Options 101 for Stock Traders

E*TRADE Securities2

08/14/17

Why options?

 

If you are an established stock trader, you may be exploring other investments, like options, to help diversify your portfolio and manage risk. Maybe you are tired of listening to your neighbor boast over cocktails at the block party about how he is killing it trading options and you want in on the action. Better yet, maybe your motivation is a desire to expand your trading skills, using these securities to control and manage the risks in your stock portfolio. You are not alone. Since the 2000s, options trading has experienced phenomenal growth and yet it is still an area within the investment community which is misunderstood and thereby underutilized. So congratulations to you for your interest in learning more, you are way ahead of the investing masses.

Below is a chart of the annual number of options contracts traded in the United States since their original listing on the Chicago Board Options Exchange (CBOE) way back in 1973.

Note the explosive growth of options trading volume since the millennium with the expansion of electronic trading. This new trading technology, along with the creation of low-cost, self-directed online retail brokers, has really leveled the playing field for retail investors like you to participate and become a critical member of the options trading marketplace.

Chart of of annual options volume

Why have we seen this impressive growth of options trading? They are versatile, financial instruments which can be used to create a wide range of investment strategies. A couple of examples:

  • Options may be used to help generate income on stock you already own in your portfolio
  • Options allow owners to participate in the ups and downs of a stock’s price without actually owning the stock
  • Options may reduce the downside loss exposure from a market sell-off

It is important to remember that nothing comes free when using options. There are costs associated with owning options and risks (which may be much greater than the premium received) associated with selling option contracts. Options involve risk and are not suitable for every investor. Prior to buying or selling an option, every broker requires investors to read a copy of the Options Disclosure Document (ODD).  But learning the proper use of options in your portfolio can provide you with more investment “options” than simply buying stock and hoping the price rises.

 

What are options?

 

Options are also known as derivatives or derivative instruments. This comes from the fact that they derive their value from another underlying asset. Equity options derive their value from the underlying equity (stock) price. They are securities just like stock and as such regulated in their transactions by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Like stock shares, they can be bought or sold. Unlike stock shares, options are contracts.

Like a legal contract, they give rights to the owner (holder) of the contract in exchange for a premium paid. Sellers (writers) of option contracts receive this premium payment in exchange for having an obligation to fulfill the contract’s terms.

Speaking of terms, there are several terms to become familiar in order to understand options.

There are two types of option contracts. Call options and put options.

Buying a call option gives the owner/holder the right but not the obligation to buy the underlying stock at a predetermined price any time on or before the contract’s expiration date.

Selling a call option obligates the seller/writer to sell the stock at a predetermined price any time on or before the contract’s expiration date. Notice the seller is obligated to fulfill the contract; the holder has all the rights to choose whether to exercise their purchased rights. The owner of the call option literally has the right to CALL the stock away from the seller. Thus the name, call option.

On the put side, the owner of the put option has the right but not the obligation to sell the underlying stock at a predetermined price any time before the contract expires.

Sellers of puts have the obligation to buy the stock at a predetermined price any time before the contact expires.  The owner of the put option literally has the right to PUT the stock to the seller.

The predetermined price is called the option’s strike price. This is the specific price at which the option contract may be exercised or acted upon. An option’s strike price relative to the underlying stock’s price determines if the option has any real or intrinsic value. A call option with a strike price lower than the stock price has intrinsic value and is considered in the money (ITM). A put option with a strike price higher than the stock price has intrinsic value and is considered in the money. If an option has no real or intrinsic value it is considered out of the money (OTM).

For example, a call option on a stock whose last price is 52 with a strike price of 45 has 7 dollars of real, intrinsic value. The right to buy stock at a price of 45 is 7 dollars better than buying it at 52 in the market. This call’s strike price is ITM.

A put option with a strike price of 50 dollars has no real benefit with the current stock priced at 52. The right to sell the stock at 50 is not better than simply selling the stock in the market at 52. It is an OTM strike price for the put.

These contracts also have an expiration date, the day after which the option expires and literally no longer exists. The holder of the option has to determine what to do with his contract before the option expires. They can always sell their rights to another buyer at any time during the option’s term, they can exercise their rights and actually buy or sell the underlying stock, or they can walk away and allow their contract to expire worthless if the option is out of the money.

As a writer of an option, you have no control over whether or not a contract is exercised. You are potentially obligated to fulfill the terms of the contract at any time before expiration. However, like a holder of an option, the writer can purchase an offsetting contract to close the obligation. You simply buy to close the same option you were short, from another seller.

In the table below, you should learn it backwards and forwards to instinctively understand which rights and obligations you have.

 

Table showing options rights and obligations

 

Alternatively, looking at the four possibilities or cornerstones of buying or selling puts or buying or selling calls you can think of what market sentiment you may be expressing by memorizing this chart. Bullish sentiment, expecting future prices to head higher, or bearish sentiment, the expectation of lower prices ahead.

 

Table showing cornerstones of buying or selling puts and calls

 

Now that you understand the basic options trading definitions and terms, learn more about trading options on the E*TRADE platform.