If you’re the type of investor who prefers to take control of your investment journey, you will need to do a bit of study in order to understand the asset classes that are available to you. The most accessible asset classes to retail investors are stocks, stock options, futures, and foreign currencies.
Out of these four, stock options are by far the least understood because of the complexity of the options markets. For one thing, there are very special terms you need to know in order to get involved in options. After that, you need to understand that options don’t work like most of the other asset classes.
We’ll help you learn the terms and concepts you need then point you in the right direction to get started.
What Are Stock Options?
A stock option, or simply “option,” is a standardized financial contract agreed to between a buyer of the contract and a seller.
There is much more to it than that, but for now, it’s important to know that each contract has only one buyer and one seller. There are benefits and drawbacks to each side, but in order to understand these, let’s start by explaining what types of options contracts there are.
What Types of Options Are There?
While there are a few different ways that you can use them, there are only two types of standard options contracts.
· Call Option: The call option contract represents the right of the buyer to purchase 100 shares of the underlying stock at a predetermined price at some point in the future prior to the contract expiration.
· Put Option: The put option is just the opposite because it represents the right, but not the obligation, of the buyer to sell the underlying stock at a predetermined price at some point in the future prior to the contract expiration.
What Other Terms To Know About Options?
We already threw out a few terms that need to be defined, but feel free to refer back to this section as you progress through so you can fully understand the concepts later on.
· Derivative: An option is a derivative asset because its value is derived from the value of the underlying stock.
· Underlying: Speaking of underlying, any time this term is used in the context of options, it is referring to the underlying stock that the option represents.
· Expiration: Every stock option has an expiration, which adds to the complexity in a very particular way. Expirations for the most liquid options occur on a monthly basis, usually after the closing bell on the third Friday of the month.
· Strike Price: This is the predetermined price of the underlying at which the buyer and seller have agreed on the contract.
· At the money (ATM): This term means that the underlying stock is at the strike price agreed for the contract. If your AAPL options strike price is $150 and AAPL is trading at $150, your option is at the money.
· Out of the money (OTM): If the price of the underlying is above the strike price, the contract is out of the money.
· In the money (ITM): If the price of the underlying is below the strike price, the contract is in the money.
· Premium: This is the money paid by the buyer of an options contract to the seller. This is effectively the risk the buyer takes on for their position.
· Intrinsic value: When an option is not at the money, the intrinsic value is the difference between the strike price of the option and the current price of the underlying.
· Extrinsic value: This is the value of an option outside of the intrinsic value and usually refers to the “time-value” of the contract. The more time until expiration, the more value the contract will have.
· Debit: This refers to a type of position where you must pay a premium (you are the buyer) to open that position.
· Credit: This refers to a type of position where you receive a premium (you are the seller) to open that position.
What Are “the Greeks?”
The “Greeks” are several derivative measures of the risk associated with an option or several options contracts. Usually, a portfolio of options will be managed based on the investor’s pre-determined strategy. There are also “Vega” and “Rho,” but they are rarely used by even institutional investors.
This is the expected change in an option’s value for every dollar up or down that the underlying moves. If the delta of your position is 0.75, then your option will increase by $0.75 if the stock price goes up $1 or decrease by $0.75 if the stock price goes down $1.
Another way delta is used is as a guide for how likely an option is to expire in the money. A delta of 0.75 means that an option has a 75% chance of expiring in the money.
This is the measure of the time-value of money mentioned earlier. If a portfolio has theta value of -10, it is expected that the position will decrease by $10 every day that the options stay out of the money. The opposite is true of positive theta – +10 thetas means that the position will increase by $10 for each day the options are out of the money.
It’s also worth mentioning that the theta of out of the money contracts will decrease as the option approaches expiration.
Getting deeper, remember that all of these measurements are constantly changing with each change in the price of an underlying stock. Gamma is a measure of how much delta will change with each $1 of the change in the stock price.
In our 0.75 delta example, if the price of the stock does go up $1, then your delta is no longer 0.75 – it is higher because there is now a higher likelihood of your contracts expiring in the money.
Gamma will tell you how much delta will change as the stock price changes
How Do Options Work?
The term “option” is fairly self-explanatory because it gives the buyer of the contract the “option” to buy or sell 100 shares of the underlying stock at a predetermined price before expiration. Let’s explain from the standpoint of long and short options to help make it a bit clearer.
How Do Long Options Work?
When you’re talking about long options, it doesn’t necessarily mean that you are taking a bullish stance in the stock market or even in the underlying. When you are long an option you are buying either a call option or a put option. Let’s use a call option for an example.
When you buy (go long) a standard option, you have the right but not the obligation to purchase 100 shares of the underlying stock at a predetermined price at some point in the future but before expiration. More simply, you can choose to buy 100 shares at your strike price before expiration any time you want, but you don’t have to.
The reason this is important is because options are cheaper to buy than actually buying 100 shares of an underlying in almost all cases. Let’s look at AAPL – the ticker for Apple, Inc. stock and stock options. As of this writing, AAPL stock price is $146.15 per share. To buy 100 shares of the stock, it would cost you $14,615 to hold Apple stock. If your brokerage offers you a 50% margin, then that’s still $7,307.50.
If you think AAPL will be priced higher than $150.00 before September 2021, then you can buy the call option at the $150.00 strike price expiring in September 2021 which only costs a $460 premium, also known as a debit.
That’s only 3% of the price to buy 100 shares, and your maximum loss on the trade is only $460. If you’re wrong and AAPL tanks, it’s up to you whether you want to exercise your option to buy the shares, so all you could possibly lose is $460.
Going long (buying) puts works essentially the same way except you are betting the stock will go down. As the put option buyer, you have the right but not the obligation to sell 100 shares of stock at a predetermined price before expiration.
You would buy a put below the current price of AAPL at, for example $140, which would cost you a $390 premium. If the stock goes up to infinity, all you can possibly lose is the initial premium you paid of $390.
In either case, your profit is the difference between your options strike price and the price at which you sell the option, less the premium you paid for it. Here’s the profit equation for long options.
Long Call Profit = (Current Price – Strike Price)*100 – premium paid
Long Put Profit = (Strike Price – Current Price)*100 – premium paid
How Do Short Options Work?
Selling or selling short options is what makes the options market far more complicated to the other markets.
When you sell a call option, for example, you have the obligation to sell 100 shares to the buyer of the option if and when the buyer exercises their option.
In our AAPL example, if you think AAPL won’t close above $150.00 per share by the expiration in September, then you can sell the $150 strike AAPL option. You collect the $460 premium from the option buyer for taking on the risk. If AAPL drops or stays the same until expiration, you keep the whole $460 premium, also known as credit.
However, if AAPL continues up and the buyer exercises their option at $165, you must sell 100 shares of AAPL to the buyer at $150 and take on a short stock position at a loss.
Alternatively, you can sell put options which work much the same as selling call options. You’ll have the obligation to buy 100 shares of an underlying stock at a predetermined price before expiration. Here are the profit equations for selling options
Short Call/Put Profit (underlying is OTM) = credit received
Short Call Loss (underlying is ITM) = (Strike Price – Current Price)*100 + premium received
Short Put Loss (underlying is ITM) = (Current Price – Strike Price)*100 + premium received
What Is the Purpose of Stock Options?
Options were primarily created as a way for investors and even companies to hedge core positions.
A company with a strong reliance on natural gas, for instance, can buy options in the US Natural Gas Fund (UNG) to lock in future prices and hedge against dramatic changes.
Investors and even hedge funds use options because they provide an opportunity to buy cheap hedges against their core stock or other positions. While they give up some profits, they can lessen the sting of losses in the event the market goes against their expectations.
How To Trade Options?
There are several strategies for retail investors to use depending on their level of risk. Defined risk strategies are good for risk averse investors, but they offer less profit potential. Undefined risk strategies offer more profit potential but also potentially higher losses.
· Long Call or Put: This is the simplest defined-risk position as your maximum loss is only the premium you pay for the option
· Long (Debit) Spreads: For a call debit spread, this is done by buying a call at one strike price then selling another call above that strike price. You restrict profits but your maximum loss is also cut down to less than half that simply buying a call. This is a bullish position, but the same can be done in a put debit spread, which is a bearish position.
· Short (Credit) Spreads: For a call credit spread, this is the opposite of a debit spread – you sell a call and then buy another call above that one. This tends to have an inverted P/L expectation but a higher likelihood of seeing a profit. A short call spread is a bearish position and a short put spread is a bullish position.
· Iron Condor: This is done by opening both a short put spread and a short call spread around the current price of an underlying. It is a neutral strategy and profits when the price doesn’t change much.
· Short Call or Put: This is simply selling an out of the money option. While a short put theoretically has a defined loss if the stock price hits $0, it’s still a higher risk than the above section.
· Strangle: This is basically an iron condor without the protecting long call and put wings. You sell both a call option and a put option around the current price. It is a neutral position.
· Straddle: This is done by selling a put and a call at the same time at the current price. While this might not make much sense, you collect a huge credit for these types of positions, but they have a low likelihood of profit.
What Are the Best Platforms to Use for Options Trading?
· Tastyworks: By far the best overall for options traders, Tastyworks was designed from the ground up to be an options trading platform. The sister company, Tastytrade, also provides hundreds of hours of education for those new to options.
· TD Ameritrade: TD provides potential options traders with the best trading tools and provides an excellent platform that is relatively user friendly. They also provide education for those new to options.
· TradeStation: The desktop platform might be complicated, but traders can customize their platform to show the information they need. They also have relatively competitive commissions.
What Risks Are There?
Trading and investing always comes with risks. There are always risks with any stock in that the company you’re investing in can go bankrupt or release information that causes wild volatility in the stock price, especially around the company earnings reports.
Options also carry more risk because they provide investors with plenty of opportunity to use leverage. Some might say “why can’t I just buy options up to the $14,615 I would normally have to pay for AAPL?” This is a textbook overleveraging because this would mean buying 31 call options. Sure, the profit potential is huge, but stocks drop all the time. If AAPL can’t climb above $155 by the time of the September expiration, you lose all $14,000.
Options provide an excellent opportunity to those who want to hedge their core positions, need an added level of stability to their business operations, or simply to profit from options trading. There are several excellent platforms available, and most commission structures are very approachable, even to beginners.