How Do Options Work?

How exactly do options work? ⚙️

This wasn’t a question ordinary investors normally used to ask. In the past, options trading was once considered ill-advised for anything but savvy financial professionals. 

However, times they are a-changin’ 🎸 (apologies to Bob Dylan). As trading volumes have risen over the years, inquisitive investors started to dip their toes, tentatively at first, into the largely unexplored options trading pool. But once the dam was broken, it was followed by an influx of specialized brokers.

As a result, option contracts started to become increasingly popular with the ordinary, rank-and-file investors. In 2018, one of the largest financial derivatives markets reported that in a single month it had over 20 million contracts, representing a 38% year-to-year increase. In addition, their average daily volume almost tripled to a record 739,000 contracts!

Since options have moved from the fringes to the mainstream of financial markets, this article is intended to shed light on the fundamental knowledge required to trade them.

What is Options Trading? 🤔

Options are contracts that give an investor a right to buy or sell an underlying security at a predetermined price and date, respectively known as the strike price and expiration date. 

Whenever someone exercises that right, another party is saddled with the obligation to perform. For instance, a call buyer has an opportunity to purchase stock, while the call seller gets the money along with the obligation to perform (in this case, supply the requested stock).

A put buyer has the opportunity to sell stock at the strike price, while the put writer (to write means to sell) sells the put option to the buyer and obligates herself to buy the shares in the event that the strike price is exercised by the buyer.

Option contracts are created on exchanges such as NYSE, or NASDAQ. They share a common denominator of standardized features and core concepts such as the following:

• ☑️ Their type, whether they are call, put, or binary options
• ☑️ The number of shares (generally standardized to 100 shares per contract).
• ☑️ Expiration date (for standard monthly options, 3rd Friday of the month).
• ☑️ The underlying financial instrument, whether a stock or Exchange Traded Fund (ETF).
• ☑️ The strike price represents the predetermined price set.
• ☑️ The premium or price of the option contract isn’t fixed.
• ☑️ The long position owns the security and stands to profits when prices go up.
• ☑️ The ability to exercise the option contracts rests with the long side of the contract.
• ☑️ When the option contract is initially bought or sold, the long side of the option contract pays the price of the contract as a premium to the short side of the option contract.

Though you might have now grasped the fundamental concepts and terms of options, your work is just beginning. In order to be a successful options trader, you need to be able to make three strategic choices:

Are Options Better than Stocks? ⚖️

The fundamental difference between options and stocks is that stocks provide the holder with a piece of the company’s proverbial pie by giving the possessor of the stock a small amount of ownership. While stocks provide outright ownership, options are first and foremost derivatives that define their existence based on securities like stocks.

While options don’t give the holder ownership, they are contracts that grant them the right to either buy or sell the underlying stock. 

So, which is actually the better financial instrument of the two?

As the means to the end of making money, options trading is a much more complex endeavor compared to stock trading. With stock trading, you typically decide what stock you intend to buy, inform your stockbroker to fill the order at either a certain limit price or at the prevailing market price. 

Options trading incorporates some of these elements, but also requires having to deal with the hurdles of opening an options account. These bureaucratic hurdles are due to the complexity of its different moving parts and the amount of capital required as a minimum for meaningful options trading. 

While the advantages of stocks are largely limited to company ownership, options, on the other hand, are like a swiss-army knife. The most popular options brokers provide investors with more tools and versatility to achieve different financial goals.

As financial instruments, options are similar to purchasing insurance to protect your portfolio; something, by the way, which stocks are incapable of doing. 

Options Can Be Used to Protect Stock but Not Vice-Versa

A key aspect of options trading is the following: options protect stocks by setting a “floor” that will protect your stock holdings in the event of  market collapse. 

For reasons of speculation, let’s assume a risk-averse but nonetheless calm investor known as Mr. John Q, bought 1,000 shares of an innovative startup tech company, ABC two years earlier in December at the cost of $20 (a total of $20,000).

Who knew that investing in Canva would have been a good idea a couple of years ago. The company’s value has been estimated at a staggering $40 billion and is thought of as the world’s most valuable software startup.

Good fortune smiled on him, and ABC stock is now trading at $125 a share, representing a present total capital value of $125,000. Ordinarily, this should be cause for jubilation at the astronomical gains he has made, but somehow Mr. John Q is feeling nervous. 

There are two voices in his head, each giving conflicting and contradictory advice. 

One voice belongs to the aggregate opinions he hears from stock analysts opining how the ABC company will be hugely successful because it is currently the industry leader in some emerging, cutting-edge internet infrastructure that will be the foundation of future growth.

The Second Voice 💭

The other voice is Mr. John Q skeptical conscience, reminding him how he lost a whole lot of money during the internet bubble. His thinking is that if ABC’s current price is based upon projections of explosive growth in internet demands for its product, what happens when that demand slows down? He has been burned before, and so he worries that ABC stock might be overvalued if demand for its product cools off.

While Mr. John Q enjoys the fact that he is now richer, he is nonetheless bothered that this good fortune could be somehow short-lived. After all, he is primarily a buy-and-hold investor who isn’t accustomed to seeing huge leaps in yields when it comes to his investment portfolio.

For a moment he considers selling his shares but resists the urge because he still believes the ABC stock still has a good run in it. Therefore, he wants to profit from this growth potential as long as it lasts.

How do You Hedge a Stock Position with Options? 💡

This is where option contracts come in. Because of options, instead of selling his shares, Mr. John Q can decide to protect his portfolio of ABC stock by purchasing 10 ABC December 100 put options. This position guarantees Mr. John Q the right to sell his ABC stock at $100 in the event that the price of the stock falls below this price at the December expiration date.

Since one option contract is equivalent to 100 shares of the underlying stock, all John Q’s bases are covered with regard to the 1,000 ABC stock that he owns. The $100 protection represents the “floor” for his ABC shares. But just as insurance isn’t free, neither is this protection; it is costing John Q $2,000 ($2 per share) as the premium paid in order to protect a $125,000 position.

Protecting Stocks with Options Explained 🛡️

There are two possible outcomes from this:

Outcome 1: ABC’s stock price stays above $100 📈

With the price above $100, John Q can sleep safely at night since he is happy that the market hasn’t taken away his money. Just like a car owner who purchased vehicle insurance but didn’t get into an accident, John Q paid a $2,000 premium he didn’t ultimately need.

Outcome 2: ABC’s stock price stays above $100 📉

If ABC’s stock price falls below $100, John Q is covered because he has an insurance policy in the form of his put option contract that guarantees him the right to sell his shares at $100. While the drop in price has decimated the account of other less prescient ABC shareholders, John Q has avoided their fate.

A Tale of Two Questions 💲

However, two questions immediately come to mind as to the choices made by the investor. The first is why didn’t John Q set the floor at $125, the current price ABC stock is trading at, but instead at only $100? It seems as if the trader would have been better protected by setting the floor at the higher price, right?

Well, not exactly, because investments are a game of tradeoffs. Better protection, just like better insurance costs more money.

Assuming John Q had bought 10 ABC December 125 put options, instead. This would obviously set the floor at $125, but instead of just paying $2 a share, he would now have to pay a much higher value, $16, for that privilege, which now translates into a total option premium cost of $16,000.

This is clearly a prohibitive increase from the $2,000 he would have had to pay for the erstwhile $100-floor protection. Therefore, it makes sense for John Q to avoid this huge expense by decreasing his protection by $20 and correspondingly, the cost of the premium he has to pay.

The second reasonable question is to inquire why didn’t Mr. John Q simply follow the easier route of placing a stop order to sell those stocks at $100? With a stop order, John Q could have simply informed his broker to sell the ABC stock as soon as it traded below or at the trigger price of $100. 

However, there are holes in this strategy. While this might theoretically protect John Q from a market downside, it plays out differently in actual events.

Assume for a moment that ABC stock had a closing price of $105.50 on November 16th. The following day, however, the market opened with ABC stock trading at $85. Then John Q would have still ended up selling the shares at $85 despite the stop order trigger price of $100.

Why Do Investors Use Options? 💰

There are three main options trading strategies. In essence, investors treat options as financial instruments — and these are utilized for speculation, hedging, and leverage.

Speculation 💸

Speculating on the market with options enables an investor to make money not only when stock prices go up, but when they go down or sideways. It entails betting on the movement of a stock or security. 

Unless you’re a savvy investor with lots of experience under your belt, you should steer clear of speculation because it is a double-edged sword; although it is where big money is made, it is also the territory where it can be lost. 

This downside is what has earned options its reputation as being risky investment instruments. This is because, as we shall see later, to successfully speculate with options, you not only have to be right in the direction of the stock, but you also have to anticipate the timing and magnitude of this movement.

There are several moving parts to juggle in order to succeed with speculation: the investor must accurately predict the stock movement; whether it will go down or up. She also has to be correct regarding how much the stock price will change, including the timeframe for all this movement to happen. 

Which begs the question as to why people would venture to speculate with options since the odds of the “game” appear to be so skewed against them? This brings us to the next reason investor use options:

Leverage 💳

Leverage enables an investment to punch above their weight, figuratively speaking. When an option is controlling 100 shares with one contract, any slight price movement in those shares can generate significant profit.

One of the characteristics of options that make them ideal as a source of leverage is their relative cheapness in comparison to stocks. Options allow a trader to be able to control a large position in stocks compared to what she would have been able to get owning the underlying stock.

For instance, Sarah Jane has $2,000 and wants to invest it in buying ABC stock. ABC is currently trading at $50, so that means her capital will net her 40 shares ($2,000/$50), not considering commission costs. 

Broadening Options 💵

However, Sarah Jane decides to broaden her options (no pun intended) and looks into option contrasts. She discovers that there is an ABC call option with a strike price $50.

This particular option contract expires in four months and costs $2 per share. Taking this position with options will allow Sarah Jane to effectively control 1,000 shares of ABC ($2,000/$2), which is a substantial improvement over purchasing 50 shares.

This much larger proportion of stock under Sarah Jane’s control provided with options means that even little losses or gains in the stocks underlying movement are acutely magnified. For example, if ABC stock price drops down even by a dollar to $49, Sarah Jane’s share capital will be worth $1,960. 

Conversely, in this scenario, with regard to the option contract, the impact will be more catastrophic: it will be worth $0, in effect losing all the money for Sarah Jane because no one in their right mind will exercise an option so they can purchase a stock at a price greater than the current value.

Hedging and Risk Management with Options Trading 💶

Another main reason investors use options is as an insurance policy. Hedging allows them to protect their portfolio from a market downturn. While insurance policies are seen as necessary, even mandated by the law for depreciated assets such as vehicles, hedging with options has attracted its fair share of critics.

This school of thought argues that if you are so unsure of the stock you pick that you need to hedge on it, then you’re probably making the wrong investment. This also induces the craze around options trading during the pandemic to a new high.

Nevertheless, hedging strategies can be useful, even indispensable for big institutions. But despite the critics, it is the opinion of yours truly that hedging can benefit individual investors also, if done right. 

In a nutshell, hedging simply entails trying to take advantage of the upside of a stock, while also simultaneously striving to limit any unforeseen losses. 

Options are an ideal vehicle for this because they provide a cost-effective means of restricting the downside effect of stock movements while equally benefiting from the upside.

More comprehensively, it involves mitigating some of the unwelcome risks associated with the stock market, including the option delta and vega. To understand the risk associated with an options trade, individual traders or firms can employ the Black Scholes model to evaluate this risk. 

As a mathematical model, Black Scholes is used to establish the theoretical value or fair price for dynamic financial instruments, especially derivatives such as call or put options.

The specific details of how it works are beyond the scope of this article but suffice it to say that the Black Scholes model works to price European options. However, Black Scholes doesn’t take into account the fact that US options are able to be exercised before the expiry of the option contract.

Income 💴

Being able to generate a fairly regular income is one of the goal standards of options trading. One of the logical places to start, especially for stock investors or those coming into their own with options trading is covered calls, since it presents a similar scenario that most of them are already used to.

When properly selected, call options are equally capable of generating income for a trading account. But as a cautionary note, the call option risk profile along with broker requirements make calls a difficult strategy to pull off. 

How Do Options Work? 🏦

It is important that traders, especially those still learning the ropes, are aware of the pitfalls involved with trading options.

Unlike stocks, there are a lot of factors to be considered before placing an order for an option. It isn’t as simple as a trader just purchasing, say, a call option, and automatically expecting to earn a profit when the stock price rises. Much more is involved. 

In a nutshell, these are the things an options investor should do if they want to make successful trades:

• ☑️ Don’t hold options for too long; they are time depreciating assets.
• ☑️ Ensure your option’s strike price is reasonable by understanding the stock’s volatility.
• ☑️ Since wide markets are difficult to trade, ensure the bid/ask spread isn’t too wide.
• ☑️ Based on your expectation of price increase, ask yourself whether purchasing options at the price you intend gives you a fighting chance to make money.

A Proper Example 🤲

Assuming there is a particular stock (WNR) an investor has been following with keen interest, and it is currently trading at $62.50. The investor foresees good things for the stock and believes its fortunes are about to get a lot better. In anticipation of its upward swing, the investor might decide to open a brokerage account and purchase 10 WNR call options. 

They expire in 60 days and the strike price is $70. The investor can hardly wait for the money to start rolling in. 

Unfortunately, there is a high probability that when the expiration date arrives, the option would expire worthless. The once exuberant investor- and this also applies to some experienced options traders too – has lost all her money. 

This investor might find what happened befuddling because, for the main part, her inclinations were right: WNR stock increased and 60 days after the options purchase, it settled at $66. 

But the trader failed to anticipate whether the trajectory of the stock would gain enough momentum to zoom past the strike price come expiration.

While the investor correctly predicted the stock price increase of WNR, however, she still lost money because she failed to anticipate how much the price needed to change in order to earn a profit. 

This is why understanding volatility is an important ingredient of successful options trading.

Volatility and Price Movement with Options 💷

Based on WNR’s price history, was it reasonable for the trader to expect its stock to make such a leap in 60 days to $70, which represents almost an 18% increase in such a relatively short period of time? 

An experienced options trader would have tried to understand WNR’s volatility, probably from gauging this information by examining the stock’s daily average price change. It was probably a wrong decision to purchase out-of-the-money (OTM) call options with a strike price of $70 in 60 days if WNR’s average stock price moves only $0.05 per day!

While it is the choice of most traders to buy OTM call options (those with stock price currently below strike price), because they assume their forecasts are right and seek to purchase the cheapest options. 

The lesson here is to be careful how volatile a stock has been while dealing with options

How Options Make and Lose Money 💱

One of the main allure of options as financial instruments is their leverage potential. 

As depicted in the earlier section on leverage, options allow investors to deploy or leverage a huge quantity of stock without the hassles of coming up with the corresponding large amount of capital required to purchase the stock. As a result, those who own call options can seize the opportunities presented by movement of the underlying stock without having to grapple with an equal amount of risk. 

In addition, holders of strong stock option contracts have several strategies at their disposal which they can use to protect against potential market downswings.

Take a Look at Our Example 👁️

Now, let’s get down to the nitty-gritty. Assume there’s a company, let’s call it Mayo’s Tequila Co. (MTC). MTC is currently trading at $57 and the premium call price is $2.25 for an August 60 Call. This call indicates that its expiration is on the 3rd Friday of August ending with a strike price of $60. 

A stock option is a contract to purchase 100 shares of the underlying stock. Therefore, the total cost of this contract would be $225 ($2.25 x 100). However, a trader also needs to take into account the commissions charged, but we’ll set this aside in this illustration. 

For the call option to be worth anything (to be in-the-money) the stock price will have to rise above the strike price of $60. In addition, in order to break even, the stock price will have to at least reach $62.25. This break-even price is obtained by factoring in the option premium ($60 + $2.25), and represents the price at which the investor will start earning a profit.

Buying the Option 🛒

When the trader buys the option, and the underlying stock price of MTC is $57, the contract is said to be on-the-money. If the stock remains at this price after the option’s expiration date, the contract expires worthless: remember the trader invested $225 in this transaction and loses the entire amount. 

Assuming that three weeks later, the MTC stock price climbs steadily to $68. Consequently, the value of the option contract will increase along with the MTC’s stock price; as a result, the option contract, which responds to changes in market value, is now worth $7.15 instead of $2.25. Therefore, the total contract purchase is now worth $715.

The trader’s profit for MTC after subtracting what was paid for the contract currently stands at ($7.15 – $2.25) x 100 = $490. In just three weeks, the investor who purchased the MTC August 60 Call has almost doubled their money! 

The Decision 🛍️

The trader can decide at this point to sell their option, which is called “closing the position,” and take their money and run. However, if the investor thinks that MTC’s stock price is going to continue being bullish, then she might decide to continue to go along for the ride.

Worst case scenario, and the expiration date arrives but against your projections, the MTC stock tanks and the price of its stock is now $52. Remember that with option contracts, you are in a race against time because of.

Since the stock price is below the strike price, there is no time left and therefore, the option expires worthless. In this case, it is said to be out-of-the-money.

As a result, the investor finds herself down by $225 (plus commission paid) after waiting eagerly for months in the anticipation, only to be let down by losing all that money.

This is what the investment looks like in tabular form:

This example illustrates how options make money for investors. It is mainly through leverage: as we observed, the price swing for the duration of the contract from its high to its low was $715, providing the trader with twice the value of her investment. 

How Much Money Do You Need for Options Trading? 🧠

There is an old saying that trading is “the hardest way there is to make easy money.” While understanding the mechanics of how options work is crucial, it is important to note the financial as well as psychological aspects of options trading. 

There is nothing worse than a trader taking too much risk without a single clue how to handle it. For options traders just starting out, this can become quite the problem. Even if an investor is flush with cash and intends to dabble into options trading, there are several factors to consider other than having the financial wherewithal to place a transaction or a bet. 

The prospect investor needs to be psychologically prepared for the inevitable ups and downs, the good and the bad times that come with trading with securities.

A trader needs to also factor in commission and fees, especially when just starting out as these have a much higher impact on smaller accounts. So, there isn’t actually a minimum, but it is always advisable to start small no matter how much the new trader has at their disposal. 

If an individual is new to options trading, it is better to start with say, $500 and gradually build up the experience and knowhow. There are various strategies that can be traded that don’t require a substantial amount of upfront investments to start.  

Why Do Options Make More Money? 💰

Options operate as leveraged instruments and therefore stand to make their investors a lot of money. However, they are a double-edged sword, because just as they can amplify gains, they can also substantially amplify losses. 

We’ve talked about leverage, hedging, and speculations, but how exactly does the average Joe investor profit from options transactions? Well, either through exercising or selling the option contract.

We have seen what happens when an option expires worthless when the stock price fails to ascend higher than the strike price at expiry. But the truth is, not all traders wait till the expiration date to cash out. In fact, in most options contracts aren’t exercised (used).

In the MTC example we illustrated earlier, the investor could decide to profit by exercising at the strike price of $60, and then proceed to sell the stock back to the market at the current value $68, thereby realizing a profit of $8 per share. 

On the other hand, the investor may decide to keep the stock instead of selling, since they have in effect purchased them at a discount to the prevailing value. 

Most of the time, however, the majority of traders tend to prefer making profit by closing out their position; which in essence means selling the option contract in the market, with option writers buying back their positions to close. 

Some estimates have it that as much as 30% of contracts expire worthless; this should put in perspective the failure rate a prospective options trader has to overcome in order to make gains. About 10% of option contracts are exercised, while 60% are closed out. 

Option contracts also make money because they provide investors with creative means to play off the strengths and weaknesses of the market. Options have birthed many strategies, which allow investors to leverage options. 

For strategies such as call option contracts, the risk to reward ratio is astronomical. This is because even if the underlying stock falls to zero, you’ll only lose the premium paid. But if it rises much higher above the strike price, 

These strategies allow traders to make more money by limiting the downside and maximizing the potential of investments through leverage.

Conclusion 🏁

Options do a lot of things that other financial instruments are incapable of providing. Options permit the integration of various investment strategies that allow traders to achieve different goals and objectives. 

They enable investors to purchase investments at an optimum price with far much less money that they would have had to utilize with comparable stock.

They provide the ability to protect those investments with hedging strategies that shield a portfolio from the vagaries of the market. 

Therefore, understanding option contracts and how they work is important for the investor who wants the versatility they provide.

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