid option markets. Except under special circumstances, all stock option contracts are for 100 shares of the underlying stock. The strike price of an option is the specified share price at which the shares of stock will be bought or sold if the buyer of an option, or the holder, exercises his option. At any given time a particular option can be bought with one of four expiration dates. As a result of this standardization, option prices can be obtained quickly and easily at any time during trading hours. Option prices are set by buyers and sellers on the exchange floor where all trading is conducted in the open, competitive manner of an auction market.

Flexibility

Options are an extremely versatile investment tool. Because of their unique risk/reward structure, options can be used in many combinations with other option contracts and/or other financial instruments to create either a hedged or speculative position. Some basic strategies are described in a later section.

Leverage

A stock option allows you to fix the price, for a specific period of time, at which you can purchase or sell 100 shares of stock for a premium (price) that is only a percentage of what you would pay to own the stock outright. That leverage means that by using options you may be able to increase your potential benefit from a stock's price movements. For example, to own 100 shares of a stock trading at $50 per share would cost $5,000. On the other hand, owning a $5 call option with a strike price of $50 would give you the right to buy 100 shares of the same stock at any time during the life of the option and would cost only $500. Remember that premiums are quoted on a per share basis, thus a $5 premium represents a premium payment of $5 x 100, or $500, per option contract. Let's assume that you bought an option expiring six months from now, paying $500. One month after the option was purchased, the stock price has risen to $55. The gain on the stock investment is $500, or 10%. However for the same $5 increase in the stock price, the call option premium might increase to $7, for a return of $200, or 40%. Although the dollar amount gained on the stock investment is greater than the option investment, the percentage return is much greater with options than with stock. Leverage also has downside implications. If the stock does not rise as anticipated or falls during the life of the option, leverage will magnify the investment's percentage loss. For instance, if in the above example the stock had instead fallen to $40, the call option premium might decrease to $2 resulting in a loss of $300 (or 60%). You should take note, however, that as an option buyer, the most you can lose is the premium amount you paid for the option.

Limited Risk For Buyers

Unlike other investments where the risks may have no limit, options offer a known risk to buyers. An option buyer absolutely cannot lose more than the price of the option, the premium. Because the right to buy or sell the underlying security at a specific price expires on a given date, the option will expire worthless if the conditions for profitable exercise or sale of the contract are not met by the expiration date. An uncovered option seller (sometimes referred to as the writer of an option), on the other hand, may face unlimited risk.

Guaranteed Contract Performance

An option holder is able to look to the system created by the Option Clearing Corporation's (OCC) Rules which includes the brokers and Clearing Members involved in a particular option transaction and to certain funds held by OCC - rather than to any particular option writer for performance. Prior to the existence of option exchanges and OCC, and option holder who wanted to exercise an option depended on the ethical and financial integrity of the writer or his brokerage firm for performance. Furthermore, there was no convenient means of closing out one's position prior to the expiration of the contract. OCC, as the common clearing entity for all exchange traded option transactions, resolves these difficulties. Once OCC is satisfied that there are matching orders from a buyer and a seller, it severs the link between the parties. In effect, OCC becomes the buyer to the seller and the seller to the buyer. As a result, the seller can buy back the same option he has written, closing out the initial transaction and terminating his obligation to deliver the underlying stock or exercise value of the option to OCC, and this will in no way affect the right of the original buyer to sell, hold, or exercise his option. All premium and settlement payments are made to and paid by OCC.

Of course, by now you're probably wondering exactly how the leverage, limited risk and potentially unlimited profits of option trading work. Here's a real trading example:

Let's say it's May, you have $10,000 to invest and XYZ stock has been doing very well lately. You think it will continue to do so in the future. You'd like to get in on this profit opportunity - but think that spending all $10,000 to purchase 100 shares at its current trading price of $100 per share is a hefty sum to tie up while you wait for the stock price to continue rising. What should you do? Here's a good time for option trading to enter the picture. Buying a XYZ July 100 call option gives you the right to purchase 100 shares of XYZ stock at a cost of $100 per share at any time before the option expires in July. As mentioned above, assume the price of the underlying shares of XYZ are trading at $100 and also assume the July 100 call is trading at 3. All you would have to invest to purchase one option contract (which controls one hundred shares) is $350. This is called the option premium. If the price of XYZ climbs as you projected, let's say to $112, before your option expires in July, the premium price will go up to at least 12, or $1200. By closing out your position and selling your option contract for the new premium price of $1200, you've made at least an $850 profit ($1200 - $350, the initial cost of option).

Now let's take a closer look at the benefits this option trade gave you:

  • Benefit #1: Leverage. Rather than tying up all of your $10,000 in capital to purchase 100 shares of XYZ outright, you used only $350 to control the same amount of shares and reap more than a 240% profit on your investment.
  • Benefit #2: Limited Predetermined Risk. Rather than putting $10,000 on the line and risking the whole amount if the stock went down in price, you paid out only $350. This premium price for the option is all you are ever required to pay for this type of option strategy. There is no further risk if the stock price declines, but you lose 100%.
  • Benefit #3: Large Potential Profits. Whether you invested all of your money in 100 shares of XYZ or went the options route and used only $350, you have large reward potential. The higher the price of XYZ goes, the more money you will make. But doesn't it make more sense to only have $350 invested to claim these rewards, while the other $9,650 is making money? That's the benefit option trading puts on your side.

Summary

In summary, ensuring that your investments remain profitable regardless of market scenarios is crucial in today's dynamic markets. Option trading stands out as a versatile solution to this challenge. Options offer individual investors substantial profit potential, limited risk exposure, and the flexibility needed to navigate various investment situations effectively. Whether you anticipate bullish, bearish, choppy, or stable market conditions, option trading empowers you to capitalize on trading opportunities and optimize your profit potential. The benefits of exchange-traded options, including orderly and efficient markets, flexibility in strategies, leverage for enhanced rewards, defined risk, and guaranteed contract performance, further underscore the advantages of incorporating options into your trading toolkit. This comprehensive suite of benefits positions option trading as a strategic and rewarding approach to managing investment risks and rewards in today's complex financial landscape.