Most people associate investments with purchasing shares on the stock market and are unaware of other lucrative terms like options trading contracts. Buying and holding stocks for long-term gains is one of the most common investment strategies and is fruitful in most cases, provided you know which stocks to buy and when to sell. While this method can help you increase your wealth over time, it doesn’t do much in the short term.
If you are an avid investor, you must have heard about options contracts. Options are financial instruments that can yield big profits or even big losses if you are not careful. During this time, the market is highly volatile, making options trading a general trend among investors.
More and more investors are hopping on the Options trading bandwagon and these financial instruments have proven to be extremely popular among traders and investors. According to the Options Clearing Corporation, there were 939 million options contracts traded in March 2022, witnessing a rise of 4.5% from the previous year. It was the second-highest trading month on record.
Despite its popularity, options contracts are not straightforward and require tactical strategies to get the most out of it. In this blog, we will explain options contracts, types of option contracts, and how traders can successfully do options trading.
Option Contract Explained
In simple terms, options trading refers to buying or selling an underlying asset at a pre-determined price at a future date.
An ‘option’ is basically a contract giving the investor the right(or option) to buy or sell a specific stock at a specified price(strike price) for a specified period of time. When the specified period of time ends, the options expire and lose their value.
However, trading options can be incredibly complex. When you buy a stock, you just have to decide how many shares you want, and the broker does the rest. However, an options contract requires an in-depth understanding of finance and advanced strategies. Moreover, the process of opening an options trading account is more complicated than opening a typical investment account.
According to Randy Frederick- Managing Director of Trading and Derivatives at the Schwab Center for Financial Research, when the market becomes volatile due to external factors like inflation, war, and rising oil prices, options trading often witnesses more action. He adds you can use options to speculate and gamble, but the best use of options is to protect your downside.
Types of Option Contracts
Before you can start trading options, you must understand the different types of options contracts. Typically, options are divided into two categories- calls and puts.
A call option is a financial agreement between the holder and the writer. The holder is the owner of the contract as they have purchased the right to buy the underlying security. And, the writer is known as the seller as they sell the contract for a fee that is paid by the holder. The financial agreement specifies the terms including strike price, underlying security, and expiration dates.
A put option is a contract that grants the right to the owner to sell the relevant underlying asset at a predetermined price at a future date. The investor who purchases the contract pays a fee in exchange for the right, but not the obligation to sell the security. This is known as exercising an option. If the buyer of the options contract exercises their right, the other party must purchase the security at the pre-determined price.
How to Trade Option Contracts?
While options contract trading can be extremely complex for beginner investors, you can follow these steps to get started on your option trading journey-
Open an Options Trading Account
Before you can start trading options, you will have to open an options trading account. This is easier said than done. Compared to opening a brokerage account for stock trading, opening an options trading account requires large amounts of capital. And, given the complex nature of multiple moving parts, brokers are required to know more about potential investors before they can provide a slip for trading options.
Most brokerage firms will screen applicants and evaluate their trading knowledge and experience before approving them. Your financial preparedness and understanding of the risks are documented in the options trading agreement used to request approval.
You will need to provide the following-
Investment Objectives: This includes income, growth, and capital preservation or speculation.
Trading Experience: The broker will require you to share your trading experience and knowledge of investing. They will assess how long you have been trading stocks, how many trades you make per year and their size. You will have to prove that you have a deep understanding of finance and are familiar with the risks associated with options contracts trading.
Personal Financial Information: You must provide your personal financial information including your liquid net worth, annual income, total net worth, and employment information.
The Types of Options You Want to Trade: There are two types of options- calls or puts. Whether they are covered or naked. The seller or the writer has an obligation to deliver the underlying stock if the option is exercised. If the writer also owns the underlying stock, the option position is covered. If the option position is left unprotected, the option is naked.
Based on your answers and experience, the brokerage company assigns you an initial trading level(from 1 to 5, with 1 being the lowest and 5 being the highest).
Pick the Options to Buy or Sell
A call option gives you the right to buy a stock at a predetermined price within a certain period whereas a Put option gives you the right to sell shares at a stated price before the contract or agreement expires.
Depending on which direction you think the stock will move, you can choose your options-
- If you think the stock price will move up: buy a call option or sell a put option.
- If you think the stock price will be neutral: sell a put option or sell a call option.
- If you think the stock price will go down: buy a put option, or sell a call option.
This is just a basic strategy and trading options involve more advanced knowledge and tactical skills.
When trading options, think of them like your car insurance policy, you don’t get car insurance hoping that you crash your car. You get car insurance because sometimes it's better to stay cautious as no matter how careful you are, crashes do happen.
Predict the Strike Price of the Option
An option only remains valuable if the stock prices close the option’s expiration dates either above or below the strike price(For call options, it's above the strike price; for put options, it’s below the strike price). To gain a profit, you want to buy an option with a strike price that reflects where you think the stock will be during its lifetime.
For example- if you think a company’s share price which is currently trading at $80, will go up to $100 in the future, you will buy a call option with a strike price of less than $100. If the stock does rise in value as you predicted, your stock option is in the money.
Similarly, if you think a company’s share price will go down to $60 in the future, you will buy a put option with a strike price above $60. If the stock price dips below the strike price as you predicted, your options contract is in the money.
However, you can’t just choose any strike price. Option quotes, also known as option chains or matrix, contain a range of strike prices that are available to the trader. The increment of the strike price is standardized across the industry and is based on the stock price.
The price you pay for the option is called a premium and has two primary components- the intrinsic value and the time value.
Intrinsic value can be defined as the difference between the strike price and the share price if the share price is above the strike. Time value is whatever is left and also depends on various factors like the volatility of the stock, the time of expiration, and interest rates, among others.
Determine the Time Frame of the OptionR
Every option contract comes with an expiration date that indicates the last day you can exercise your right to buy or sell the particular option. Similar to the strike price, you can’t make up your own expiration date. Your choices are limited to the ones offered to you when you call up an option.
Depending on the time frame and when can they be exercised, there are two types of options- American and European. American option holders can exercise their right at any point till the expiration date whereas European option holders can only exercise their right on the expiration date.
Since American options offer more flexibility for the buyer and more risk for the seller, they usually cost more than European options.
Expiration dates for options can range from weeks to months to years. Daily and weekly options are the riskiest options and are usually reserved for experienced option traders. Monthly and Yearly expiration dates are preferable for long-term investors. A longer expiration date allows the option to move freely and time for your prediction to play out. That being said, the longer the expiration date, the costlier the option.
Moreover, a longer expiration date is also preferable as the option can retain its time value, even if the stock trades below the strike price. Since an option’s time value deteriorates as the expiration date approaches. If the stock finishes below the strike price, the option is worthless. In this case, investors can still sell any time value remaining on the option, which is more likely if the option contract is longer.
Key Terms Used in Options Trading
In order to better understand options trading contracts, you must first understand the various terms associated with the financial instrument.
Option: The right but not the obligation to buy or sell an underlying financial instrument at a specific price and on a particular maturity date.
Strike Price: The price at which the holder of the option exercises their right to buy or sell.
Call Option: A financial agreement that gives the owner the right but not the obligation to buy an underlying security at a specific price with a specific expiration date.
Put Option: A financial agreement that gives the owner the right but not the obligation to sell an underlying security at a pre-determined price.
American Style Option: One of the types of option contracts that can be exercised anytime within the expiration date.
European Style Option: A type of option contract that can only be exercised on the expiration date, unlike the American style option.
At-the-market: A financial agreement where the order to buy or sell a security is executed at the current market price.
At-the-Money Spot: A type of option contract whose strike price is equal to the current market price in the market of cash spot.
At-the-Money Forward: A type of option contract whose strike price is equal to the current market price in the forward market.
Commodity Swap: A financial contract in which both parties agree to exchange payments related to indices, at least one of which is a commodity index.
Currency Swap: The exchange of an interest in one currency for the same in another currency.
Delta: The change in the financial instrument’s price in relation to the changes in the price of the underlying cash index.
Equity Swap: A financial contract in which both parties agree to exchange payments related to indices, at least one of which is an equity index.
Forward Contracts: An obligation to buy or sell a financial instrument settled privately between two parties.
Futures Contracts: An exchange-traded obligation to buy or sell an options contract.
Gamma: The degree of curvature of the option contract’s price curve to its underlying price.
Hedge: A transaction that counteracts an exposure to fluctuation in financial prices of other contracts or business risk.
In-the-Money Spot: An option with positive intrinsic value for the current market rate.
In-the-Money Forward: An option with positive intrinsic value to the current forward market rate.
Premium: The cost associated with an options contract that refers to the combination of time and intrinsic values.
Theta: The sensitivity of a financial product’s value relative to changes in the date.
How Risky are Options Trading Contracts?
Due to its complexity, options trading contracts are known to be quite risky and are not suitable for beginner traders or investors. This is why it is essential that traders know how options work and have relevant experience in the field of trading before getting involved with options. It is not a smart financial move to invest your money in something you don’t understand.
The risk you take in options trading depends on your role in contracts(which party are you) and your investment strategy. There are multiple strategies that you can implement with different combinations of options. That being said, options investors can lose a little prepaid amount of the premium or experience unlimited losses, depending on their implemented strategies.
As options trading is relatively risky, most brokers have implemented strict guidelines and qualification criteria that investors must meet to start options trading. There are various resources available to help you better understand the world of options trading.
Keep in mind that options trading is not for everyone, especially beginner and inexperienced investors. If you are eager to start trading options, it will be beneficial for you to understand options and take an options trading course, available on online financial sites.
By now, you must have a general idea about what options are, the different types of options, and how to start options trading, including the risk level associated with it. While options may seem like a lucrative investment opportunity, it is important to understand the world of options trading before you dive into it. Options trading is incredibly complex and is not suitable for beginners. It is important to have relevant experience in the field of investing before you can start your options trading journey.
That being said, experienced investors can use alternative strategies to profit from underlying securities. There are a variety of strategies that involve different combinations of options, underlying assets, and other financial instruments. Use them wisely and reap the various benefits of trading options, instead of underlying assets.
Frequently Asked Questions(FAQs)
Ans. An option contract is the right but not the obligation to buy or sell an underlying financial instrument at a specific price and on a particular maturity date. It is essential to understand that options contracts have two parties involved, a buyer(also known as the holder), and a seller(who is also known as the writer).
Ans. When opening an options trading account, brokers will assign you a level depending on your experience and financial knowledge. You must be approved till a certain level to use the strategies associated with those levels. The levels are as follows-
Level 1: covered calls and protective puts.
Level 2: long calls and puts, including straddles and strangles
Level 3: options spread, involving buying one or more options and at the same time selling one or more different options of the same underlying
Level 4: selling naked options, means unhedged, posing the possibility for unlimited losses
Ans. Most options contract trade on specialized exchange platforms like the Chicago Board Options Exchange, the Boston Options Exchange, and the International Securities Exchange. These exchanges are mostly online now and any order you send through your broker will be directed to one of these exchanges.