7 Things You Should Know When Trading Options

Options are flexible financial tools that can be used to enhance, diversify, and protect your portfolio. Options are available for equities, debt, real estate, and specific sectors. They are traded using stocks, indexes, and exchange-traded funds as the underlying asset.

In short, trading options can be endlessly complicated, but it doesn't have to be. If you have a solid grasp of a few simple concepts, trading options can be a brilliant way to help you achieve your financial goals.

So, what do you need to know? Let's begin with the basics:

What Is an Option?

Options are simply a contract between a buyer (the holder) and a seller (the writer). The buyer pays a premium, which is the price of the contract, in exchange for the right to purchase or sell an underlying asset such as a stock.

The seller agrees to buy from or deliver the underlying asset to the buyer at the agreed-upon price. The contract specifies the price of the stock per share (the strike price), the number of shares (usually 100), and the expiration date. Buyers of a call or put have a "long position." Sellers of a call or put have a" short position."

Options are bought and sold on exchanges in the same fashion as any other publicly traded security. Price is based on demand in the market and is influenced by intrinsic value, time to expiration, and anticipated fluctuations in the underlying stock price (volatility).

Intrinsic value is the difference between the underlying stock's current price and the strike price. Only the seller is obliged to buy or sell the stock at the strike price. The contract is "exercised" at the buyer's discretion. A contract that gives the holder the right to purchase the stock is a "call." 

A call holder believes that the value of the stock will be greater than the strike price at or before the expiration date. A call writer believes that the value of the stock will be less than the strike price at or before the expiration date.

A contract that gives the holder the right to sell the stock is a "put." A put holder believes the price of the stock will be less than the strike price at or before expiration. A put writer thinks the price of the stock will be greater than the strike price at or before expiration.

How Investors Make or Lose Money

Let's examine how option holders and writers make money using this example of a call.

Company: The EZ Company

Option Type: Call

Expiration Date: August 5^th, 2019

Strike Price: $100.00

Premium: $ 4.00

EZ Company Stock Price: $97.00

In this example, the holder agrees to pay the writer $ 4.00 per share for the right to buy 100 shares of EZ Company for $100.00 on or before August 5^th, 2019. The stock price of EZ company is $97.00 per share. This option is "out of the money" because the stock price is less than the strike price.

If the stock price is not above $100.00 per share on or before August 5^th, 2019, the option will expire worthless. The holder will have lost $400.00, which is the premium paid to the writer.

The writer made $400.00, the premium the holder received. If the stock price were $ 110.00 per share on or before August 5^th, 2019, the option would be "in the money" because the stock price is higher than the strike price.

The holder would have made $1,000 (110 – the strike price of 100 per share X 100 shares) less the premium paid to the writer of $ 400.00. The holder made $ 600.00 on a $ 400.00 investment, a 150% return. The writer could have sold the stock for $110.00 per share but had to sell to the holder for $100.00 per share.

Our example illustrates the concept at the heart of the power of options: leverage. The holder risked a small amount of capital, $ 400.00, to control $11,000 of EZ stock (100 shares X 110 per share), resulting in a 150% return. Let's use a similar example to illustrate how holders and writers make money using puts:

Company: The EZ Company

Option Type: Put

Expiration Date: August 5^th, 2019

Strike Price: $100.00

Premium: $ 4.00

EZ Company Stock Price: $103.00

In this example, the holder agrees to pay the writer $ 4.00 per share for the right to sell 100 shares of EZ Company for $100.00 on or before August 5^th, 2019. The stock price of EZ company is $103 per share.

This option is "out of the money" because the stock price exceeds the strike price. If the stock price is not below $100.00 per share on or before August 5^th, 2019, the option will expire worthless. The holder will have lost $400.00, which is the premium paid to the writer.

The writer made $400.00, the premium the holder received. If the stock price were $ 90.00 per share on or before August 5^th, 2019, the option would be "in the money" because the stock price is lower than the strike price.

The holder would have made $1,000 (the strike price of 100 - 90 per share X 100 shares) less the premium paid to the writer of $ 400.00. The holder made $ 600.00 on a $ 400.00 investment, a 150% return. The writer could have bought the stock for $ 90.00 per share but instead had to pay the holder $100.00 per share.

What Options Are Available Besides Stock?

The example above is based on an individual stock. Options are also available on indexes, ETFs (exchange-traded funds), and individual stocks. Options using indexes and ETFs offer exposure to the broad market, specific sectors, and even market metrics such as price volatility.

Index and ETF options have several significant differences. An index is a measure of the change in price up or down of a basket of individual stocks, such as the S&P 500, or a market metric, such as price volatility (VIX).

Only cash is exchanged after the transaction between the writer and the holder (settlement). As shown in our example above, there is no purchase or sale of the underlying security. ETF options settle in the same fashion as individual stocks.

Index options may only be exercised on the expiration date (European style). ETF options may be exercised at any time before expiration (American Style). Options are typically available with expirations of 90 days out. Still, other options (LEAPS) can be up two years out.

Trading Option Strategies

So far, we have examined option features, calls and puts, writing and holding, strike prices, expiration dates, and underlying assets. Option features may be combined into strategies designed to achieve a specific goal.

There are options and strategies to speculate, enhance portfolio income, protect against losses, and boost returns. Option strategies are also used to capitalize on current market conditions.

The strategies are generally categorized as bull or bear. Bull strategies anticipate that the underlying asset price will rise, and bear strategies that the price will fall. They all have risks, ranging from loss of the premium paid to unlimited losses.

Placing Option Orders

Options differ from other types of orders that you place In your brokerage account, such as buying or selling a stock or mutual fund. An options order "opens" or "closes" a position. Opening a position initiates.

For example, if you wanted to purchase a call (long position), the order would specify "buy to open." If you wanted to sell or write a call (short position), the order specified would be "sell to open." Closing a position liquidates. If you wanted to liquidate a long position, the order would specify "sell to close," and a short position would specify "buy to close."

Research Your Broker-Dealer

Options are generally purchased through brokerage accounts. A standard brokerage account does not include an options feature unless requested.

The Broker-Dealer (Charles Schwab or Raymond James, for example) will require additional information from you about your risk tolerance, financial experience, and financial resources. They may only permit certain types of options trades in your account.

Broker-dealers have different levels of resources and support for options trading. Some broker-dealers are much better at it than others. You must become familiar with your broker dealer's option capabilities, procedures for exercise and settlement, and their commission schedules before you begin trading options.

Know What Your Goals Are

Your option trades should be aligned with your financial goals and risk tolerance. Trading options differ from trading other assets like stocks, bonds, and mutual funds. Getting good results begins with good research. Invest in learning the terminology and concepts before you trade.

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