Options Trading

RECENT NEWS
Mondo Visione  Oct 1  Comment 
The Options Industry Council (OIC) announced today that 365,917,341 contracts were traded in September, a 15.83 percent increase compared to the 315,911,302 contracts traded in September of last year. Average daily volume for the month was...
Benzinga  Sep 30  Comment 
On CNBC's Options Action, Dan Nathan spoke about an options trading strategy that he noticed on Monday in Alibaba Group Holding Ltd (NYSE: BABA). He said that somebody placed a large bet that the stock is going to trade range bound in the next...
Mondo Visione  Sep 29  Comment 
Montréal Exchange Inc. (MX), Canada’s derivatives exchange, today marked the launch of trading in its Options Trading Simulation contest. A key part of MX’s derivatives education initiatives, the Options Trading Simulation contest offers...
Forbes  Sep 26  Comment 
Investors in Colony Financial Inc. (NYSE: CLNY) saw new options begin trading this week, for the November 22nd expiration. At Stock Options Channel, our YieldBoost formula has looked up and down the CLNY options chain for the new November 22nd...
Forbes  Sep 25  Comment 
Investors in Pan American Silver Corp. (NASD: PAAS) saw new options become available this week, for the April 2015 expiration. One of the key data points that goes into the price an option buyer is willing to pay, is the time value, so with 204...
Benzinga  Sep 24  Comment 
CNBC Options Action's Dan Nathan analyzed on the show trading activity in Sunedison Inc (NYSE: SUNE) after the stock spiked 5.08 percent on rumors that it could be a takeover target. Nathan explained that when the rumors came out, the stock...
Forbes  Sep 9  Comment 
Investors in Basic Energy Services Inc (NYSE: BAS) saw new options begin trading this week, for the September 20th expiration. At Stock Options Channel, our YieldBoost formula has looked up and down the BAS options chain for the new September 20th...




 

This is an introduction to Options Trading. This page focuses on plain-vanilla options, (puts and calls) and should serve as a general overview of how options are constructed, options terminology and how options payoff.

Other articles in the Guide to Options investing include:


What is an Option?

Options can be confusing because they add another level of complexity to investing. They also have a unique terminology that must be mastered to understand what a particular option contract represents. Perhaps the most common misunderstanding for those new to options, is the idea that no shares of the underlying security change hands when an option is written or purchased; an option is nothing more than a contract between two parties.

Options are a type of financial security, just like stocks, bonds and mutual funds, and can be bought and sold just as easily as one buys and sells stocks. Options are known as derivative investments because their value is derived from the value of the underlying stock (when buying or selling options on stocks) or commodity (when buying or selling options on commodity futures). Generally, options are used as a tool to make more leveraged investments in common securities. Because they are less expensive than the underlying asset, relative percent return that can be achieved through options is significantly higher than on the underlying asset alone. The graph below shows just that.

With the advent of low commission online brokers offering options, it is becoming easier to invest in options. This is a good thing for retail investors as it allows them to take advantage of the two main benefits of trading options: versatility to respond to any market situation and leverage. It is also a potentially dangerous situation since options, especially individual options, generally entail more risk than the underlying security and this risk is magnified when investors do not know how to invest in options appropriately. The purpose of this guide is to educate investors on how options are priced and how to use options to augment one's current investment goals.

Important Option Terms

Exercising the option - This is the buying or selling of the underlying asset via the option contract.

Strike or exercise price - This is the fixed price in the option contract at which the holder (investor) can buy or sell the underlying asset (e.g. stock).

Expiration date - The maturity date of the option; the option doesn't exist after this date.

Types of Options

Calls and Puts

Calls and puts are the two types of "plain vanilla" options, and most advanced option positions are constructed using a combination of calls and puts.

American vs European

There are also two types of standard put and call options, known as American options and European options. The difference between the two has nothing to do with physical geography, but rather how and when the options can be exercised. American options can be exercised anytime before the option contract expires, while European options can only be exercised on the expiration date. Options traded publicly on exchanges are nearly always American options, while options that are traded over the counter are mainly European options.

Components of an Option Contract

  • A Buyer and a Seller: The seller, or writer, of a call option is obligated to sell shares of the underlying security should the buyer decide to exercise the option. The seller, or writer, of a put option is obligated to buy the shares of the underlying security should the buyer decide to exercise the option. If the buyer chooses not to exercise their option by the expiration date, neither party holds any further obligation. In most cases, one option contract represents the right to buy or sell 100 shares of the underlying security. Stock splits and corporate actions can change the number of shares which an option contract represents.
    • Call buyers are bullish on the underlying security and owning a call is equivalent to having a long position in the underlying. Call sellers are neutral or bearish on the underlying security and look to profit by taking in premium from call buyers.
    • Put buyers are bearish on the underlying security and owning a put is similar to shorting the underlying. Put sellers are neutral or bullish on the underlying security and again look to profit from the option premium.
  • An Underlying Asset: All options require some other asset, whose price determines the payoff of the option. Options are most commonly written on shares of stock, but they can also be made for bonds and other types of securities.
  • Option Pricing:

See Below

  • Strike Price: The strike price is the agreed price at which an option buyer can buy (in the case of a call option) or sell (in the case of a put option) the underlying security. For plain-vanilla options the strike price is a fixed part of the option contract and does not change during the life of the option. When an option is exercised, meaning the underlying security is either bought or sold by the option buyer, it is exercised at the strike price.
  • Expiration Date: Options are bought or sold for a given time period and therefore have an expiration date. After this date, the option buyer loses his right to buy or sell the stock and the option seller is released from their obligation. For options on stocks, the last day of trading is the third Friday of the month and the options expire on the third Saturday. For example, if one bought July '08 call options on IBM, the last day of trading for those options would be July 18, 2008 and they would expire July 19, 2008

Option Payoffs

For standard put and call options the payoff to the option holder is relatively simple. Note that when talking about option payoffs it is convention to ignore the price of the option and consider only the amount of money the holder gets for holding the contract to maturity.

Call Options

The holder of a call option will only execute the option if, on maturity, the current price of the underlying asset is greater than the strike price. If this is the case, the call holder can purchase shares at the strike price and sell shares at the market price, netting the difference as profit. In the case that the strike price is greater than the price of the underlying asset at the time of maturity, the call option is worthless - the holder would prefer to purchase the asset at the current market price and thus would not exercise the option. The payoff of a plain-vanilla call option at maturity is,

CT = Max[(ST - K), 0],

where CT represents the value of the call at maturity time, T, K represents the strike price and ST is the price of the underlying stock at time T. The graph below shows the relationship between the payoff of a call option and the price of the underlying security at maturity.

Put Options

The holder of a put option has the right (but not the obligation) to sell shares of the underlying asset at the strike price upon maturity. As such, it is only profitable for the holder to do so if they can sell the shares when the strike price is greater than the market price at maturity. The value of a put option at maturity is,

PT = Max[(K - ST), 0],

where PT is the value of the put option at time T, K is the strike price and ST is the price of the underlying asset upon maturity. The graph below shows the relationship between the payoff of a call option and the price of the underlying security at maturity.

Option Pricing

An option's value and payoff is directly related to the price and volatility of an underlying asset, as well as factors such as the proximity to the expiration date. Options can be valued using different valuation methods including the popular Black-Scholes Model which uses many variables to calculate the estimated value of an option. When someone purchases 1 call option on a stock which expires in 1 year, the value of the option will increase as the underlying security rises in value. At the same time, the option will slowly lose time value as time progresses and the option gets closer to the expiration date. Most options expire worthless at expiration becuase they are "out of the money." A call option is considered out of the money when the underlying stock price is trading below the strike price of the option. On the flip side, a put option is considered "out of the money" when the underlying stock price is trading above the strike price of the option.

The price of a particular option contract consists of intrinsic value and time value.

  • Intrinsic value for a call option is the price of the underlying security minus the strike price.
  • As put options are the opposite of call options, intrinsic value of a put option is the strike price minus the price of the underlying.
  • Time value is the amount of the option premium that can be attributed to the time remaining until expiration and is simply the option premium minus the intrinsic value.
  • Option premiums are determined using complex mathematical equations that take into account price of the underlying security, strike price, time to expiration and most importantly volatility of the underlying security. See the Option pricing page for more.
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