What Are Options: A Complete Guide for Beginners

Views 16KOct 31, 2024

Curious about trading options? We’ve got you covered!

Here is your complete guide to options and how some traders use them as a tool to build their portfolio and trading strategy. Read on to uncover an insightful look into the mechanics, risks, and potential benefits associated with options.

What is An Option?

To put it simply, an option is a contract that allows a trader to buy or sell a specific stock at an agreed-upon price by a specific date -- but only if they want to or if it meets certain conditions. In other words, when you buy an option, you are basically purchasing the right to buy or sell a stock, but you're not required to do so. Conversely, from the seller's perspective, they are obligated to either sell or buy the stock if the buyer exercises their option.

Here are some terms you should know:

The stock specified in an options contract is known as the underlying asset. (You may see options referred to as a derivative because they derive value from the underlying asset.)
The strike price is the agreed-upon price that the underlying asset will be bought/sold for.
The date specified in an options contract is the expiration date. After that date, the option expires and is no longer valid.
A premium is the amount a trader pays to buy an options contract. This is considered the option's price and fluctuates daily. The buyer would pay this amount to hold the option and the seller would receive this amount when writing (selling) the option.
Important to remember: Underlying assets for options can be bonds, currencies, or commodities as well, but for now, we are focusing on what are options in stocks.

How Do Options Work?

There are two parties involved in each options contract:

1. The trader or institution who creates or “writes” the options contract

2. The trader who purchases the contract

When purchasing an options contract, traders have two main choices:

Allow the contract to expire without taking action, which might result in it becoming worthless.
Execute the contract and buy/sell the underlying asset. This can occur either on or before the expiration date.

When writing an options contract, sellers should be aware that if the contract is exercised by the buyer, they are obligated to buy/sell the underlying stock. It's worth noting that many brokers automatically exercise options that expire in-the-money (ITM).

Good to know: Options contracts are typically sold in groups of 100 shares of the underlying stock.

Types of Options

There are only two types of options contracts — calls and puts.

A call option gives the holder the opportunity to buy the underlying stock on or before the expiration date, while the writer is obligated to sell the stock if the option is exercised.
A put option gives the holder the chance to sell the underlying stock on or before the expiration date, with the writer obligated to buy the stock if the option is exercised.

When deciding between a call or put option, traders have to consider data and how they expect the market to perform. The main strategies with both types of options are:

Buying a call option when the underlying asset is expected to increase in value
Buying a put option when the underlying asset is expected to decrease in value

Call Options

When you buy a call option, you have the right to buy the underlying stock at the specified strike price on or before expiration, while the writer of the call option is obligated to sell the stock at the specified strike price if the option is exercised by the buyer.

If a trader expects the price to rise, they may go with a long call strategy. A long call would give them the ability to buy the stock at a lower price than the going value (assuming the option is in the money) and their maximum loss would be the premium they paid for the options contract.

Call options contracts generally increase in value when the underlying stock price rises.

Call Option Example

Company A is currently selling for $5 a share and a trader buyer buys a call option with a $7 strike price and an expiration date a month in the future. Their premium is $1 per share, so they pay $100 since options are usually bought in groups of 100.

If the price for Company A stocks rises to $10 a share the next week and the trader decides to exercise the contract early. They would then purchase 100 shares at $7 for a total of $700. The trader would have invested a total of $800, including the premium, and can sell their new stocks at the current $10 share price, for a net gain of $200. Note that the other option would have been to sell the appreciated contract back to the market, if the holder didn't want to own the underlying shares.

If the stock price had dropped, the trader would let the contract expire worthless and would only lose the $100 they spent on the premium.

Put Options

When you buy a put option, you have the right to sell the underlying stock at the strike price on or before expiration, while the writer of the put option is obligated to buy the stock at the strike price if the option is exercised by the buyer.

A put strategy would give a trader the chance to sell a stock at a higher price than the going value (assuming the option is in the money), and the maximum loss would be the premium they paid for the option contract. Put options generally increase in value when the underlying stock price decreases.

Put Option Example

Suppose Company X is trading at $10 per share, and a trader anticipates a decrease in its value. They purchase a put option with a $9 strike price, expiring in a month, paying a $1 premium per share, totaling $100 for the contract.

If Company X's stock price drops to $5, the trader may choose to exercise the put option. However, exercising would require selling 100 shares, which could pose challenges for beginner investors. Alternatively, they could close the trade by selling the option back into the market if its value has appreciated, potentially yielding a profit without the complexities of short selling.

In the event of unexpected price increases, the trader can let the contract expire, limiting their loss to the $100 premium spent.

Options Contracts: Terms to Know

There are a few different elements of the contract that you should know before you begin trading options. As you begin to understand each part and how they interact, you can potentially build a stronger strategy.

Premium

The premium, also known as the option's price, is what a trader pays for an options contract, assessed per share. Since options contracts usually cover 100 shares, multiplying the premium by 100 gives the total contract cost. For instance, if a contract has a $1 premium per share, the total investment would be $100 for the contract. This price can fluctuate based on market conditions.

From a seller's perspective, receiving the premium is the initial income earned from writing the option contract. While buying options limits the theoretical maximum loss to the premium paid, sellers may face additional risks if the option is exercised or assigned, potentially leading to greater losses than the initial premium received.

Strike Price

When an options contract is written, it specifies what price the underlying assets will be bought/sold if the contract is exercised. This amount is called the strike price.

Expiration Date

An options expiration date is the date the option ceases to exist (expires) and marks the deadline for the contract holder to exercise and buy/sell the underlying stock, set at the contract's inception. For American options, traders can exercise before or on the expiration date. The decision often hinges on the option's moneyness — whether it's in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM). If a trader lets the option expire without action, they forfeit its value, typically losing the premium paid. Therefore, understanding the option's moneyness is crucial in determining whether to exercise, close the position, or allow it to expire worthless, based on market conditions.

American vs. European Options

The difference between American and European options has nothing to do with location, only the timing of the option.

With American options, the contract holder can exercise the option at any time before the expiration date. However, European options can only be exercised on the expiration date.

American options may command higher premiums due to their flexibility, allowing for early exercise. However, exercising an in-the-money (ITM) option prematurely isn't often advantageous for most traders. It could result in forfeiting remaining extrinsic value and assuming the risk of holding the underlying stock (in the case of a call option). Thus, while some traders may value the option to exercise early strategically, many opt to capitalize on the option's time value and market conditions instead of exercising prematurely.

Options Risk Metrics: Understanding the Greeks

When it comes to risk metrics used with options, you may be thinking, “It’s all Greek to me!” Let’s look at what these risk metrics are and how you can use them with your strategy.

In the options market, the term “the Greeks” is used to describe the variables used to measure different factors that might affect the price of an options contract. They are called this because they are usually associated with Greek symbols. The most commonly used are Delta, Theta, Gamma, Vega, and Rho.

Fun fact: Vega is not actually a real Greek letter, but is now an accepted term in options trading.

Delta

Delta measures how sensitive the option’s price is in relation to the underlying asset’s price. This sensitivity is calculated by measuring how much an option’s price changes with a $1 change in the underlying asset price.

For call options, delta has a range between zero and one. The range for put options is between zero and negative one.

Delta can also be used for more advanced strategies that are beyond a beginner’s level, so we won’t explore them here.

Theta

Theta measures how much an option’s price would decrease as it gets closer to its expiration date if every other factor remained the same. The rate of change between the option price and time is called time sensitivity.

Theta’s value is negative for long calls and long puts. Short calls and puts have a positive theta.

Good to know: When trading traditional stocks and not options, theta is zero because there is no expiration date and no time decay.

Gamma

Gamma helps determine how stable the option’s delta is. The variable measures stability by calculating how much the delta would shift if there was a $1 change in the underlying asset’s price.

The higher the gamma, the greater the instability. And increased instability means the delta is more likely to change drastically, even with small movements in the underlying asset’s price.

Time is a significant factor for gamma because options contracts are more sensitive to price changes the closer they get to expiration. So, the closer to the expiration date, the higher gamma tends to be.

Options with a longer expiration will typically have a lower gamma value because they are less sensitive to changes in the delta.

Vega

Vega measures how sensitive an option is to volatility and shows how much the option's value may change when there is a 1% increase or decrease in the underlying asset’s implied volatility.

Volatility has a major impact on the value of options. A higher implied volatility usually means that the underlying instrument is more likely to experience extreme value fluctuations, which can lead to increased uncertainty.

The higher the volatility, the higher the value of the option. The lower the volatility, the lower the value of the option, all things remaining equal. Because of this correlation, options with longer expiration periods will have a higher vega because the price will not be as easily influenced by fluctuations in the underlying asset value.

Long option calls always have a positive vega value. Short options have a negative vega value.

Rho

Rho measures how sensitive options contract prices are to the risk-free interest rate changes. This value shows how the option’s value will change when there is a 1% change in the interest rate.

Typically, Rho will have a positive value for long calls and a negative value for long puts. Rho is positive for short puts, and negative for short calls.

If interest rates are low, price differences between call and put options are typically rather small. The gap between the two tends to increase as the interest rates rise, generally making calls more expensive and puts cheaper, all things remaining equal.