Options Trading Explained: More Opportunities to Profit
For the most part, traders and investors can only make money by buying stocks. Futures allow traders to add short selling and leverage to their trading arsenal. Options add two new tools to the trader’s arsenal. Firstly, traders can limit their risk to a known and fixed amount. And, secondly, traders can profit from rising and falling volatility.
If a trader buys an option, their risk is limited to whatever they pay for the option. That is because, unlike a futures contract, an option gives the holder the right to buy or sell an asset, but there is no obligation. However, the risk is not limited for the trader that sells or writes the option.
One of the variables used to calculate an options price is implied volatility. This is a prediction of the volatility that the traders entering an option trade believe will occur during the life of the option contract. That means option traders can structure strategies to profit when volatility increases or decreases regardless of the direction of the market.
Options are a little more complicated than most other instruments, so we need to go over the jargon you will encounter with options trading, how to price an option, and how to structure a strategy. So, let’s move on to puts, calls, spot and strike prices, in the money and out the money and the other jargon to familiarise yourself with.
Puts Versus Calls and Other Jargon You Need to Know
Before you learn how to trade options you will need to learn which type of option to buy or sell. A put option gives the holder the right to sell an underlying asset at a specific price, known as the strike price. A call option gives the holder the right to buy an asset at the strike price.
If an option holder exercises their right, the option is exercised. In both cases, the trader that sold the option is the one that takes the opposite side of the trade once exercised.
In other words, if you buy an option, giving you the right to buy the underlying asset at the strike price, and you exercise the option, the seller of the option contract has to sell that asset to you at the strike price.
It’s easiest to have options trading explained by way of example. Let’s say a stock is trading at $10. A trader buys a call option with a strike price of $15 and expiry in 12 months’ time. The price or premium the trader pays for the option is $1.
That means that at any time in the next 12 months the option holder can buy that stock from the option seller for $15. So, if the stock price rises to $20, the option holder can exercise the option and buy the stock for $15.
In-the-Money and Out-the-Money Options
In the example above, the option holder will only want to exercise the option if the stock price is above the strike price, or $15. If the stock price rises from $10 to $14, there is no reason to exercise the option. Doing so would mean buying the stock for more than the market price. For a call option, if the spot price (the current stock price) is below the strike price, the option is out-the-money.
However, if the stock price were to trade up to $16, the option holder could exercise at $15 and sell the stock in the market for $16. When the spot price is above the strike price, a call option is in-the-money. The difference between the spot and strike price is the intrinsic value. Only in-the-money options have intrinsic value.
However, we need to remember that in the above example, the trader paid $1 for the option. So, exercising the option when the spot price is $16, will result in the trader breaking even. An option trade only becomes profitable when the spot price is higher than the strike price plus the option premium.
For put options, the spot price needs to be below the strike price for an option to be in-the-money.
When you learn how to trade options you will quickly discover things can get complicated. When doing an options broker comparison, you should look at the educational resources each broker offers – option trading is an ongoing learning curve.
Option Pricing Models: How Volatility Comes into Play
So far, this guide on options trading explained in-the-money and out-the-money put and call options, spot and strike prices and what a premium is. When learning
how to trade options you don’t actually need to be able to work out the price, as there are lots of online calculators that will do it for you.
The actual price an option trades at is determined by supply and demand in the market. However, an option always has a theoretical price for a given set of contract specifications. The most common formula for calculating theoretical option prices is the Black and Scholes model.
This model uses a normal distribution to calculate the probability of an option expiring at a range of given levels. It then calculates an average option value. The formulae which are available online take into account, the spot price, the strike price, the number of days until expiry, interest rates and most important the implied volatility. While most of the inputs are either certain or easy to predict, implied volatility is very subjective.
While option prices are determined by supply and demand, it’s worth being able to check the theoretical price to know if you are paying a reasonable price.
There is one last thing you’ll need to know about options trading: how to differentiate between American and European options. American options can be exercised at any time before expiry. European options can only be exercised on the expiry date.
Writing Options: Covered or Naked?
We should briefly mention option writing before going over strategies. When a trader buys an option, they are usually buying from the options writer (unless they are buying from someone else that bought the option previously.) While the buyer of an option has limited downside 0 they can only lose the premium – the writer of an option has an unlimited downside.
Writing options can be very risky unless the option position is hedged or covered. An option position that is not covered is a naked position.
In the example we used above, if the stock price were to go to $1000, then the writer of the option would lose $1000 minus the strike price of $15. All for a premium of $1! However, if they already owned the stock, they would not have to go out and buy it for $1000 when the option was exercised. In that case, if the owned the stock, their position would be a covered call. If they did not own the stock, it would be a naked call.
When you are looking for the best options broker for your needs, you should take into account the risk management tools they include to mitigate your risk if you write options. For instance, if you write a covered call, but your stock position is stopped out, you need to be able to automatically close the option positions to make sure you are not left with a naked position.
Basic Option Strategies
Now that you know the most basic facts about how to trade options, it’s time to talk about strategies. An option strategy combines put and call options with different strike prices and expiry dates to profit from a specific scenario in the market. A strategy can be designed to profit in almost any scenario that may play out. Of course, predicting what will happen in the market isn’t easy, but sometimes we can forecast the most likely way that things will play out.
We will start with a covered call which we already touched on briefly. But when would you buy a stock and write a call option together. Well, if you think the stock will go up over the long term, but might not move right away, you sell a call to earn extra money in the form of the premium. Hopefully, the option will expire worthless, and you get to keep the premium and then benefit when the stock price does go up. But if the stock goes up right away, you sell it at a profit, and still keep the option premium.
A call spread allows traders to benefit from the initial part of a rally cheaply. The trader will buy a call option, and write a call option with a higher strike price. That means the trader captures the price move from the lower strike price to the higher strike price.
More Complex Option Strategies
When you learn how to trade options you will discover that there are hundreds of strategies. Briefly here are some of the other strategies to know about:
If you own stocks and are worried there may be a selloff, you can hedge the position cheaply with a put spread or a zero-cost collar. A put spread entails buying a put with a strike price just below the spot price and writing another put with a strike 10 or 20 percent lower down. The written put help you pay for the bought put, and you are protected while the spot price falls from one strike to the other.
With a zero-cost collar, you sell a call at a higher level and buy a put with the premium you earn. That means you are hedged when the spot price falls, but you also lose any upside if the stock goes up.
If you think the price will stay where it is, you can sell puts and calls. That means that as long as the price doesn’t move too far, you earn premium from the put and call you sold. This is called a strangle or straddle. The strangle has identical strike levels, while the straddle has strikes a little way apart.
How to Trade Options
This article has covered all the basics you need to get started trading options, including the basic terminology related to options trading, how to decide on the right strategy to trade, and the theory behind options pricing.
You now know the difference between a put and a call, how to tell if an option is in-the-money or out-the-money, what the premium, spot price, and strike price are. You know the difference between European options and American options and you know the basics of writing options.
You know what implied volatility is and how you can use various option strategies to profit from rising and falling volatility. You know what a covered call is and when to use it, and you have a basic overview of straddles, strangles and zero-cost collars.
There is plenty more to learn as your trading advances. So, when doing a broker comparison make sure the broker you choose gives you access to more educational content.