|Buyers of call options use them to hedge against their position of a declining price for the security or commodity.
|Buyers of put options use them to hedge against their position of a rising price for the security or commodity.
|American importers can use call options on the U.S. dollar to hedge against a decline in their purchasing power.
|American exporters can use put options on the U.S. dollar to hedge against a rise in their selling costs.
|Holders of American depository receipts (ADRs) in foreign companies can use call options on the U.S. dollar to hedge against a decline in dividend payments.
|Manufacturers in foreign countries can use put options on the U.S. dollar to hedge against a decline in their native currency for payment.
|Short sellers use call options to hedge against their positions.
|Short sellers have limited gains from put options because a stock’s price can never fall below zero.
How to Trade Options
Many brokers today allow access to options trading for qualified customers. If you want access to options trading you will have to be approved for both margin and options with your broker. Once approved, there are four basic things you can do with options:
- Buy (long) calls
- Sell (short) calls
- Buy (long) puts
- Sell (short) puts
Buying stock gives you a long position. Buying a call option gives you a potential long position in the underlying stock. Short-selling a stock gives you a short position. Selling a naked or uncovered call gives you a potential short position in the underlying stock.
Buying a put option gives you apotentialshortposition in the underlying stock. Selling a naked or unmarried put gives you a potential long position in the underlying stock. Keeping these four scenarios straight is crucial.
People who buy options are called holders and those who sell options are calledwritersof options. Here is the important distinction between holders and writers:
- Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights. This limits the risk of buyers of options to only the premium spent.
- Call writers and put writers (sellers), however,areobligated to buy or sell if the option expires in the money (more on that below). This means that a seller may be required to make good on a promise to buy or sell. It also implies that option sellers have exposure to more—and in some cases,unlimited—risks.This meanswriters can lose much more than the price of the options premium.
Options can also generate recurring income. Additionally, they are often used for speculative purposes, such as wagering on the direction of a stock.
Note that options trading usually comes with trading commissions: often a flat per-trade fee plus a smaller amount per contract. For instance, $4.95 + $0.50 per contract.
Examples of Trading Options
Call options and put options can only function as effective hedges when they limit losses and maximize gains. Suppose you’ve purchased 100 shares of Company XYZ’s stock, betting that its price will increase to $20. Therefore, your total investment is $1,000. To hedge against the risk that the price might decline, you purchase one put option (each options contract represents 100 shares of underlying stock) with a strike price of 10, each worth $2 (for a total of $200).
Consider the situation when the stock’s price goes your way (i.e., it increases to $20). In such a scenario, your put options expire worthless. But your losses are limited to the premium paid (in this case, $200). If the price declines (as you bet it would in your put options), then your maximum gains are also capped. This is because the stock price cannot fall below zero, and therefore, you cannot make more money than the amount you make after the stock’s price falls to zero.
Now, consider a situation in which you’ve bet that XYZ’s stock price will decline to $5. To hedge against this position, you’ve purchased call stock options, betting that the stock’s price will increase to $20. What happens if the stock’s price goes your way (i.e., it declines to $5)? Your call options will expire worthless and you will have losses worth $200. There are no upper limits on XYZ’s price after it takes off. Theoretically, XYZ can go all the way to $100,000 or higher. Therefore, your gains are not capped and are unlimited.
The table below summarizes gains and losses for options buyers.
Using Long Calls
As the name indicates, going long on a call involves buying call options, betting that the price of the underlying asset will increase with time. For example, suppose a trader purchases a contract with 100 call options for a stock that's currently trading at $10. Each option is priced at $2. Therefore, the total investment in the contract is $200. The trader will recoup her costs when the stock’s price reaches $12.
Thereafter, the stock’s gains are profits for her. There are no upper bounds on the stock’s price, and it can go all the way up to $100,000 or even further. A $1 increase in the stock’s price doubles the trader’s profits because each option is worth $2. Therefore, a long call promises unlimited gains. If the stock goes in the opposite price direction (i.e., its price goes down instead of up), then the options expire worthless and the trader loses only $200. Long calls are useful strategies for investors when they are reasonably certain a given stock’s price will increase.
Writing Covered Calls
In a short call, the trader is on the opposite side of the trade (i.e., they sell a call option as opposed to buying one), betting that the price of a stock will decrease in a certain time frame. Because it is a naked call, a short call can have unlimited gains because if the price goes the trader’s way, then they could rake in money from call buyers.
But writing a call without owning actual stock can also mean significant losses for the trader because, if the price doesn’t go in the planned direction, then they would have to spend a considerable sum to purchase and deliver the stock at inflated prices.
A covered call limits their losses. In a covered call, the trader already owns the underlying asset. Therefore, they don’t need to purchase the asset if its price goes in the opposite direction. Thus, a covered call limits losses and gains because the maximum profit is limited to the amount of premiums collected. Covered calls writers can buy back the options when they are close to in the money. Experienced traders use covered calls to generate income from their stock holdings and balance out tax gains made from other trades.
A long put is similar to a long call except that the trader will buy puts, betting that the underlying stock’s price will decrease. Suppose a trader purchases a one 10-strike put option (representing the right to sell 100 shares at $10) for a stock trading at $20. Each option is priced at a premium of $2. Therefore, the total investment in the contract is $200. The trader will recoup those costs when the stock’s price falls to $8 ($10 strike - $2 premium).
Thereafter, the stock’s losses mean profits for the trader. But these profits are capped because the stock’s price cannot fall below zero. The losses are also capped because the trader can let the options expire worthless if prices move in the opposite direction. Therefore, the maximum losses that the trader will experience are limited to the premium amounts paid. Long puts are useful for investors when they are reasonably certain that a stock’s price will move in their desired direction.
In a short put, the trader will write an option betting on a price increase and sell it to buyers. In this case, the maximum gains for a trader are limited to the premium amount collected. However, the maximum losses can be unlimited because she will have to buy the underlying asset to fulfill her obligations if buyers decide to exercise their option.
Despite the prospect of unlimited losses, a short put can be a useful strategy if the trader is reasonably certain that the price will increase. The trader can buy back the option when its price is close to being in the money and generates income through the premium collected.
The simplest options position is along call(or put) by itself. This position profits if the price of the underlying rises (falls), and your downside is limited to the loss of the option premium spent.
If you simultaneously buy a call and put option with the same strike and expiration, you’ve created astraddle. This position pays off if the underlying price risesorfalls dramatically; however, if the price remains relatively stable, you lose premium on both the call and the put. You would enter this strategy if you expect a large move in the stock but are not sure in which direction.
Basically, you need the stock to have a move outside of a range. A similar strategy betting on an outsized move in the securitieswhen you expect high volatility (uncertainty) is to buy a call and buy a put with different strikes and the same expiration—known as astrangle.A strangle requires larger price moves in either direction to profit but is also less expensive than a straddle.
On the other hand, being short a straddle or a strangle (selling both options) would profit from a market that doesn’t move much.
Spreads use two or more options positions of the same class. They combine having a market opinion (speculation) with limiting losses (hedging). Spreads often limit potential upside as well. Yet these strategies can still be desirable since they usually cost less when compared to a single options leg. There are many types of spreads and variations on each. Here, we just discuss some of the basics.
Vertical spreads involve selling one option to buy another. Generally, the second option is the same type and same expiration but a different strike. Abull call spread, orbull call vertical spread, is created by buying a call and simultaneously selling another call with a higher strike price and the same expiration. The spread is profitable if the underlying asset increases in price, but the upside is limited due to the short-call strike. The benefit, however, is that selling the higher strike call reduces the cost of buying the lower one. Similarly, abear put spread, or bear put vertical spread, involves buying a put and selling a second put with a lower strike and the same expiration. If you buy and sell options with different expirations, it is known as acalendar spread or time spread.
Abutterflyspread consists of options at three strikes, equally spaced apart, wherein all options are of the same type (either all calls or all puts) and have the same expiration. In a long butterfly, the middle strike option is sold and the outside strikes are bought in a ratio of 1:2:1 (buy one, sell two, buy one). If this ratio does not hold, it is no longer a butterfly. The outside strikes are commonly referred to as the wings of the butterfly, and the inside strike as the body. The value of a butterfly can never fall below zero. Closely related to the butterfly is the condor—the difference is that the middle options are not at the same strike price.
Combinations are trades constructed with both a call and a put. There is a special type of combination known as a “synthetic.” The point of a synthetic is to create an options position that behaves like an underlying asset but without actually controlling the asset. Why not just buy the stock? Maybe some legal or regulatory reason restricts you from owning it. But you may be allowed to create a synthetic position using options. For instance, if you buy an equal amount of calls as you sell puts at the same strike and expiration, you have created a synthetic long position in the underlying.
Boxes are another example of using options in this way to create a synthetic loan, an options spread that effectively behave like a zero-coupon bond until it expires.
American vs. European Options
American optionscan be exercised at any time between the date of purchase and the expiration date.European optionsare different from American options in that they canonlybe exercised at the end of their lives on their expiration date.
The distinction between American and European options has nothing to do with geography, only with early exercise. Many options on stock indexes are of the European type. Because the right to exercise early has some value, an American option typically carries a higher premium than an otherwise identical European option. This is because the early exercise feature is desirable and commands a premium.
There are alsoexotic options, which are exotic because there might be a variation in the payoff profiles from the plain vanilla options.Or they can become totally different products altogether with "optionality" embedded in them. For example,binary optionshave a simple payoff structure that is determinedifthe payoff event happens regardless of the degree.
Other types of exotic options include knock-out, knock-in,barrier options,lookback options,Asian options, andBermuda options. Again, exotic options are typically for professional derivatives traders.
Short-Term Options vs. Long-Term Options
Options can also be categorized by their duration. Short-term options are those that generally expire within a year. Long-term options with expirations greater than a year are classified aslong-term equity anticipation securities, or LEAPs. LEAPs are identical to regular options except that they have longer durations.
|Time value and extrinsic value of short-term options decay rapidly due to their short durations.
|Time value does not decay as rapidly for long-term options because they have a longer duration.
|Time value decay is minimal for a relatively long period because the expiration date is a long time away.
|The main risk component in holding short-term options is the short duration.
|The main component of holding long-term options is the use of leverage, which can magnify losses, to conduct the trade.
|The main component of risk in holding LEAPs is an inaccurate assessment of a stock’s future value.
|They are fairly cheap to purchase.
|They are more expensive compared to short-term options.
|They are generally underpriced because it is difficult to estimate the performance of a stock far out in the future.
|They are generally used during catalyst events for the underlying stock’s price, such as an earnings announcement or a major news development.
|They are generally used as a proxy for holding shares in a company and with an eye toward an expiration date.
|LEAPs expire in January and investors purchase them to hedge long-term positions in a given security.
|They can be American- or European-style options.
|They can be American- or European-style options.
|They are American-style options only.
|They are taxed at a short-term capital gains rate.
|They are taxed at a long-term capital gains rate.
|They are taxed at a long-term capital gains rate.
Options can also be distinguished by when their expiration date falls. Sets of options now expire weekly on each Friday, at the end of the month, or even on a daily basis. Index and ETF options also sometimes offer quarterly expiries.
Reading Options Tables
More and more traders are finding option data through online sources. Though each source has its own format for presenting the data, the key components of an options table (or options chain) generally include the following variables:
- Volume (VLM) simply tells you how many contracts of a particular option were traded during the latest session.
- The "bid" price is the latest price level at which a market participant wishes to buy a particular option.
- The "ask" price is the latest price offered by a market participant to sell a particular option.
- Implied Bid Volatility (IMPL BID VOL) can be thought of as the future uncertainty of price direction and speed. This value is calculated by an option-pricing model such as theBlack-Scholes model and represents the level of expected future volatility based on the current price of the option.
- An Open Interest (OPTN OP) number indicates the total number of contracts of a particular option that have been opened. Open interest decreases as open trades are closed.
- Deltacan be thought of as a probability. For instance, a 30-delta option has roughly a 30% chance of expiring in the money. Delta also measures the option's sensitivity to immediate price changes in the underlying. The price of a 30-delta option will change by 30 cents if the underlying security changes its price by $1.
- Gamma is the speed the option for moving in or out of the money.Gamma can also be thought of as the movement of the delta.
- Vegais a Greek value that indicates the amount by which the price of the option would be expected to change based on a one-point change in implied volatility.
- Theta is the Greek value that indicates how much value an option will lose with the passage of one day.
- The "strike price" is the price at which the buyer of the option can buy or sell the underlying security if they choose to exercise the option.
Options Risks: The "Greeks"
Because options prices can be modeled mathematically with a model such asthe Black-Scholes model, many of the risks associated with options can also be modeled and understood. This particular feature of options actually makes them arguablylessrisky than other asset classes, or at least allows the risks associated with options to be understood and evaluated. Individual risks have been assigned Greek letter names, and are sometimes referred to simply as"the Greeks."
The basic Greeks include:
- Delta: option's price sensitivity to price changes in the underlying
- Gamma: option's delta sensitivity to price changes in the underlying
- Theta: time decay, or option's price sensitivity to the passage of time
- Vega: option's price sensitivity to changes in volatility
- Rho: option's price sensitivity to interest rate changes
What Does Exercising an Option Mean?
Exercising an option means executing the contract and buying or selling the underlying asset at the stated price.
Is Trading Options Better Than Stocks?
Options trading is often used to hedge stock positions, but traders can also use options to speculate on price movements. For example, a trader might hedge an existing bet made on the price increase of an underlying security by purchasing put options. However, options contracts, especially short options positions, carry different risks than stocks and so are often intended for more experienced traders.
What Is the Difference Between American Options and European Options?
American options can be exercised anytime before expiration, but European options can be exercised only at the stated expiry date.
How Is Risk Measured With Options?
The risk content of options is measured using four different dimensions known as "the Greeks." These include the Delta, Theta, Gamma, and Vega.
What Are the 3 Important Characteristics of Options?
The three important characteristics of options are as follows:
- Strike price: This is the price at which an option can be exercised.
- Expiration date: This is the date at which an option expires and becomes worthless.
- Option premium: This is the price at which an option is purchased.
How Are Options Taxed?
Call and put options are generally taxed based on their holding duration. They incur capital gains taxes. Beyond that, the specifics of taxed options depend on their holding period and whether they are naked or covered.
The Bottom Line
Options do not have to be difficult to understand when you grasp their basic concepts. Options can provide opportunities when used correctly and can be harmful when used incorrectly.
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Options Industry Council. "Options Expiration Calendar."
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I am an options trading enthusiast with a deep understanding of the concepts and strategies involved in the options market. My expertise stems from practical experience and a thorough knowledge of the intricate details that govern options trading.
Let's delve into the concepts mentioned in the article:
Call Options and Put Options:
- Call Options: Buyers use them to hedge against declining prices, and they give the right (but not obligation) to buy an underlying asset at a specified price.
- Put Options: Buyers use them to hedge against rising prices, and they give the right (but not obligation) to sell an underlying asset at a specified price.
Hedging Strategies for Importers, Exporters, and ADR Holders:
- Importers can use call options on the U.S. dollar to hedge against a decline in purchasing power.
- Exporters can use put options on the U.S. dollar to hedge against a rise in selling costs.
- ADR holders can use call options on the U.S. dollar to hedge against a decline in dividend payments.
Short Sellers and Options:
- Short sellers use call options to hedge against their positions.
- Put options have limited gains for short sellers as a stock's price can't fall below zero.
How to Trade Options:
- Brokers approve access to options trading for qualified customers who are approved for both margin and options.
- Four basic actions: Buy (long) calls, Sell (short) calls, Buy (long) puts, Sell (short) puts.
Options Trading Strategies:
- Call and put holders (buyers) are not obligated to buy or sell; they have the choice to exercise their rights.
- Call and put writers (sellers) are obligated to buy or sell if the option expires in the money, exposing them to more risks.
Examples of Trading Options:
- Illustrates how call and put options function as hedges and their potential gains and losses.
Using Long Calls:
- Explains how going long on a call involves betting on the price increase of an underlying asset.
Writing Covered Calls:
- Short call strategy betting on a stock price decrease, with covered calls using already-owned assets to limit losses.
Long Puts and Short Puts:
- Long puts involve betting on a stock's price decrease, while short puts involve writing options betting on a price increase.
Combinations, Spreads, and Synthetics:
- Explains straddles, strangles, spreads, and synthetics as combinations using calls and puts.
American vs. European Options:
- American options can be exercised at any time; European options can only be exercised at expiration.
Short-Term vs. Long-Term Options:
- Describes the differences between short-term and long-term options, including LEAPs.
Reading Options Tables and The Greeks:
- Introduces essential elements in options tables: Volume, Bid, Ask, Implied Bid Volatility, Open Interest, Delta, Gamma, Vega, Theta, and Strike Price.
Options Risks: The "Greeks":
- Describes the key Greeks: Delta, Gamma, Theta, Vega, and Rho, used to measure and understand options risks.
Exercising an Option and Options Taxation:
- Explains what exercising an option means and how options are generally taxed based on their holding duration.
In conclusion, understanding these options concepts and strategies is crucial for making informed decisions and managing risks in the dynamic options market.