Options trading is often viewed as a “black box”, an asset class that is not well-understood by the masses. The truth is, when used correctly, options offer many advantages that trading stocks alone cannot provide.

In this introductory article to options, we will break down the essentials of options trading:

Options do not have to be difficult to understand when you grasp their basic concepts. When used properly, one will realize that options are a very useful tool to have in one’s trading arsenal. Conversely, when used incorrectly, it can result in substantial losses.

Hence, it is important to obtain the necessary education if one wishes to trade options well.

What are options? Key characteristics and terminology used in the options world

Options are derivative contracts because they derive their value from an underlying security such as stocks, but options may also be written on any sort of underlying security from currencies to commodities.

One stock option contract typically represents 100 shares of the underlying stock. Hence, when one purchases 1 option contract, he/she has indirect exposure to 100 shares of the underlying stock. This might be a “problem” when one starts with a small options trading account, as 1 option contract on a “high-price” stock such as Amazon can also be extremely costly.

We will address this issue when we talk about options spreads.

Besides each option contract representing 100 shares of the underlying stock, there are other key characteristics and terminology used in options:

Option Buyers vs. Sellers

After paying the premium, the buyer of the option will now have the RIGHT, but not the obligation to buy or sell the asset at a stated price (strike price) within a specific time frame (before expiration).

Conversely, after receiving the premium, the seller of the option will now have the OBLIGATION to buy or sell the asset (from/to the buyer of the option contract) at a stated price (strike price) within a specific time frame (before expiration).

Before we explain the concept of options buying and selling with a simple illustration, it will be useful to highlight the two types of options.

Call Option vs. Put Option

There are just two types of options:

A buyer of a call option will hold a BULLISH view of the underlying asset and gets to profit when the underlying asset price appreciates.

Conversely, a buyer of a put option will hold a BEARISH view of the underlying asset and gets to profit when the underlying asset price falls.

Let’s put it all together with a simple illustration.

Example

Let’s say, for example, that Peter has a bullish view on stock ABC and believes that the market could appreciate by 20% over the coming 3 months. He purchases a call option (Bullish) contract with a strike price of $100/share (allows him to purchase Stock ABC at the agreed price of $100/share) for a contract horizon of 3 months (expiration period).

The current price of stock ABC is also at $100/share.

As a buyer of the option contract, he is required to pay an option premium. In this case, let’s assume that the option premium is $10/share. Since each options contract is equivalent to 100 shares, Peter has to pay over $10 * 100 shares = $1,000 in options premium, which is also his maximum risk exposure.

Even if he is wrong in his expectation of stock ABC appreciating and the price collapses instead, his maximum downside risk potential is $1,000 (premium paid).

Assuming that Peter is indeed correct in his assessment that the price of stock ABC appreciates by 20% to $120/share after 3 months. His value of his call option is now worth $20/share or $2,000/contract on expiration, for a profit of $1,000/contract ($2,000 final value – $1,000 cost).

He has essentially generated a 100% return on investment (ROI) on this option trade vs. the underlying price appreciation of 20%. This demonstrates the leverage effect of options trading.

If the price of stock ABC is below $100/share on expiration day (3 months later), then his call option expires worthless and Peter loses his $1,000 premium.

Popular Option Strategies

Options can be used for leverage, as can be seen from the example above. Instead of paying $10,000 to own 100 shares of the underlying (at $100/share), one only requires a capital of $1,000 (10% of capital to own the stock) in this example.

More importantly, this capital amount of $1,000 is also the maximum risk exposure to the trade. Since the max risk is now defined, it allows one to sleep well at night.

Long Call

A simple long call strategy (aka buying of a call option) is executed when one is bullish on the underlying asset, as seen in the earlier example.

We have seen that the maximum risk is defined by the premium paid, while the maximum profit potential is theoretically unlimited. Therefore, a long call promises unlimited gain. Long calls are useful strategies for investors when they are reasonably certain a given stock’s price will increase.

Long Put

A long put strategy (aka buying of a put option) is executed when one is bearish on the underlying asset and believes that its price will decline. This allows the buyer of the put option contract the opportunity to profit from the underlying asset price decline.

The maximum risk of the Put Option buyer is once again limited to the premium that he/she paid. This occurs when the price of the underlying is ABOVE the put option strike on expiration. On the other hand, his/her profit potential could be substantial if there is a significant decline in the price of the underlying, capped at the price falling to ZERO.

Long puts are useful for investors when they are reasonably certain that a stock’s price will move down.

Covered Call

A covered call is a strategy of combining the purchase of 100 shares of the underlying + selling a call option contract. As a buyer of the shares, one is taking a bullish stance, while as a seller of a call option contract, one is taking a bearish stance.

Such a combination is undertaken predominantly to generate income on a short-term basis. Recall that as a seller of a call option, one receives a premium upfront for the option trade. A covered call structure allows the owner to benefit from the appreciation of the underlying asset while concurrently being paid an income (from selling a call option).

This is a relatively safe strategy when structured correctly. Many newbie traders structure a covered call “incorrectly” when they sell a call option without the ownership of at least 100 shares of the underlying stock. This will result in a “mismatch” in terms of long and short exposure and significant losses could be incurred if the underlying price APPRECIATES substantially.

Short Put

A short put is a strategy of selling put options. This is typically seen as a BULLISH strategy. The seller of the put option will receive a premium from the sale and this is his/her maximum profit potential. If the price of the underlying appreciates or remains above the strike price on expiration, that put contract expires worthless and the put seller is entitled to his/her full premium received.

However, the maximum losses could be substantial if the underlying price declines substantially. There is now an obligation on the part of the put seller to take over the shares of the buyer at a higher-agreed level (strike price) when the underlying price is now lower.

A short put strategy is often used by value investors to receive income while waiting for the price of the underlying to fall to their desired entry level. Hence, they will look to sell a put option contract at a strike price that is often lower than the current market price and be prepared to take ownership of the stock if the price does indeed fall below the strike price.

Constructing an options spread

Unlike stocks, which do not allow for the concurrent buying and selling of the same underlying symbol, options allow one to be both a buyer and seller of the underlying stock at the same time.

There are a variety of reasons why someone would like to structure an options spread, but the main reason is that such a structure costs less when compared to a single options leg (aka, just buying of options).

A spread is created by buying and selling the same type of option (call or put) simultaneously. As a buyer, you pay a premium while as a seller, you receive a premium. The premium will thus offset each other; thus, it could mean a lower overall outlay (smaller debit vs. a long call) or it could be an inflow (credit).

Vertical

The simplest way to structure an options spread is by creating a vertical. This is a structure where one purchase and sells the same type of option (call or put), with the same expiration period, but at different strike prices.

This is typically executed for “high price” counters or index ETFs. I mentioned earlier in this article that the purchase of options for high-priced stocks, such as Amazon, could be extremely costly in terms of capital outlay.

A vertical, specifically a call debit vertical or bull call vertical, can be structured to reduce one’s outlay significantly, while still benefitting from the upside price movement of Amazon.

Take, for example, the price of Amazon is currently at $3,320/share. The purchase of 1 call option on Amazon, expiring in 319 days, at a strike price of $3,320 will cost $35,500 which is a substantial outlay for most retail options traders.

However, that outlay can be significantly reduced by concurrently selling a call option at a higher strike of say $3,500, receiving a premium of $26,735 for a lower net debit outlay of $8,765 (vs. original outlay of $35,500 for the long call).

The upside potential, however, is no longer unlimited (vs. when structuring a long call) and now is capped by the sell call strike of $3,500/share.

Nonetheless, a vertical will allow an options trader to benefit from the upside price movement of a “high price” stock such as Amazon, due to the lower capital outlay, which might be the main inhibiting factor when structuring a long call.

Such verticals can be structured not just for stocks but also for index ETFs (which are typically “high price” stocks). This will allow an options trader to trade the market easily with a much lower capital outlay, sometimes as little as a few hundred dollars.

Conclusion

We have gone through the basics of options in this introductory option article. As previously mentioned, options trading can be learned and one is NOT required to execute on complicated options strategies (such as butterflies, condors, etc) to profit from options trading.

Making money from options can be as simple as executing a long call or a long put. For those with limited capital or who do not wish to risk a large amount of capital, the structuring of verticals (buying and selling of options contracts simultaneously) can be an easy way to partake in the upside/downside of a “high price” stock or index (such as S&P 500) without the need for excessive capital outlay.

In the coming series in collaboration with Nasdaq, we will look to introduce the concept of trading index options through a mixture of both primer option articles and videos.

The understanding of how options work and the characteristics of options introduced in this article will be useful when going through the articles/videos about index options.

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