What is option trading? I’ve been asked this by so many people over the years that I finally decided to write an article covering the basics of options trading. So this article is designed to be an options trading tutorial guide. By the end of the post you should have a decent grasp of all options trading basics.
Options are one of the most versatile trading tools available. A trader can use an option in order to limit risk on speculative investments. An option can also be used as a hedge against a declining stock market to limit downside losses. Though trading options can be extremely profitable, a trader must understand that they involve risks and are therefore not suitable for everyone. Understanding how options work and how to utilize them can allow you as a trader understand the working of the market better and therefore have a much higher chance of being a successful trader.
What is a derivative?
An option is the most basic example of a group of securities known as derivatives. But what is a derivative? A derivative is a security whose price is dependent on, or derived from the price of another asset. A non-financial example of a derivative would be coffee, which is a derivative of coffee beans. In summation, a derivative is just a financial security whose value is tied to the price of another asset.
What is an Option?
As stated above, options fall under the derivatives category. An option’s price is intrinsically linked to the price of something else. Options are financial contracts that grant the buyer of the option the right, but not the obligation to buy or sell the underlying asset at a set price on or before a certain date in the future. The right to sell is a put option, while the right to purchase the underlying security is a call option.Subscribe to Learn to Trade for Profit
Option Terms – Basics
- Call Option Definition
- Gives the buyer the right to buy a security(such as a stock) at a fixed price (strike price) before or on a specified date (expiration date).
- The seller (writer/creator of the option contract) of a call is obligated to sell the stock at the strike price if the option is exercised
- Put Option Definition
- Gives the buyer the right to sell a security at a fixed price (strike price) before or on a specified date (expiration date).
- The seller (writer) of a put is obligated to purchase the stock at the strike price if exercised.
- Strike (or exercise) price
- The price at which the holder can purchase (for a call) or sell (for a put) the underlying asset.
- The process by which an option buyer (holder) invokes the terms of the option.
- Calls will buy the underlying asset
- Puts will sell the underlying asset
- The process by which an option buyer (holder) invokes the terms of the option.
- Expiration Date
- The last day on which the option may be executed.
- To be long an option means to have purchased it and therefore own or hold it.
- To be short an option means to have sold it.
- The price of an option contract.
Option Terms – Advanced
- Covered Call
- A call option that is written (sold) against an existing security position. The call is said to be covered by the underlying asset, which could be delivered if the call option is exercised.
- A conservative strategy used to reduce investment risk by implementing a transaction that offsets an existing position.
- Intrinsic Value
- The amount of profit that can be theoretically obtained if the option is exercised at the moment and the underlying asset is either purchased (call) or sold (put) at the current market price.
- A call option’s strike price is below the market price of the underlying asset or that the strike price of a put option is above the market price of the underlying asset
- An option’s strike price is identical to the price of the underlying security
- A call option with a strike price higher than the market price of the underlying asset, or a put option with a strike price that is lower than the market price of the underlying asset
What is an option – Calls?
A simpler way of thinking of a call option is as a deposit for a future purpose. For example, a land developer may want the right to purchase a vacant lot in the future, but will only exercise that right if certain zoning laws are put into place. The developer can buy a call option from the landowner to buy the lot at say $250,000 at any point in the next 3 years. Of course, the landowner will not grant such an option for free, the developer needs to contribute a down payment to lock in that right. With respect to options, this cost is known as the premium and is the price of the options contract. In this example, the premium might be $6,000 that the developer pays the landowner. Two years have passed, and now the zoning has been approved; the developer exercises his option and buys the land for $250,000 – even though the market value of that plot has doubled. In an alternative scenario, the zoning approval doesn’t come through until year 4, one year past the expiration of the option. Now the developer must pay market price. In either case, the landowner keeps the $6,000.
What is an option – Put?
A put option, on the other hand, might be thought of as an insurance policy. Our land developer owns a large portfolio of blue chip stocks and is worried that there might be a recession within the next two years. He wants to be sure that if a bear market hits, his portfolio won’t lose more than 10% of its value. If the S&P 500 is currently trading at 2500, he can purchase a put option giving him the right to sell the index at 2250 at any point in the next two years. If in six months time the market crashes by 20%, 500 points in his portfolio, he 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, he will still only lose 10% given his put option. Again, purchasing the option will carry a cost (its premium) and if the market doesn’t drop during that period the premium is lost.
American vs. European Options
- An American option can be exercised at any time between the date of purchase and the expiration date.
- A European option can only be exercised on the date of expiration.
- Most options on stock indices are European Options.
Where are Options Traded?
Options can be traded through any regular brokerage accounts, such as Charles Schwab or Fidelity. The only requirement being that the trader must complete additional documentation that states their understanding of the volatility associated with options. I have listed the most popular options brokerages below, along with the fees associated with each brokerage.
- OptionsHouse LLC:
- The option trading rates start from $5 for up to five contracts, and decreases (per contract) when more contracts are traded. Currently, OptionsHouse does not require a minimum funding level to open a new account, but funding is required to start trading. Along with plain vanilla call and put option trades, OptionsHouse also offers option strategies including covered calls/puts, protective calls/puts, collars, etc. Trading platforms offered are desktop and mobile-based applications for convenient trading and include advanced charting, portfolio management, and analysis tools.
- A variety of account types are available to suit client needs. Trading commission rates start at $12.5 per 10 contracts (or $1.25 per contract). Effective trading rates per contract go down with more contracts traded (to $0.1 per contract for 100,000+ contracts).
- Now part of Charles Schwab & Co., claims to offer one of the most economical option trading commissions, starting at $1.25 and $1.5 per contract for 10+ contracts for Active Trader and Standard accounts respectively. The same fee applies to spreads, straddles, and combos trading. No minimum balance is needed for a standard account, but a margin account (and margin trading) needs funding ranging from 6% to 8.25%, depending on the trade valuation.
- Now part of TD Ameritrade. Internet-based orders cost $9.99 + $0.75 per contract, interactive voice response (IVR) orders cost $34.99 + $0.75 per contract, and broker-assisted orders cost $44.99 + $0.75 per contract.
- Charles Schwab
- Online option trading charges start from $8.95 + $0.75 per contract and multi-leg trades (spreads, combos, and straddles) are charged only one $8.95 base commission, plus per-contract fees for the total number of option contracts. Broker-assisted trades and automated phone trades are comparatively costly as they include additional services charges of $25 and $5 respectively.
As you can see, options can be an extremely useful addition to any trading strategy. Whether you are conservative or speculative, you can use options to diversify your portfolio and become a more profitable trader. Options are sophisticated trading tools that can be dangerous if you do not educate yourself before using them. Check back with us in the coming weeks to learn more about how you can use options as a strategic investment opportunity to grow your wealth. I hope that you found this article helpful and that I successfully answered your questions on how to get started trading options. Have a great day!