Options

What are options?

An option gives you the right, but not the obligation, to buy or sell a specified amount of a particular underlying security at a particular price. You can do this by excercising the option before it's specified expiration date. An option that gives you the right to buy an underlying security is called a "call option", or "call". An option which gives you the right to sell an underlying security is a "put option", or "put". The amount you pay for the option is called the premium. A buyer of an option is called a holder while a seller of an option is called a writer.

Most options have standardized terms - such as: the underlying security, the contract size, expiration date, exercise price, and other terms. This means you can't customize the option. For example, a call option on a stock gives you the right to buy 100 shares. You can't buy a stock option which gives you the right to buy 67 shares of the underlying stock. The reason there are standardized terms is that it allows the options to have more liquidity because the options share similar characteristics.

Options give you considerable leverage as they allow you to control a large amount of an underlying security with very little money. Many times you'll hear investors talk about "derivatives". Options are an example of a derivative because their value is dervied from the value of another security.

Although when most people hear the word "options" they think of stock options, options are written on almost all financial products, including: stocks, stock indexes, bonds, currencies, commodities, futures contracts, and even market characteristics like volatility.

When it comes to stock options, not all stocks have options traded on them. In order for a company to have it's stock have an option traded on it, the stock must meet eligibility requirements. If a stock no longer meets those requirements then the exchanges will stop issuing new options on the stock while (most of the time) allowing continued trading of the existing options. Occassionally, adjustments have to be made to stock options to adjust to stock splits or stock dividends.

Why do people trade options?

There are two main reason why investors trade options. The first reason is to hedge another position. An investor may have a position in the underlying security and feel they can make more money by integrating options into their position. For example, they may be long a stock and feel the stock price will stay the same price for a while so they write a covered call option to collect the premium.

The other reason investors trade options is for speculation. Investors feel they can make alot of money if they buy an option which they think will rise considerably in value. Many times they are seduced by the higher leverage and lower cash requirements available with options. Other times it is the unique options strategies which seduce them into thinking they are more likely to be sucessful using a supposedly "complicated" strategy.

Although any option tutorial will teach you about how options can be exercised, almost none of the retail traders have any intention of exercising an option. They mostly close out their options position by liquidating the position through an offsetting transaction.

Types of Options

Cash settled vs. Physical Delivery. Another distinction between the different kinds of options is physical delivery vs. cash-settled options. Physical delivery options means you get a physical delivery of the underlying asset when a call option is exercised. If it is a put option then you have to make physical delivery if the option is exercised.

A cash-settled option allows you to receive a payment of cash when the option is excercised. The amount of cash settlement is the difference between the value of the underlying asset and the exercise price.

An example of a physical delivery option would be a stock option. If you exercise a call option then then the underlying stock will get delivered to you. An example of a cash-settled option would be an index option (an option on a stock index).
American vs European-style options. The refers to when an option is able to be exercised. A European-style option can only be excersized during a specified time frame - usually at expiration. An American-style option can be exercised anytime before expiration. This means for an option writer that they may be assigned at any time in which the option is excersizeable.
Exchange traded vs. over-the-counter. Exchange-traded options have standardized features and trade at exchanges. Over-the-counter options are traded between private partie - often big institutions.
LEAPS. LEAPS (long-term equity anticipation security) are options which don't expire for a year or more but are similar to other options in every other way.

Basic option terms

Strike price. The price at which the option can be exercised. Also, the price at which the option begins to build intrinsic value.
Expiration date. The date on which the option expires.
Contract Size. Refers to the amount of the underlying asset. For stock options it is 100 shares per option.
Exercise. Electing to buy or sell the underlying security at the strike price.
Premium. To the buyer, this is the cost of the option. To the writer, this the amount of money received for selling the option.
Intrinsic Value. The amount of profit that would be realized if the option were to be exercised. This is determined by the amount that the option is in-the-money.
Time Value. The value of the time remining before expiration. Also, the portion of the value that exceeds intrinsic value. At expiration the time value is always zero.
Out-of-the-money. For a call option this occurs when the price of the underlying asset is below the strike price of the option. For a put option this means that the price of the underlying asset is above the strike price of the option. This is sometimes abbreviated as "OTM". Out-of-the-moeny options have only time value and no intrinsuc value.

Example: If a stock is trading at $54 then any call option with a strike price above $54 would be out-of-the-money. And any put options with a strike price below $54 would be out-of-the-money.
In-the-money. For a call option this means that the price of the underlying asset is above the strike price of the option. For a put option this means that the price of the underlying asset is below the strike price of the option. This is sometimes abreviated as "ITM".

Example: If a stock is trading at $54 then a call option with a strike price of $50 would be in the money by $4 and a put option with a strike price of $60 would be in the money by $6.
At-the-money. The occurs when the price of the underlying asset is the same as the strike price of the option.
Near-the-money. "Near-the-money" is a more informal term meaning that the price of the underlying is near the strike price.
Implied volatility. This is the estimation of the volatility of the underlying security during the life of the option.

My Opinion

There are two unique advantages options offer - leverage and versatility. But each of these advantages also has limited potential. First, the problem with using large amounts of leverage is that it eventually leads to going broke. Just because you can use leverage doesn't mean you should. In order to ensure that you won't go broke, you need to employ a pretty conservative money management system to manage your risk. But this de-leveraging ends up negating the leverage offered by options in the first place.

The other advantage options offer is versatility. This refers to the ability to put on trades based on custom-made strategies so you can take advantage of market opportunities that are not available by trading "plain" products. For example, these strategies may involve taking advantage of options-specific features like volatility or time value. Or the strategies may involve structuring a trade so that there is limited downside. The problem with these versatile strategies is that they don't offer an intrinsicly higher return than other option strategies or trades involving plain securities for that matter. One mistake amateur traders make is that they see some unconventional strategy like option combinations or straddles and assume there is some greater-than-normal profit in these strategies simply because fewer people use them. The truth is that, although not as many people trade these strategies, these strategies are popular enough so that these markets are just as efficient as other markets. In cases like these, amatuer investors sometimes feel like they are discovering something new when these strategies are well-known to advanced investors and traders.

Despite the unique features that options offer, they are very over-rated. This is because they are "wasting assets". This means that - everything else being equal - the price of the option will decline as time goes on because the time value erodes. It is said that something like 80% of all options expire worthless. Buyers of options must not only be correct about the direction of the market but also the timing and the magnitude of the move.

One of the tells of an overconfident beginner is that they want to jump right into options. There is plenty of money to be made in "plain" investments so that there is no need to start with complicated securities. Even if you "only" trade stocks you will still be learning essential trading skills that you can later apply to options like market psychology, entries and exit criteria, risk management, money management, and other stuff.

If you do trade options, pay attention to liquidity. When it comes to options that don't trade often, it is important to keep in mind that the last sale price of the option many times may be "stale". This means the market has moved away from the last sale price so the last price is not indicative of where the market is. You should always be looking at the bid and ask to see what the current value is.

Education > Investing > Options > Intro to Options

Options

What are options?

Why do people trade options?

Types of Options

Basic option terms

My Opinion

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