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 predetermined price at or before the contract expires. Like most other asset classes, options can be purchased 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 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 a substantial risk of loss.
Options are 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. 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.
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 after certain developments around the area are built.
The potential homebuyer 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 homebuyer 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 homebuyer 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 predetermined 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 homebuyer 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 the process of purchasing homeowner’s insurance. A homeowner buys a homeowner’s policy to protect their home from damage. They pay an amount called a premium for a certain 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 their 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 $2,500, they can purchase a put option giving them the right to sell the index at $2,250, for example, at any point in the next two years.
If in six months the market crashes by 20% (500 points on the index), they have made 250 points by being able to sell the index at $2,250 when it is trading at $2,000—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 and Puts
There are four things you can do with options:
- Buy (long) calls
- Sell (short) calls
- Buy (long) puts
- Sell (short) 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 because 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 the underlying price moves against their trade—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 that profits from that event would be. 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. Because time is a component of 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.
Call Options vs. Put Options
Call options and put options can only function as effective hedges when they limit losses and maximize gains. Suppose you’ve purchased 100 shares of Company XYZ’s stock, betting that its price will increase to $20. Therefore, your total investment is $1,000. To hedge against the risk that the price might decline, you purchase 1 put option (each options contract represents 100 shares of underlying stock) with a strike price of 10, each worth $2 (for a total of $200).
Consider the situation when the stock’s price goes your way (i.e., it increases to $20). In such a scenario, your put options expire worthless. But your losses are limited to the premium paid (in this case, $200). If the price declines (as you bet it would in your put options), then your maximum gains are also capped. This is because the stock price cannot fall below zero, and therefore, you cannot make more money than the amount you make after the stock’s price falls to zero.
Now, consider a situation in which you’ve bet that XYZ’s stock price will decline to $5. To hedge against this position, you’ve purchased call stock options, betting that the stock’s price will increase to $20. What happens if the stock’s price goes your way (i.e., it declines to $5)? Your call options will expire worthless and you will have losses worth $200. There are no upper limits on XYZ’s price after it takes off. Theoretically, XYZ can go all the way to $100,000 or higher. Therefore, your gains are not capped and are unlimited.
The table below summarizes gains and losses for options buyers.
|Maximum Gain||Maximum Loss|
Uses of Call and Put Options
Call options and put options are used in a variety of situations. The table below outlines some use cases for call and put options.
|Call Options||Put Options|
|Buyers of call options use them to hedge against their position of a declining price for the security or commodity.||Buyers of put options use them to hedge against their position of a rising price for the security or commodity.|
|American importers can use call options on the U.S. dollar to hedge against a decline in their purchasing power.||American exporters can use put options on the U.S. dollar to hedge against a rise in their selling costs.|
|Holders of American depository receipts (ADRs) in foreign companies can use call options on the U.S. dollar to hedge against a decline in dividend payments.||Manufacturers in foreign countries can use put options on the U.S. dollar to hedge against a decline in their native currency for payment.|
|Short sellers use call options to hedge against their positions.||Short sellers have limited gains from put options because a stock’s price can never fall below zero.|
How Do Experienced Investors Use Options?
As mentioned earlier, traders use options to speculate and hedge. To maximize their returns, traders track options prices and employ sophisticated strategies, such as a strangle or an iron condor. Here is a quick introduction to some of the strategies that are fairly simple but effective in making money. You can find out more about options strategies here.
As the name indicates, going long on a call involves buying call options, betting that the price of the underlying asset will increase with time. For example, suppose a trader purchases a contract with 100 call options for a stock that’s currently trading at $10. Each option is priced at $2. Therefore, the total investment in the contract is $200. The trader will recoup her costs when the stock’s price reaches $12.
Thereafter, the stock’s gains are profits for her. There are no upper bounds on the stock’s price, and it can go all the way up to $100,000 or even further. A $1 increase in the stock’s price doubles the trader’s profits because each option is worth $2. Therefore, a long call promises unlimited gains. If the stock goes in the opposite price direction (i.e., its price goes down instead of up), then the options expire worthless and the trader loses only $200. Long calls are useful strategies for investors when they are reasonably certain a given stock’s price will increase.
In a short call, the trader is on the opposite side of the trade (i.e., they sell a call option as opposed to buying one), betting that the price of a stock will decrease in a certain time frame. Because it is a naked call, a short call can have unlimited gains because if the price goes the trader’s way, then they could rake in money from call buyers.
But writing a call without owning actual stock can also mean significant losses for the trader because, if the price doesn’t go in the planned direction, then they would have to spend a considerable sum to purchase and deliver the stock at inflated prices.
A covered call limits their losses. In a covered call, the trader already owns the underlying asset. Therefore, they don’t need to purchase the asset if its price goes in the opposite direction. Thus, a covered call limits losses and gains because the maximum profit is limited to the amount of premiums collected. Covered calls writers can buy back the options when they are close to in the money. Experienced traders use covered calls to generate income from their stock holdings and balance out tax gains made from other trades.
A long put is similar to a long call except that the trader will buy puts, betting that the underlying stock’s price will decrease. Suppose a trader purchases a one 10-strike put option (representing the right to sell 100 shares at $10) for a stock trading at $20. Each option is priced at a premium of $2. Therefore, the total investment in the contract is $200. The trader will recoup those costs when the stock’s price falls to $8 ($10 strike – $2 premium).
Thereafter, the stock’s losses mean profits for the trader. But these profits are capped because the stock’s price cannot fall below zero. The losses are also capped because the trader can let the options expire worthless if prices move in the opposite direction. Therefore, the maximum losses that the trader will experience are limited to the premium amounts paid. Long puts are useful for investors when they are reasonably certain that a stock’s price will move in their desired direction.
In a short put, the trader will write an option betting on a price increase and sell it to buyers. In this case, the maximum gains for a trader are limited to the premium amount collected. However, the maximum losses can be unlimited because she will have to buy the underlying asset to fulfill her obligations if buyers decide to exercise their option.
Despite the prospect of unlimited losses, a short put can be a useful strategy if the trader is reasonably certain that the price will increase. The trader can buy back the option when its price is close to being in the money and generates income through the premium collected.
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 Bermuda options. Again, exotic options are typically for professional derivatives traders.
Short-Term Options Vs. Long-Term Options
Options can also be categorized by their duration. Short-term options are those that generally expire 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 except that they have longer durations.
|Short-Term Options||Long-Term Options||LEAPs|
|Time value and extrinsic value of short-term options decay rapidly due to their short durations.||Time value does not decay as rapidly for long-term options because they have a longer duration.||Time value decay is minimal for a relatively long period because the expiration date is a long time away.|
|The main risk component in holding short-term options is the short duration.||The main component of holding long-term options is the use of leverage, which can magnify losses, to conduct the trade.||The main component of risk in holding LEAPs is an inaccurate assessment of a stock’s future value.|
|They are fairly cheap to purchase.||They are more expensive compared to short-term options.||They are generally underpriced because it is difficult to estimate the performance of a stock far out in the future.|
|They are generally used during catalyst events for the underlying stock’s price, such as an earnings announcement or a major news development.||They are generally used as a proxy to holding shares in a company and with an eye toward an expiration date.||LEAPs expire in January and investors purchase them to hedge long-term positions in a given security.|
|They can be American- or European-style options.||They can be American- or European-style options.||They are American-style options only.|
|They are taxed at a short-term capital gains rate.||They are taxed at a long-term capital gains rate.||They are taxed at a long-term capital gains rate.|
You can read a more detailed discussion of options and taxes here.
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. Though 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.
- An 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. Delta also measures the option’s sensitivity to immediate price changes in the underlying. The price of a 30-delta option will change by 30 cents if the underlying security changes its price by $1.
- Gamma is the speed the option for 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 they choose to exercise the option.
Buying at the bid and selling at the ask is how market makers make their living.
Long Calls and Puts
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 the 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 in 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.
Spreads and 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, wherein 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.
Options Risks: The “Greeks”
Because options prices can be modeled mathematically with a model such as the Black-Scholes model, 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.”
What Does Exercising an Option Mean?
Exercising an option means executing the contract and buying or selling the underlying asset at the stated price.
Why Do Traders Use Options?
Traders generally use options to speculate and hedge. For example, a trader might hedge an existing bet made on the price increase of an underlying security by purchasing put options.
What is the Difference Between American Options and European Options?
American options can be exercised anytime before expiration, but European options can be exercised only at the stated expiry date.
How is Risk Measured With Options?
What Are the Three Important Characteristics of Options?
The three important characteristics of options are as follows:
- Strike price: This is the price at which an option can be exercised.
- Expiration date: This is the date at which an option expires and becomes worthless.
- Option premium: This is the price at which an option is purchased.
How Are Options Taxed?
Call and put options are generally taxed based on their holding duration. They incur capital gains taxes. Beyond that, the specifics of taxed options depend on their holding period and whether they are naked or covered.
The Bottom Line
Options do not have to be difficult to understand when you grasp their basic concepts. Options can provide opportunities when used correctly and can be harmful when used incorrectly.