What Are Options? - A Simplified Overview of Options Trading
By Michael Young | Updated: December 12, 2019
While most retail investors have been taught to study and invest in stocks, professional traders utilize leveraged asset classes such as futures, forex and options. Leverage implies that less capital is needed for an investor to make a trade. In addition, leveraged assets may provide tax advantages and have longer market trading hours. Of the leveraged asset classes mentioned above, in the opinion of the author, options are by far the most versatile.
What Are Options?
There are only two types of options...Puts and Calls. If an investor owns a Put, they have the right, not the obligation, to sell their shares of a stock at a fixed price by a certain date. A Call option gives the investor the right, but not the obligation, to buy a certain number of shares of a stock at a fixed price by a certain date. That certain date is called the expiration date.
What Is Options Trading?
Most investors would be surprised to learn that they probably already know a lot more about options than they realize. Two common analogies that are used to explain how options work are insurance and coupons.
Puts were actually created to be insurance, and most people certainly have insurance in their lives. Just as homeowners and auto insurance policies are commonly purchased to offset the risk of something bad happening to someone’s property, puts were created so that institutions could purchase insurance against their portfolios. As insurance, Puts increase in value when a stock drops in value.
A Call is very similar to a coupon that people use in everyday life to buy things at the grocery store. A coupon gives a shopper the right to buy an item at a fixed price, for a certain amount of time (until the expiration date). Similarly, a call option gives the investor the right to buy a stock at a fixed price for a certain amount of time (until the expiration date).
Basics of How to Trade Options
First, it’s important to understand that options are derivatives. Their price or value is derived from the price of something else. In the case of options, the price of the put or call is derived from the price of the stock. Hence, if the price of a stock goes up in value, the price of the Call options should also go up; and if the price of a stock falls, the value of the Calls should fall. For Puts, if a stock drops in price, the value of the Puts should rise, and if a stock rises in price then the value of the Puts should fall.
No matter the asset class, an investor needs a method to put the odds of success for any given trade on their side, and a plan for managing the risk if things do not go as planned. A price chart, when utilized properly, should provide an investor with most of the information needed.
Once an analysis of curve and trend is completed, a trader should have a good idea of where the price of the stock is headed. If the analysis shows a bullish picture (the market going up), then a Call option could be purchased at a quality Demand Zone. If the picture is more bearish (the market going down), then a Put option could be purchased at a quality Supply Zone.
Once a trade is placed there is nothing to do but wait to see if the profit targets are hit. If the trade works out, the trader would close the position and say, “thank you”. In the event that the stock goes in the wrong direction, the trader could close the position with a small loss, if the trader pays attention to the market.
Note that the plan for the above example came from the chart itself. An options trade was used for the trade because it’s a more efficient use of capital. An investor’s goal is to keep emotions out of trade planning by using the charts to determine the possible direction that probability suggests and by risking an amount of capital that is appropriate (based on their account size and experience level). Options make so much more sense than transacting in the stock itself because of the lower amount of capital needed and the potentially limited risk inherent in buying a Put or Call.
Examples of Basic Options Trades
Buying a Put Option
An investor could utilize puts in the following manner: one Put option controls 100 shares of the underlying stock, so if an investor owned 100 shares of IBM, they could buy one put option to protect the 100 share position. If the IBM stock fell in price, the Put would increase in price, offsetting the loss. This is the insurance example, but now let’s go a step further.
What if the IBM stock was in a downtrend, and a trader expected a decline in the price of the stock? Without having any current position, a trader could buy one Put on the shares of IBM and actually be in the position to make a profit if IBM shares decline. This is called “shorting”. So, active investors can make money when the stock or overall market goes up and can also make money when the market drops in price. Buying a Put with the expectation of a stock falling is one way of doing this.
Buying a Call Option
Imagine clipping a coupon out of the newspaper that gives the holder the right to pay $1.99 for an item that would normally cost $3.99 at the store. That coupon would actually have a value of $2.00 under the assumptions above. If something crazy happened overnight to cause the item to increase at the store to $7.99, our coupon would now have a new value of $6.00, as long as the coupon has not expired. The coupon derives its value from the price of the item we wish to buy at the store.
Similarly, a Call option on a stock derives its value from the price of the stock. If we buy a Call option on IBM, and the price of IBM goes higher, the value of the Call we bought should go higher as well. At some point we could sell it to someone else and make a profit on the transaction. As an example, if an investor buys 100 shares of IBM stock, at $140 per share, it would require $14,000 in capital. A Call option that allows an investor to control 100 shares of IBM stock for 90 days might cost only $600.
Pros and Cons of Trading Options
Less Capital Needed to Place a Trade
Buying or shorting shares of the company outright will always be much more expensive than buying a Put or Call. Because of the smaller amount of capital needed for option trades, the rates of return on the trade or investment could be in the 100s or 1000s percent range when the stock performs as expected. If the stock moves in the wrong direction, the option buyer could lose the entire amount invested, but that is the maximum potential risk.
Options can be utilized when the expected move in the stock is up or down. There are also options strategies that can be profitable when the stock stays in a sideways trading range, so that they can be used regardless of market direction.
Liquidity is the key
There are really no negatives to trading options, provided that the options are liquid and risk is recognized by the investor. To be liquid there needs to be enough volume traded in the options so that it’s easy to get in, or out, of a position. Most of the well-known stocks and ETFs have sufficient liquidity. It’s best if the difference between the bid and the offer price of the option are as close together as possible. When there is liquidity, it lowers the risk of the trade.
Most investors avoid learning and trading options out of a mistaken belief they are complicated and risky. Options are certainly different and may have a slightly steeper learning curve, but when used the correct way, they are a very effective way to engage the markets with much less risk. As with anything, proper training and learning how to manage the risk is the key.
About the Author
Michael Young began trading in 1980 and trading on the floor of the Chicago Board of Options Exchange in 1983. While on the floor, Michael hired and taught over 50 traders how to be market makers and trade options. He has his passion for trading and teaching, both as an Online Trading Academy instructor and through his writing.
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