Investing > What is Options Trading?

What is Options Trading?

This guide will help you discover what options trading is, how it can help you meet your financial goals, the pros and cons, fees, and more.
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Updated September 04, 2020

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Options trading can seem mysterious and even overwhelming at the beginning, but as long as you understand the basics, it’s (really) quite simple. Investor portfolios typically comprise several different asset classes.

These can include stocks, ETFs, bonds, and maybe a couple mutual funds. Options are a separate asset class, and so long as you use them in the right way, they can bring lots of advantages that other assets on their own cannot.

In this guide, we’ll go through how options trading work, the types of options and the difference between U.S and European options. For example, in the U.S you can exercise options at any stage after you buy them up until their expiry date. In Europe, however, options can only be exercised on their expiry date. 

We’ll also highlight the pros and cons of trading, and go through some of the key strategies for options trading to help you get the best results. Most importantly, we’ll go through what to prioritize when looking for a broker, including fees, customer support and research.

Overview & Summary

  1. Options are contracts that give the holder the right, but not the obligation, to either buy or sell an underlying asset at a fixed price one or before the expiry date.
  2. Options can be categorized in two ways: Short-term and long-term. Short-term options expire in about a year. Long-term options have expirations of more than a year, and are known as LEAPs (long-term equity anticipation securities).
  3. Options are a part of a wider community of securities called derivatives. The price of a derivative depends on the price of something else. For example, orange juice is a derivative or oranges, chocolate is a derivative of cocoa, and a stock option is a derivative of a stock.
  4. The safety of options trading is a key component of the positives of options trading.
  5. The risk associated with options trading can be interpreted in a few different ways. But, in essence, the risks all circulate around how volatile or uncertain the market is.

What is Options Trading?

Options are contracts that give the holder the right, but not the obligation, to either buy or sell an underlying asset at a fixed price one or before the expiry date. Options can be bought in the same way as other assets through a regulated broker.

Options have the ability to transform a traders portfolio in a powerful way. They do this through protection, added income, and leverage.

In many cases, you can find an option that will help meet an investor’s individual goals. One of the most popular examples of this is using options to hedge against a declining stock market in order to minimize losses.

Some traders use options to help create an ongoing income. In addition, options can be used for speculative trading, like betting on whether a stock will increase or decline.

It gets very complicated, very fast however. That’s why it’s imperative to learn how to trade options before getting your feet wet.

How Do Options Work?

In terms of the value of option contracts, essentially, it all comes down to determining the probabilities of future price events. The more chance something has of happening, the more expensive the option will be to make a profit. For example, the value of a call increases as the stock (the underlying asset) increases. Once you understand this concept you understand the relative value of options.

The closer an option gets to expiry, the more its value drops. This is because the closer it is to the expiry time the less there is of a price move in the underlying stock. For this reason, an option is a wasting asset. Should you purchase a 2-week option that is out of the money, and the stock remains the same, the option loses its value with each day that passes.

Given that time is a key component of how valuable an option is, a one week option is going to be worth less than a one month option, and so on. Again, this is due to the fact that more time offers more of a chance for the price to move in your favour, and vice versa.

In accordance, an option strike that expires in one year will be worth more than it will for 6 months. Options are a wasting asset because of time decay; a measurement of the rate of decline in the price of an options contract as a result of the passing of time.

Another aspect that increases the value of an option is volatility. This is because the more uncertain something is the higher it pushes the price outcome.

If an underlying asset becomes more volatile, bigger swings could cause substantial movement in either direction. Bigger swings increase the possibility of an event happening.

Thus, the more volatility, the more the option will be priced at. Volatility and options trading are intertwined as such.

On a lot of the U.S exchanges, stock option contracts offer the choice to either buy or sell one hundred of shares; for this reason you will need to multiply the contract premium by this number (100) to reach the total price of each call.

What Happened to Our Option Investment

May 1May 21Expiry Date
Stock Price$57$69$62
Option Price$2.10$6.20worthless
Contract Value$215$420$0
Paper Gain/Loss$0$405-$315

In most cases, holders decide to exit the trade and take the profit (closing out). This means that options are sold on the market by the holders and writers purchase their position to close.

In fact, just about 10% of options are exercised, 60% are closed out, or traded, and 30% expire to $0.

Option that fluctuate can be understood by intrinsic value and extrinsic value, as referred to as time value. A premium is a mixture of the intrinsic and extrinsic value. The intrinsic value of an options contract is also the in-the-money amount, which is the amount the stock is trading above the stock price.

Time value is a representation of the additional value an investor pays for the option above the intrinsic price. We can think of the value of an option as so:

Premium = Intrinsic Value + Time Value
$7.35 = $7.00 + $0.35

In reality, options nearly always trade at a level beyond the intrinsic value due to the fact that the probability of an event occurring can’t be completely zero, even though it might be very unlikely.

Types of Options

U.S. and European Options

Options in the U.S can be exercised at any time from the time you buy them to the expiry date. Options in Europe work differently as they can be exercised on their expiry date only. The only distinction between U.S and European options then is when you can exercise the option.

A lot of options on stock indexes are European. Because exercising your option early holds value, U.S options usually carry a higher premium than European options. In short, being able to exercise an option early is more desirable and requires a premium. 

In addition to this, we have exotic options. They are called exotic because there could be different payoff structures from standard options. These options can also be completely different and come with an embedded “optionality” in them.

For instance, binary options offer a simple structure of a yes or no outcome. If you are correct, the payoff is the same regardless of the degree. While many investors stay away from binary options due to their often unregulated nature, there are a a few top-tier binary options brokers in the USA.

Other exotic options include barrier options, a knock-out, knock-in, Asian options, Bermudan options and lookback options. These types of exotic options are usually more for professional derivatives traders.

🏆 Interested in trading binary options? See the top binary options brokers for more info. There are several key factors you’ll need to keep an eye out for.

Expiry and Liquidity

Options can be categorized in two ways: Short-term and long-term. Short-term options expire in about a year. Long-term options have expirations of more than a year, and are known as LEAPs (long-term equity anticipation securities).

There is no difference at all between these are standard options, apart from the duration.

Another way to distinguish options is by their expiration date. Some options expire daily, weekly, or monthly. ETF and index options can also offer expiry dates per quarter.

Long Calls

A long call, also known as a put is the simplest option. This will bring you a profit if the price of the underlying asset increases and the downside is fixed to the loss of the option premium you invested in.

Should you buy a put option and a call option with the same expiry and strike option, this is called a straddle.

A straddle will pay off if the underlying price moves significantly in either direction; however, if it stays stable, you will lose your premium on the put and the call. This strategy can be used when a large price movement in stock is expected but you can’t be sure of the direction it will go in.

Essentially, the stock will need to move outside of range. Another strategy you can use to bet on a move that goes outside a range in securities when increased volatility is expected  is to purchase a put and a buy with the same expiration but different strikes – this is called a strange.

Large price movements are required for a strangle to profit but it will cost less than a straddle. That said, going short on a strangle or a straddle would make a profit from a relatively stable market.

Options as Derivatives

Options are a part of a wider community of securities called derivatives. The price of a derivative depends on the price of something else. For example, orange juice is a derivative or oranges, chocolate is a derivative of cocoa, and a stock option is a derivative of a stock.

Options themselves are derivatives of financial securities ie. The value of an option depends on the price of another asset. For example a derivative can be put, calls, forwards, futures, mortgage-backed securities, and swaps, to name a few.

Call and Put Options

Buying an option contract will give you the right but not the obligation to buy or sell an underlying asset at a fixed price before or on a particular date.

Call options give the owner the right to buy stock and put options give the owner the right to sell it. A call option can be thought of as a deposit for a later date. While there are many popular options trading strategies, all of them involve either a call or a put option.

Example of a Call Option

Someone looking to buy a home in the future might inquire about a housing development. They might be interested in buying the house at a later date, but only after the house and surrounding area has reached a certain standard.

In this case, the owner would maintain a strong position from having the option to buy at that stage, or to decline. Ideally, the interested party could purchase a call option from the housing developer to buy the house for $500,000 at any stage over the next two years.

This is exactly what happens, but the interested party would have to pay a price to avail of such a right. In other words, they pay what you would know as a non-refundable deposit to gain the right but not the obligation to buy the house later.

In relation to an option, this is called the premium. This is how much you pay for the option contract.

For the example of the house, the developer might decide to charge the interested party $20,000 for the right to the contract. At some stage later, say after a year or so, the development might be up to a good standard and all the zoning is approved. The interested party thinks yep, this is for me, I’d like to buy this house for $500,000 as we agreed in the contract.

In terms of the market value by that stage the house may have dramatically increased in value to $900,000. However, because you were thoughtful enough to lock in a fixed price at an earlier date, you save yourself a lot of money and by only the original agreement of $500,

On the other hand, the zoning might not get approved until the third year, which is a year past your contract date. If this happens and you haven’t bought the house within the 2 year time period of your contract, then you will have to pay the market value for the house. The developer keeps the original $30,000 that you paid to buy the contract in both cases.

📖 Further reading: See our in-depth guide to call options.

Example of a Put Option

Not sure what a put option is? The easiest way to grasp put options is to conceive of them as something like an insurance policy.

Most homeowners will be familiar with buying house insurance. Homeowners usually buy this insurance to protect their home for the price that it’s worth should anything cause it damage.

To get this protection, the homeowner pays a regular premium payment for the policy for a set period, a year for example. This will agree to a face value for the house and offer the homeowner protection in case it gets damaged.

Now, let’s say for example that instead of needing protection for your home, you need it for another asset, like an index or stock investment. In the same way, an investor can insure their stock portfolio by buying put options.

An investor might be afraid that the stock market will start to decline overtime and won’t want its stock to lose more than 10% of their long position in NASDAQ. 

Say NASDAQ is trading at $1,000, traders can buy a put option that gives them the right but not the obligation to sell the stock at $1,000, at any stage over the next for example 3 years.

If the stock market crashes in a year by 30% (300 points) the trader has made X points because he can still sell it at $1,000.

If in six months the market crashes by 20% (500 points on the index), he or she 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%. 

As a matter of fact, even with a market drop to zero, a trader would still only lose 10% with this put option. So, to buy the option you will pay the premium, and if the market doesn’t go into a decline and stays relatively the same then your only loss will be the premium price.

Buying and Selling Calls/Puts

Okay so, traders can do one of the following with options:

  1. Buy a call
  2. Sell a call
  3. Buy a put
  4. Sell a put

If you buy stock then you will have a long position. If you buy a call option then you will potentially hold a long position in the underlying asset. Selling a stock short will give you a short position. If you sell an uncovered or naked call then you will potentially gain a short position in the underlying stock.

If you buy a put option you will potentially gain a short position in the underlying stock. Selling unmarried, or naked will give you the potential for a long position in the underlying stock. It’s crucial to keep these four scenarios straight.

We call those who buy options holders and people selling options are called writers. There are several distinctions between holders and writers, here’s the key points to understand:

1. There is no obligation for call or put holders to buy or sell an asset. As we mentioned, they have the right to do this, but they have bought the right to make a choice at a later date. They do this to minimize the risk of potentially paying more than the premium in the future.

2. Call and put writers on the other hand do have an obligation to buy/sell the option if it expires in the money. For this reason, the seller should keep his word to buy or sell. This also indicates that option sellers are exposed to more, and sometimes, an unlimited amount of risk. Therefore, writers could potentially lose far more than they paid for the premium.

Options Risk Metrics and The Greeks

We can look to the Greeks to help us understand options better. In the options market, the term the Greeks describes the various elements of risk price sensitivity that comes with taking an options position. They’re called the greeks because they’re similar to greek symbols.

These variables are called gamme, delta, theta and vega. These help you assess and understand the risk exposure that comes with an option, or portfolio of options.

Delta

Delta is shown using the symbol (Δ). This is the symbol for how fast or slow the rate changes between the price of the option and a $1 move in the asset’s underlying price. 

For call options, the Delta ranges between zero to one, and a put option has a range of between zero and minus one. 

For example, should the investor go long on a call with a delta of $1, and the underlying stock increases by $2, the price of the option would increase by $1.

Gamma

Now let’s look at Gamma (Γ). This symbol is a representative of the move between the delta and the asset’s underlying price. Gamma shows how much the delta would change should the underlying security move by $1.

For example, assume an investor is long one call option on hypothetical stock XYZ. The call option has a delta of 0.50 and a gamma of 0.10. Therefore, if stock XYZ increases or decreases by $1, the call option’s delta would increase or decrease by 0.10.

Vega

Vega (V) is the symbol for how fast or slow the option’s value and the likelihood that the underlying asset will move. It is an indicator for how much the option’s price will change should there be a 1% move in implied volatility.

For example, should an option have a vega of 0.12 then the value of the option is expected to move by 12 cents if the implied volatility moves by 1%.

Rho

Rho (p) is the symbol for the rate of change between the value of the option and a 1% change in its interest rate.

For example, assume a call option has a rho of 0.05 and a price of $1.25. If interest rates rise by 1%, the value of the call option would increase to $1.30, all else being equal. The opposite is true for put options. Rho is greatest for at-the-money options with long times until expiration.

Theta

Theta (Θ) is the symbol for the rate of change between the price of the option and time – also known as time decay. Theta is an indicator of how much the price of the option would decrease in relation to the expiration decreasing, too.

For example, let’s say an investor is going long on an option and the theta is 0.20. The price of the option would reduce by 20 cents for every day that goes by, all else equal. Should two trading days go by, the value of the option would go down by $0.60 theoretically.

When options are at-the-money, theta increases, and when options are in or out of the money, theta decreases. 

Minor Greeks

There are some other Greeks that aren’t mentioned as much, including epsilon, lambda, vera, vomma, zomma, speed, ultima, and color.

Pros and Cons of Options Trading

The safety of options trading is a key component of the positives of options trading.

Some say options are more resilient to fluctuations in market prices which can help you bring in more income on your investments, capitalize on your equity increasing or decreasing over time without needing to directly invest it. Like everything, there are cons too, including risk.

The risk associated with options trading can be interpreted in a few different ways. But, in essence, the risks all circulate around how volatile or uncertain the market is. For example, options with high uncertainty ie. a volatile market that makes a particular asset riskier to trade, are more expensive

Options Trading Strategies

Strategies for options trading are endless (almost) – the one that suits you best will depend on how much risk you want to take, reward, budget, in addition to other key factors.

From regular options to the top binary options strategies, there are a number of routes you can take. It is recommended to choose one relative to your trading experience.

Although there are a lot of different strategies (which can get very complicated) we’ve outlined some key strategies that are suitable for all levels.

Straddles and Strangles

A trader would use a straddle (long for this example) if they were anticipating a highly volatile asset, but are not sure in which direction it will move i.e. up or down.

When you use a straddle strategy, you will buy a call and put options for the same underlying price, strike price, and expiry date. This strategy is usually employed when a trader expects the price of an asset to skyrocket or plummet, typically after an event like the release of an earnings report. 

For example, when a company like Facebook is preparing the release of its second quarter report, an options trader might use a straddle strategy to buy a call option that expires on the release date at the current Facebook stock price, as well as buying a put option that expires on the same date at the same price.

With strangles (long, for the sake of this example), you will purchase an out-of-the-money- call, as well as an out-of-the-money put at the same time, with the same expiry date for the exact same underlying asset – I think you’re getting the idea!

This strategy could be used when investors assume an underlying asset will move dramatically but again, they just aren’t sure what direction it will go – up or down! A long strange is considered safe to trade because the investor only needs the asset to move more than the total premium paid, and it doesn’t matter what direction that is.

A benefit of a strangle strategy is that there is less risk involved, because the premiums are cheaper to buy as they are “out-of-the-money.

Covered Call

Those considering longer investments should consider covered calls such as a stock. This is best suited to investors who are either take a slightly aggressive or neutral position. 

To use a covered call strategy you could buy 10 shares of a stock and sell one call option per 10 shares in the stock. A strategy like this reduces the risk involved in your stock investments and also gives you the opportunity to profit from the option.

With covered calls, Investors can make a profit when the stock price either stays constant or increases until the expiry date. That said, the stock price could fall more than you expected which will result in a loss of money.

Using a covered call strategy will help protect your investments from falls in the share price while at the same time, affording you the opportunity to profit on the flat stock price.

Selling Iron Condors

A selling iron condors strategy allows traders to take a more conservative or risky position, depending on your own risk preference – a huge plus! Iron condors offer a position that has no set direction, it can either up or down – offering a pretty wide range.

In order to implement an iron condor strategy, simply sell a put and buy another at a cheaper strike price. Then, buy a call and sell a call at an increased price. These will be short positions. 

So long as the stock price remains between the calls or puts you will earn a profit. You will, however, lose money if the stock price goes above or below the spreads by too much. This is why the iron condor is known as a neutral position.

How to Choose an Options Broker

If you’re considering trading options, you’ll need the right broker by your side. Prioritize these key aspects:

Fees & Commissions

These vary drastically from one broker to the next. This can also get complicated if the broker doesn’t offer transparent fees. Make sure to work out any hidden fees that may apply to you, and remember cheap stocks don’t necessarily mean competitive commission charges.

Research 

The right tools can elevate your options trading, and help you evaluate them better, but these are not offered by all companies.

Customer Support

Most brokers offer some form of customer support but options trades, in particular, generally need more support getting with trades their preferred way. The more complex your strategy, the more you will need customer support. For this reason, finding an efficient and knowledgeable customer support team is crucial for the success of your options trading journey.

🏅 Looking for the best options trading platform? See our report on the top options brokers to get started. There are a number of platforms available, each with their own strengths and weaknesses.

An Overview of US Options Regulations and Taxes

Trading strategies and financial instruments have become more prominent in recent times as a result of increased technical and financial innovations, on a global scale. As a result, this has led to a lack of regulations surrounding the market in terms of transparency, control and procedures.

Maintaining the integrity of the market has become increasingly difficult, never mind the fact that options are complex instruments that require an extra layer of regulations.

How are Options Regulated in the US?

Here are some key US regulations you should consider noting:

  • US options traders must adhere to the restrictions set out by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC).
  • That extra later we mentioned for options trading? This is because traders can lose more than they trade, which makes it riskier, and in turn, stricter regulations are necessary to protect traders.
  • Minimum margin amounts must be adhered to in compliance with regulations. This will usually be displayed on the brokers website.
  • When it comes to forex trading and short options, the value of the notional transaction, in addition to the option premium should be kept as a security deposit.
  • Long positions will require the full option premium as a deposit.
  • Holding similar option positions is prevented by the first-in, first-out rule (FIFO).

How are Options Taxed in the US?

Unfortunately, taxes follow us everywhere, including options trading. The majority of individual stock options are taxed as ordinary income. This means they’ll be taxed 100% at your short-term tax rate.

💡 Not ready to jump into options? Review the top CFD trading platforms to see if Contracts for Difference are up your alley.

Options Trading Tips

Some investors tend to choose stock trading over options because it takes less effort to do well.

Options trading can be a bit trickier than stock trading, and some investors avoid it altogether because it requires more work to be successful. But once you have a good understanding of options, options strategies, and the pros and cons, you can make an informed decision on whether options trading is for you. Of course, choosing the right broker will go a long way.

24Option is an excellent broker for those looking to get some good quality education, while eOption offers traders contracts for as little as $0.10.

Choosing the Wrong Broker Could Cost You

When it comes to long term investing, the stock market is the best way to grow your wealth. That said, should you end up with the wrong broker, your returns could be seriously impacted.

📈 Looking to trade stocks instead of options? Check out our list of the top platforms for stock trading to get started.

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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