What is options trading?

What is an option?

An option is a contract that gives you the right to buy or sell an underlying security at a specific price (known as the ‘strike’), on or before a certain date (the ‘expiration’). Even though you have this contract, you’re under no obligation to follow through – it just means that you can, if you want to. It’s basically like putting a price lock on.

If you don’t act on your trade, you do lose whatever you paid to buy the contract in the first place – known as the ‘premium’. Think of this as your deposit – it’s non-refundable, but it’s bought you the right to buy or sell something in the future, and potentially make (or save) money. 

Options are part of a group of securities known as derivatives because they derive their value from the underlying asset. Other types of derivatives include futures, forwards and swaps.

Usually, each stock option contract represents 100 shares of the underlying stock. But it’s not just stocks that you can get options contracts for – you can also find bonds, currency and commodity options. They all work the same way, however – as a contract to buy or sell shares at a set price, on a set date. 

Choosing which options to invest in involves considering which direction a stock will move in, how far it’s likely to rise or fall, and when you think this is going to happen.

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Benefits of trading options

Options were invented for hedging: helping investors to reduce the risk of loss in their stock portfolio. When they’re used to hedge, it’s similar to an insurance policy. 

Because options contracts allow you to sell stocks at an agreed price, they can help to limit your losses in case the price drops. In cases like this, the premium you pay for the options contract acts like the premium on your insurance policy. Ideally it would be lower than the amount you’d stand to lose should the floor fall out of the market.

You can also make a profit on options, if your contract is to buy stocks at a set price and the market rate goes higher. Then, you can buy the stocks at the lower price and sell them at the higher market rate. Your profit will be the difference between the premium you paid and the money you make in the sale.

If this all sounds like something you’d like to get your teeth into, check out our options trading journal today. Track, analyze and improve your trading activity with your all-in-one Options Trading Journal.

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Types of options trading

Calls and puts

There are two options classes: ‘calls’ and ‘puts’. Call options give you the right to buy the assets at an agreed price, while put options give you the right to sell them at an agreed price. Call options become more valuable as the underlying stock rises in price, as you gain the ability to buy assets at a lower price. On the other hand, put options grow in value if the underlying stock price drops and you can sell at the higher price.

Spreads and straddles

‘Spreads’ are when you have two or more options of the same class (e.g. call). This allows you to speculate while limiting your losses. Doing this can also limit your profit, but tends to be more cost-effective than entering just one position. There are lots of different spreads: for example the bull call and bear put, which we’ll look at a little later.

A ‘straddle’, on the other hand, is where you buy a call option and a put option with the same strike and expiration. This is a great way to hedge your bet on volatile assets, as it pays well if the price rises or falls dramatically. Straddles are best when you think the asset is going to make a big move, but you’re not sure whether it’s going to go up or down. 

Don’t do it for assets with a fairly stable price point. You’ll lose out on both positions. 

Long and short positions

In options trading, holding your ‘call’ or ‘put’ is a long position while selling it is a ‘short’ position. As in other type of trading, long positions indicate a ‘bullish’ attitude because you expect the value to increase. Short positions are ‘bearish’ because you’re anticipating that the price will drop – and you want to get out before it does.

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Option strategies

Covered calls

This refers to selling your call option while also owning the same amount of the underlying security as a long-term position. This gives you an income in the form of an options premium while you wait and hold. This strategy works best if you want to hold on to the stocks for a long time, but don’t expect the price to change much in the near future.

The plus side is the extra income and having a short-term hedge on a long position. The downside is that you lose out on any gains if the price moves above the strike price. You also need to provide the shares if your buyer decides to exercise their right to buy or sell under the options contract.

Protective put

This risk-management strategy involves buying a put option for a fee (premium). While puts are generally bearish – traders usually take them when they think the stock price will drop – protective puts are used as an insurance policy when the trader has a bullish attitude. 

So maybe you’re 75% sure that the stock price will rise: the protective put is there in case the other 25% of you is correct, and the price drops. It helps guard against major losses by setting a known floor price that the asset can’t fall further than.

Interested in finding out more about how to manage trading risk management? Check out our article on the subject - The Definitive Guide to Risk Management in Trading.

‍Bull call spread

This popular options trading strategy uses two call options to benefit from a short, sharp price rise in a security. It involves simultaneously buying and selling two call options. Both options should have the same expiry date, with one call having a higher strike price, creating a range between the two. 

The profit is the difference between the lower strike price and upper strike price, less the premium you paid at the beginning to buy your call.

To do the bull call spread:

1. Choose an asset that you think will rise slightly over a set time period – whether that’s days, weeks, or months.
2. Buy a call option for a strike price above the current market rate of your chosen asset
3. At the same time, sell a call option for a higher strike price, with the same expiration date as the option you just bought.

Bear put spread

As the name suggests, this spread works in a similar way, but when you expect a big decline in the price of a security or asset instead of a rise. 

It involves using two puts: you buy one put at a higher strike price and simultaneously sell one at a lower strike price. Both have the same expiration date. While this strategy has a limited potential for profits, it costs less than only buying the higher strike option as it’s offset by selling the lower strike price.

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Understanding strike price and premiums

Theoretical value of an option contract

The theoretical value of an option is the estimate of what it should be worth, based on all known variables. This is its fair value –investors can use this to work out their strategy. Complex mathematical models – such as the binomial option pricing, the Monte-Carlo simulation and Black-Scholes – are used to calculate theoretical value. All of them use different variables, such as current market price and volatility, to work out the theoretical value of an option contract.

Expiration dates for options contracts

The expiration date of your option is decided when the contract is drawn up. In most cases, it’s the third Friday of the month. This is the last day that you’re allowed to buy or sell the underlying asset at the chosen strike price. 

For call options, you’re hoping that the price has risen enough to ensure you make a profit over and above the premium you paid. For put options, you’re hoping that the price has dropped enough to safeguard your portfolio from bigger losses. 

However, if you fail to act – or if the market has behaved differently to what you expected – you simply cut your losses and lose the premium you paid for the options contract.

Time decay for options contracts

Time decay is the rate of decline in value of the option contract as it gets closer to the expiration date. Time decay gets faster the closer you get to the date because you have less time to make a profit. 

So, an option with a few months until expiry will be worth more money than one that expires in a few days. That’s because, with the latter, it’s less likely that the price will change enough to make a meaningful profit.

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How to get started with options trading

Becoming an options trader isn’t as easy as starting to trade stocks. Options brokerages screen potential traders to make sure they have enough experience and capital, and that they understand risk. If you’ve already been trading stock for a while, and want to try your hand at options, it’s worth applying. If you’re a complete beginner it’s best to cut your teeth on different securities first.

For the screening, you’ll need to provide a bunch of information: for example your investment objectives, your trading experience, personal financial information and the type of options you want to trade.

Obviously, you should do your own background check on the brokerage, too, to make sure they’re going to help you reach your trading goals. 

No matter what type of asset you’re working with, it’s important to reflect on how you’re performing as a trader. Self-reflection can help you to understand how different factors – from your mood, to the day of the week – impact your performance. 

While you can use a good old Excel spreadsheet for this, the best way to do it is with software like TradeZella. This can automatically sync your trades from a range of brokers, while the dashboard has a range of features to help you become a better trader.

Sign up for TradeZella to get in-depth analytics about your trading style.

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