Whether you’re a full-time trader or a beginner in the investment world, you’re probably wondering a few things about options trading. It’s a bit of a different game, and many market gurus believe beginners should stay away, at least until they figure out how things work.
This article is the ultimate guide for those interested in options trading. It will address some of the most common questions, explain various trading terms, and talk about options trading strategies.
The market doesn’t wait, so let’s begin!
What Is Options Trading?
Options trading gives the ability to investors to speculate about the direction of the stock market or particular securities in the future. Options trading is based on options contracts.
To put it simply - stock traders trade shares, real estate investors trade (buy and sell) homes, and options traders trade contracts.
Now, let’s dive in deeper.
What Are Options Contracts?
Options are an asset class, just like stocks, mutual funds, or ETFs. They’re contracts that give the investor the right to buy or sell the underlying asset. The investor is not obligated to buy or sell, but if they decide to, they have to do so on or before a certain date at a predetermined price.
The options contracts may be written on any underlying asset, regardless of its sort, including but not limited to commodities, bonds, and currencies. Typically, one option contract represents 100 shares.
Options Are Derivatives
You have probably heard the term derivatives, but you may wonder how they’re connected with options contracts. The short answer is - options are derivatives. In fact, they’re one of the several types of derivatives in the trade market.
What are derivatives?
Derivatives are contract assets with value based on another asset. They are contracts between two or more parties and can be used for multiple reasons.
They can be risky, as they depend on the fluctuations in the underlying asset. But they can also be a powerful financial instrument. This is why some field experts consider derivatives trading an advanced trading level.
Billions of dollars are traded in derivatives each year by both corporations and individual traders. They use these financial instruments for hedging, accessing assets out of their range, income, and leverage.
All underlying assets can be used for derivatives. However, the assets that are commonly used are stocks, commodities, interest rates, bonds, currencies, and market indexes.
Now, not all derivatives are the same. There are four major derivatives types. The options discussed in this article are one of the common types, while the other types are futures, forwards, and swaps.
Options Types
After taking a slight jump to explain derivatives in the previous section, now is the time to get back to the main topic - options and options trading. The reason why they belong to the derivatives group is that their value depends on or derives from the price of the underlying asset.
Previously in the article, you learned that options are contracts that give freedom to the owner to buy or sell shares of the underlying asset at a specific price. That specific price is called “the strike price”.
Now, each contract is different. However, options contracts are divided into two categories or types, those being put options and call options.
Let’s take a look at both types in more detail.
Call options
Call options, as a specific type of option, are contracts allowing the contract holder to buy the underlying asset at the strike price within the specified time period. It’s important to note that the holder is not obligated to buy the stock, commodity, bond, or another type of asset.
Investors buy these contracts in order to have the right to buy the asset. If they want to purchase a call option, investors pay a fee known as “a premium”.
Call options trading example
To understand how call options work, check out the following example.
The asset you want to buy a call option is stock. With the call options you’ll purchase, you’ll have the right to buy 100 shares of the asset at the strike price. You are allowed to buy those shares up until the date specified in the contract, which is also known as the expiration date.
For instance, if you purchase a call option contract of $15 per share for stock that’s trading at $150 per share, you’ll pay $1,500 for 100 shares. Now, let’s say the strike price of the stock is $20 up ($170), and you buy the contract with an expiration date set three months from now.
So, the stock has to reach over $185 per share ($170 strike + $15 premium) for you to profit by $10 per share. Moreover, the stock must surpass your break-even point (more this below) within a specific period and not after the expiration date set in your options contract.
If the stock reaches only $175, for example, you’ll lose a total of $1,000 ($10 per share), while the maximum loss may be $1,500.
Put options
Like call options, put options are also contracts whose value is derived from the underlying asset. The investor who wants to buy put options has to purchase a premium. The premium gives the holder the right to sell the stock at the strike price within a specified time period but not after the expiration date. Of course, the holder is not obligated to sell the stock.
Put options are a bit more complicated than call options. There are multiple factors that affect their price. For instance, the time factor is highly significant. The value of the put option decreases as the expiration date approaches because there’s less and less time to realize a profit.
Since the value of the put option goes higher as the price of the underlying goes down, these contracts are typically used for hedging as a part of a risk management strategy (protective put). The other reason investors use put options is to speculate on downside price action.
Put options trading example
To understand put options better, take a look at this simple example.
A stock of a particular company is trading at $100 currently. Suppose you want to bet that the stock will go down. So, you buy a premium for a put option, which costs you $5 per share, or a total of $500.
With this purchase, you obtain the right to sell 100 shares. You can decide whether to exercise the option or not.
In case you decide to exercise, and the stock drops at, let’s say, $80 per share, you’ll earn a total of $1,500. How?
The stock dropped from $100 to $20 and hit your prediction. Therefore, you earn $20 per share, which is a total of $2,000. You paid for the premium of $500, meaning your profit is $1,500.
In case you don’t own the stocks, you obviously can't sell them. However, you can sell the option contract to another investor, which basically is the point of options trading.
What Is Break-Even Point in Options Trading?
A break-even point is the asset price that has to be reached so the option holder avoids a loss. The break-even point is different for call options and put options. For call options, the asset has to go higher than the strike price, while for put options, lower.
This is the shorter explanation, of course. In the following subsections, you can find out how break-even points are calculated for call and put options.
Break-even point for call options
When it comes to call options, the break-even point is the minimum price the underlying asset has to reach for the holder to avoid loss. Of course, this applies to cases where the holder decided to exercise the option.
Simply put, the asset price has to go up, at least to the point where you won’t profit, but you’ll avoid a loss.
The calculations are simple. Add the price you paid for the premium to the strike price of the option. The number you’ll get is the break-even point. For instance, if you buy a $10 premium for an underlying asset currently trading at $100 with a $150 strike price, the break-even point would be $160.
Let’s not forget that the premium gives you the right to buy the stock at $100 before the options expire. If the stock is trading at $180 and you buy at a $150 strike price, there’s a $30 difference. Your profit is $180 (market price) minus $160 (break-even point), or $20 per share.
Break-even point for put options
The meaning of the break-even point for put options is the same as the break-even point for calls. The difference is that the price of the underlying asset has to go lower than the strike price for you to avoid a loss.
To reach the break-even point for put options, the underlying asset price has to be equal to the strike price minus the premium. Here’s an example.
Suppose you buy a $10 premium for a put option with a $150 strike price. The break-even point of this option would be $150 minus $10, or $140 per share. If the stock trades above that point, your options contract is not exceeding its cost.
If the underlying asset price goes down to $140, you’ll reach the break-even point (no win, no loss).
However, if the market price goes down to $130 per share, you’ll profit. To calculate your profit, you should subtract the current market price ($130) from the break-even price ($140). Your profit is $10 per share or a total of $1,300.
Intrinsic Value Explained
Intrinsic value is the exact value of an asset. This doesn’t necessarily mean that it’s equal to the asset's current market price. The intrinsic value actually shows the worth of an asset without the price being affected by the market’s whims.
The difference between the current asset price and its intrinsic value helps investors to get an idea of whether the asset is overvalued or undervalued.
When it comes to options trading, the intrinsic value of the contract is the difference between the underlying and the strike price, with the bottom of zero. What does it mean “with the bottom of zero”? It means that the calculated value only measures the profit. If the number is negative, the value is zero.
The intrinsic value is important for options trading because it can be used to determine how much profit currently exists.
How to calculate the intrinsic value of calls
The math for calculating the intrinsic value is rather simple.
IV = asset current price - strike price
Let’s see an example:
You buy five options with a $30 strike price for an asset that currently trades at $35 per share. Keep in mind that your purchase gives you the right to buy 100 shares of stock per option. Now, let’s calculate the intrinsic value.
IV = ($35 - $30) x (5 options x 100 shares)
IV = ($35 - $30) x 500
IV = $5 per share or $2,500 total
It’s crucial to note that this number is not equal to the exact profit because the intrinsic value doesn’t include the initial cost, that is, the premium. Instead, it shows how in-the-money your option is when the strike price and the market price of the underlying asset are considered.
How to calculate the intrinsic value for puts
With puts, the math is reversed. Put options have intrinsic value or, as we say, are in the money if the strike price is above the current price.
IV = strike price - current asset price
Here’s an example:
You buy a put option with a $20 strike price for an asset currently trading at $16.
IV = $20 - $16
IV = $4 per share or $400 total
Extrinsic Value Explained
The value of options contracts is composed of two parts, those being the intrinsic value and the extrinsic value. As you saw above, the intrinsic value shows how much the option is worth at the moment.
On the other hand, the extrinsic value, as the name suggests, represents the other external factors that can impact intrinsic value. Although the worth of an option depends on the underlying asset price, other external factors, such as time and volatility, can also influence a portion of the option’s worth.
Time value
Unlike stocks, for instance, options have expiration dates. So, time is crucial and directly impacts the extrinsic value of the contract.
Typically, the contract gradually loses its value as the expiration date approaches. That’s because the underlying asset has less and less time to move.
Volatility
The other factor that influences the extrinsic value is implied volatility. Implied volatility is a term that refers to a metric. This metric seizes the market’s opinion on a particular asset’s price changes.
Simply put, it’s the expected volatility of stock within the options contract timeframe. You should keep in mind that historical volatility is not the same as implied volatility since the former shows actual results, that is, changes that have already happened.
How to calculate the extrinsic value of the option contract
If you want to calculate the extrinsic value, you should subtract the intrinsic value of the total option premium. Therefore the math will depend on whether you have a call or a put option.
Extrinsic value = total option value - intrinsic value
For calls: EV = total option value - (market price - strike price)
For puts: EV = total option value - (strike price - market price)
What Are Greeks in Options?
The four letters from the Greek alphabet that are used in options trading are delta, gamma, vega, and theta. These letters, known as the “Greeks”, represent a set of risk measures and can indicate the sensitivity of an option when time decay, implied volatility, and asset price changes are considered.
What are delta and theta in options?
Delta shows the change in the premium’s price that resulted from a change in the underlying asset. Delta’s value ranges from -100 to 0 for put options and 0 to 100 for call options.
Theta is used for measuring the impact caused by a change in time. As discussed above, options operate within a time frame, which is why the remaining time (until the expiration date) has a significant impact on the value.
Gamma and vega
Another Greek in the set of risk measures is gamma, which measures the rate of change in delta over time. Although it sounds a little confusing, this Greek is necessary because delta values change constantly. So, gamma measures the rate of the changes in order to present the investor with an idea of what to expect.
Lastly, vega measures the risk coming from changes in implied volatility. It’s different from delta because it measures the expectations and not the current price changes.
How to Trade Options
With so many terms, possibilities, and risks, options trading is considered difficult for beginners, requiring advanced trading abilities and knowledge. That’s now necessarily true because, despite many variations, in the end, options trading offers four trading positions.
Since there are two types of options - calls and puts - the four basic positions of options trading would be buying or selling calls and buying or selling puts.
If the trader buys options contracts, whether calls or puts, they’re called “options holders”. The trader who sells options is known as “a writer”. The holder buys premiums, but they’re not obligated to buy or sell the underlying asset.
On the other hand, the writer is obligated to buy or sell in cases where the option expires in the money. Sellers are exposed to more risks than holders, and they may lose more money than the actual premium price.
How to read an options table
Learning the terms found on the options table is the first step you should take if you want to enter the options trading game. On a regular table, you’ll see terms like “strike”, “last price”, “bid”, and “ask”.
The term “strike price” is already discussed previously in this article. That’s the price the underlying asset has to reach, and after buying the contract, you’ll have the right to buy or sell the shares at that specific price.
Next in the table, you’ll find the term “last price”. This doesn’t refer to the stock, but to the last price the option contract traded for. You should also keep in mind that the last price is not necessarily the price you’ll be able to trade the option.
Next in line are the “bid” and “ask prices”. These numbers can be good indicators of the trade’s price at the moment. The former refers to the highest amount some investor is willing to pay for the contract. The latter refers to the lowest amount anyone is willing to accept to sell the contract.
How to Start Trading Options
Create an options trading account
You can’t start buying calls and puts and begin your options trading journey at once. First, you need an options account, meaning you’ll have to apply to open one.
To apply, you have to complete a questionnaire with details about your investing experience, net worth, income, etc. After the broker reviews your application, they may grant you approval.
In case you don’t get approved, you’ll be allowed to trade by using a restricted account and reapply for approval later.
Options trading requirements
As stated previously, the broker may grant you approval based on your application. This means that there are requirements you have to meet in order to be able to trade options.
You have to provide:
- Investment objectives (may include income, capital preservation or speculation, growth)
- Experience (how long you’ve been trading, how often you trade, your trade knowledge, size of trades, etc.)
- Personal information (financial information such as net worth, annual income, employment information, etc.)
- Options types you want to trade
Pick options
Now, this is the part where you start analyzing. You have to research carefully and pay attention to everything, starting from, let’s say, a particular company’s announcements, or upcoming events, earning releases, dividend yields, etc.
Ask for help
Options trading is a lot more than buying call options if you think the stock will go up or buying put options when you think the price will go down.
So, finding an option-picking service can be beneficial. Instead of going one stock after another yourself, there are services focused on options trading that can comb the market for you.
Here at Foolproof for instance, we are focused on options trading and constantly analyze the market, to notify our clients when to make a move.
If you choose this service, you’ll receive three alerts per week (you may receive more, depending on the market) in the form of a message. The message will contain the ticker symbol, options type, strike price, and even a suggested trade idea. You’ll also be notified about the estimated time for the trade to pan out.
Our plan costs only $97 per month, and besides the trade alerts, it includes full support and guidance. You can try it out for free with our 14-day free trial.
Conclusion
The reason why options trading is attractive to many traders is the ability to earn a lot of money at once. Moreover, with this trading strategy, you can lose the money you paid for the premium, which is a significantly lower amount than trading and losing with stocks.
However, as stated multiple times previously in this article, stock market experts are not wrong when they say options trading requires a lot of experience and options knowledge.
Since there are many potential benefits from this trading, but it can be challenging to keep up, it’s always recommended to find a service, like FoolProof, to help you catch the changes in the market and make a move before it’s too late.