A Beginners Guide to Options Trading

A Beginners Guide to Options Trading

What are Options?

An option is a contract between a buyer and a seller. They are a popular derivative instrument used in financial markets. Their value is based on an underlying stock or security. The buyer of an option has the right, but not the obligation to buy or sell the underlying security at a specific price on or before a specified date. The seller of an option collects a premium from the buyer and is subject to produce or buy the underlying security.  

  • Options are traded within the stock, forex, and futures markets.
  • Options are a separate instrument from the stock/security.
  • One option contract in the U.S. stock market controls 100 shares.
  • Options are a leveraged instrument.
  • Every options contract has:
    • An underlying security
    • An expiration date (expiry)
    • A strike price (exercise price)
  • Options are called derivatives because their value is derived from the underlying security.

ITM, ATM, and OTM

An option contract is either in the money (ITM), at the money (ATM), or out of the money (OTM).

In the Money (ITM)

  • A call option is in the money when the price of the underlying stock is higher than the strike price. Example: a call option with a strike price of $40 on a stock with a share price of $45 is ITM by $5.
  • A put option is in the money when the price of the underlying stock is lower than the strike price. Example: a put option with a strike price of $40 on a stock with a share price of $35 is ITM by $5.
  • In the money options have:
    • Both intrinsic and extrinsic (time) value
    • A higher chance of success, thus they are more expensive 

At the Money (ATM)

  • A call or put option is at the money when the strike price is the exact same as the underlying.
  • Example: Option strike price is $40, stock price is $40 the option is ATM. 

Out of the Money (OTM)

  • A call option is out of the money when the strike price is higher than the share price of the underlying. Example: a call option with a strike price of $40 on a stock with a share price of $35 is out of the money by $5.
  • A put option is out of the money when the strike price is lower than the share price of the underlying. Example: a put option with a strike price of $40 on a stock with a share price of $45 is out of the money by $5.
  • Out of the money options are cheaper because they’re more likely to expire worthless. 

Intrinsic and Extrinsic Value

An option contract can have intrinsic value, extrinsic value, or both. Intrinsic value is the tangible value of an option. If the option is in the money by $3, its intrinsic value is $3.  
 
Extrinsic value is the time value and volatility value of an option. If the option doesn’t expire for a long time, it will have more extrinsic (time) value. If the stock is highly volatile, meaning it can rapidly move up or down, its options will have more extrinsic (volatility) value.   
 
ITM options can have both intrinsic and extrinsic value. Out of the money and at the money options will only have extrinsic value. 

A Beginners Guide To Options Trading

There are two types of options, call options and put options.

Call Options

A call option is a contract that gives the buyer the right to buy the underlying security at a certain price by a certain time. The underlying security can be a stock, commodity, bond, or other financial instrument. Buying a call is a bullish strategy. The call buyer profits if the price of the underlying security increases.

Example of Buying a Call (Long Call)

You purchase one call option for the underlying stock XYZ. The expiration date is in 2 months, and the strike price is $42. The share price of XYZ is currently trading at $40. The option you purchased is “out of the money” (OTM) by $2. You paid a premium because the option doesn’t expire for two months, this option only has “extrinsic value.” 

You bought the option for $5 (this is the premium). If you choose to hold the option until expiry, the share price of XYZ must rise to $47 to break even. Strike price $42 + $5 (premium) = $47 breakeven price.

If the share price is above $47 at expiry, you will profit. If the option expires while the share price is below the strike price of $42, you will lose the entire premium. But, if the share price of XYZ goes above $42 before the expiry date, your call option will have both intrinsic and extrinsic value. The faster and higher the share price rises the more you will profit.

Once the option goes above the strike price, it is considered “in the money” (ITM). If the call option is “ in the money,” it can be exercised, and you can purchase 100 shares at the strike price of $42. An option contract can be exercised at any time although it is rare for OTM options to be exercised.

You do not have to exercise the call or hold it until expiration. Instead, you can simply sell it back and keep the profit, or sell to limit your losses. Most options traders will take a profit or a loss before letting the option expire.

Call Buying Takeaways

  • A bullish strategy used by investors that believe the underlying share price will increase.
  • Unlimited potential profit
  • Losses are limited to the premium paid.

Selling Calls (Short Call)

The seller of a call collects a premium. (The amount the buyer pays for the call.) The call option can be exercised anytime the price of the stock is above the strike price.  When a call option is exercised the seller must deliver shares to the buyer at the agreed-upon strike price.  

Selling a covered call means the seller owns the shares. Selling a naked call means the seller must buy the shares at market price if the call is exercised.  

If the underlying stock price is below the strike price at expiry, the option expires worthless and the seller profits off the premium. 

Example of Selling a Covered Call

If you own 100 shares of stock and sell one call option, that is a covered call. The shares of your stock are held as collateral in case the option gets exercised or “called away.” If the call option you sold gets exercised, your shares will be sold at the strike price. 

Example of Selling a Naked Call

If you sell a call on a stock that you do not own, that is referred to as selling a naked call. Selling naked calls is extremely risky because losses are potentially unlimited. The more the price rises past the strike price, the more you will lose. If you sell a naked call and it gets exercised, you will be forced to buy the shares at market price and sell them for the strike price.

Selling Calls Takeaways

  • Selling covered calls:
    • Offers downside protection but will limit the upside potential
    • Lets you take advantage of sideways movements
  • Selling naked calls is a high-risk strategy and is not recommended for beginners.
  • With covered calls you risk losing out on substantial gains if the underlying price rises higher than anticipated.
  • Losses on naked calls are potentially unlimited.

Put Options

A put option is a contract that gives the buyer the right to sell the underlying security at a certain price by a certain time. The underlying security can be a stock, commodity, bond, or other financial instrument. Buying a put is a bearish strategy. The put buyer profits if the price of the underlying security decreases. Buying a put option is the exact opposite of buying a call option. 

Example of Buying a Put (Long Put)

You purchase one put option for the underlying stock XYZ. The expiration date is in 1 month, and the strike price is $45. The share price of XYZ is currently trading at $40. The option you purchased is “in the money” (ITM) by $5.  This option has both intrinsic and extrinsic value. 

You bought the option for $7 (this is the premium) intrinsic value $5 + extrinsic value $2. If you choose to hold the option until expiry, the share price of XYZ must be $38 to break even.  Strike price $45 – $7 (premium) = $38 breakeven price.  

If the share price is below $38 at expiry, you will profit. If the option expires while the share price is above the strike price of $45, you will lose the entire premium paid. The more XYZ decreases in price, the more you will profit off your put option. If you choose to exercise the put option, you can sell 100 shares at the strike price of $45. You do not have to wait for the option to expire in order to make a profit or take a loss. Many options traders will sell the option back well before expiry.

Put Buying Takeaways

  • A bearish strategy used by investors that believe the underlying share price will decrease.
  • High potential profit, but profit is limited since the stock price can only go to 0.
  • Losses are limited to the premium paid.

Selling Puts (Short Put)

The seller of a put collects a premium. (The amount the buyer pays for the put.) The put option can be exercised anytime the price of the stock is below the strike price. When a put option is exercised the seller must purchase shares from the put buyer at the agreed-upon strike price.  

Selling a covered put or cash-secured put means the seller has the cash to purchase the shares held as collateral. Selling a naked put means the seller will have to come up with the money to purchase the shares if the put is exercised.

If the underlying stock price is above the strike price at expiry, the option expires worthless and the seller profits off the premium. 

Selling Puts Takeaways

  • Selling cash-secured puts:
    • Used by investors that want to buy a stock and collect premium
    • Lets you take advantage of sideways movements
  • Selling naked puts:
    • Means you don’t have the money in your brokerage account if the put gets exercised
    • Not allowed by all brokerages
  • You can profit by collecting a premium and getting a lower price on a stock you are bullish on.
  • The more the stock drops below the strike price, the more you will lose.
  • Losses are limited because a share price cannot go below 0.

Remember the Multiplier

American options trade at a multiplier of 100, meaning one option controls 100 shares. This also means that the price of the option is multiped by 100.  Example: an option contract priced at $0.05 is multiplied by 100 so the total cost to buy the option is $5.00. 

Implied Volatility (IV)

Implied volatility, also called volatility or IV, is the market’s estimate of movement in the security price. High volatility means the security is subject to large price swings in either direction. Low volatility means the market is estimating the price will be relatively stable and only experience small fluctuations. 

It’s important to understand volatility because it factors into the price of options. When the future of an underlying stock is uncertain, the demand for its options rises. Higher uncertainty = higher volatility which = higher premiums. 

Time Decay (Theta)

Time Value Decay of an Option Price

All options lose extrinsic value as time passes. Time decay decreases the price of an option over time. It accelerates as an option nears its expiration date.

  • Only extrinsic value (time value) is affected by time decay.
  • Options are a wasting asset that decay over time. 
  • Time decay:
    • Works against option buyers
    • Benefits option sellers
    • Is calculated daily

Bottom line

Options are a mathematical concept and have a learning curve. They offer a higher reward potential and come with a higher risk than trading stocks.

The next step to further your options knowledge is to learn and understand the option greeks.

Always check the volume (liquidity) of the options you are interested in trading. Low volume will result in a wide bid-ask spread and could make it hard to exit a position at a reasonable price.