How To Start: Options Basics

In short, options trading and investing has come to the masses; and at times it causes mass confusion.

Before you jump in, you should have a strong grasp on the basics.  This article is obviously geared towards new options traders but if you’re already swimming, a refresher from time-to-time can be quite useful.

WHAT ARE OPTIONS?

Equity options are contracts whose value is derived from the value of a specific (called underlying) stock trading in the market. These contracts can be used to profit, leverage, and hedge your position in its underlying stock, based on your belief in the direction of the market and/or how market volatility will behave.

An option establishes a right to buy or sell the underlying property.  A standard equity option establishes the right to buy or sell 100 shares of the underlying stock at a fixed price before a specific date in the future, known as the expiration date. The expiration date for an option usually occurs in three, six, or nine months. In the United States, options are traded on the Chicago Board Options Exchange, over-the-counter, and on several other exchanges.  Don’t worry about using a specific exchange, your broker will take care of that for you.

Now that you have a basic definition of what an options contract is, the rest of this article will focus on the difference between calls vs. puts; buying and holding vs. selling and writing; pricing and premiums; type, class, and series of options; opening and closing positions; and, European versus American-style options.  Wow, that was a mouthful!

THE BASICS OF OPTIONS

Calls vs. Puts 

The right to buy the underlying stock at a fixed price (strike price) before expiration is a call option; the right to sell the underlying stock is a put option. Call options only make financial sense to exercise (i.e., exercise the call buyer's right to purchase the shares) when the price of the stock goes above the strike price of the call while the put options would only be exercised if the price of the stock goes below the strike price.

Buying and Holding vs. Selling and Writing

The purchaser of an option contract is known as the holder. The holder pays the seller (writer) of the option a premium (at the time of the options trade), which isalso the price for the option.  The price, like stock, is what is reported by the exchange as the last price and will vary throughout the day and remaining life of the contract.  The buyer, (holder) exercises the option by informing broker, who then informs the writer that she wishes to buy (for a call option) or sell (for a put option) shares of the underlying security at a specified price (strike or exercise price).  

Options are always described from the standpoint of the holder. The holder has a right to exercise the option while the writer has an obligation to deliver the underlying stock at the specified price, or strike price. A call holder would have a bullish outlook for the market or shares upon which the option was purchased, believing prices are generally going to rise. A put holder has a bearish or contrary outlook of the market.  The seller, or writer, of the contract (should) have the opposite view.

Pricing and Premiums 

The exercise price is the set price at which the 100 shares of stock trade will be executed. Exercise (strike) prices are determined by the exchange(s) where the options trade. These strike prices are set at certain standard increments depending on the current price of the underlying stock.  Often beginning options traders get confused with the strike price.  It’s important to note that the strike prices are not arbitrary and are set for the life of the contract.

If the underlying stock is trading at less than $200 per share, the strike prices on the options contract will be set at 5-point intervals.  For example, if the stock for FB (Facebook, Inc.) has been trading around $140 to $160/share, there will be puts and calls set at strike price intervals of 140, 145, 150, 155, 160, etc.  

If the underlying stock is trading over $200 per share, the strike prices of the options contracts will generally be set at 10-point (dollar) intervals.  For example, if GOOGL (Alphabet Inc, the parent company of Google) stock has been trading in a range from $1,300 to $1,000 over the past few months, there will be puts and calls on GOOGL at 1030, 1040, 1050, and so on and so forth.

The premium is the price buyers pay and sellers receive for the options contracts.  Premiums are determined, largely, by supply and demand in an auction market (on the respective exchange) in the same way a stock’s price will fluctuate based on supply and demand in the market.The relationship between the strike price of the option and the market price of the underlying stock is a major one.  If the market price is above the strike price, calls at that strike price will have a greater premium than puts at that strike price (this is because the call is considered in-the-money while the put would be out-the-money).

Type, Class, and Series of Options 

There are two types of options; puts are one type and calls are the other type. All calls are one type of option, and all puts are another type. By adding the underlying stock to the type, we get the class of options. All IBM calls are one class; all IBM puts constitute another options class.

Once the expiration month added to the class then this establishes the maturity class of an option.

All GM JAN(January) calls are one maturity class; all GM JAN puts are another maturity class. Adding the strike (exercise) price to the maturity class gives the series of an option. All XOM (Exxon Mobil Corporation) JAN 75 calls are one series; all XOM JAN75 puts are another series. Once the series is defined, this is the final level of granularity in defining the contract to be traded.

Opening and Closing Positions

Every beginning options contract position begins with an opening transaction. Whether you write (sell) or hold (buy) the option, you are executing a corresponding ‘opening’.

Ex.

Buy 1 JAN IBM 120 Call @4.00 = opening buy ($400 + commission paid = total transaction cost) 

Sell 5 APR MSFT 100 Puts @4.25 = opening sale ($2,125 - commission paid = net proceeds received)

A closing transaction takes place when you purchase the same contract at or near expiration to close out your position before an exercise occurs.

Ex.

Buy 1 JAN IBM 120 Call @ 4.00 = opening buy; Sell 1 JAN IBM 120 Call @8.00 = closing sale

Sell 5 APR MSFT 100 Puts @4.25 = opening sale; Buy 5 NOV MSFT 125 Puts @2.00 = closing buy

How Many Options Contracts Are There?

Unlike stock, the company does not “issue” its options contracts as it would its shares.  Rather, the exchange standardizes the classes of options available and the market creates the supply.  How, you might ask?

The exchange standardizes the series of options available for each class.  A new contract is created when a seller initiates an opening transaction.  Did you notice that I used the term “write” synonymously with “sell” above?  When a contract is “Sold to Open” it creates a contract that can be bought on the exchange.  Once the buyer and seller make the deal (via the efficiency of the exchange) a new contract is born and the “Open Interest” of the series will increment by 1 contract.  Open interest shows how many contracts are still “active” in the market.

Remember, the seller (who has the obligation of the contract) must hold up the terms of the contract or execute a closing transaction to cancel out their obligation.  Why bring this up again?

Let’s take our initial example and say the series only has an open interest of only 1.  In this case, the seller could only close the position if the buyer would sell the contract back.  The series is said to be very illiquid in this case. The seller would likely be forced to maintain the obligation throughout the contracts life.  On the contrary, if the series had 10,000 open interest then the seller would easily be able to find another seller in order to purchase the closing order and exit the trade.

European versus American-style Options

Most exchange-listed options in the United States are classified as American-style options, meaning that the contracts may be exercised at any time up to their expiration date. This differs from European-style options, which may only be exercised at expiration. Certain ETFs and index options trade European-style despite being listed on American Exchanges.

Understand that the style is very important, especially when writing options contracts.  In general, American-style options tend to have higher premiums than European-style because there is more flexibility to exercise the rights of the contract (for the holder) and more risk to be exercised against (for the seller).  Remember, it is the seller’s obligation to either deliver 100 shares at the strike price or buy 100 shares from the holder at the strike price depending on the contract type.  Have I said this enough times?  It’s a very important point.

BASIC OPTIONS TRADING SETUPS** or ‘STRATEGIES’

The most basic options strategies involve buying and selling single contracts. For some, this is fine way to trade options. Buying and selling calls and selling puts meets the basic requirements when looking to take advantage of movements in the market.

Buying calls or selling puts are a position taken when your outlook is bullish on the market.  In the other hand, selling a call or buying a put creates a bearish position. Establishing these positions as a holder gives you a right to purchase the stock at a price lower than what it is currently trading. Writing calls and puts provides premium as income, however, it also inherits an obligation (risk) to deliver (or buy) the stock at a price that is reserved by the holder (repeated once again!).

Buying and selling a single contract is the most basic ‘options strategy’ and far from ideal in many circumstances.  Most of the trades we use are known as “spreads”, or combinations of puts and calls within the same class.  Spreads allow us to control our trading risk and be more strategic; this is why the various spread type is often referred to as the ‘Options Strategy’. 

I have to note.  I’ve never liked the term ‘Options Strategy’ to refer to a spread.  A spread can be used strategically, but purchase or sale of a spread does not constitute an options strategy in my book.  A strategy must holistically evaluate multiple criteria and be rule-based for entry and exit…but I digress….

For sake of simplicity, and to get your feet wet.  Let’s take a closer look at these three ‘strategies’:

Example 1: Buy 1 AAPL JAN 170 CALL (Market Price of AAPL $165) @ about $5

In this example, you are bullish on AAPL stock and believe that the market price is going to rise well above the strike price of $170. Currently, the market price of AAPL is $165, meaning that the call is considered out-of-the-money (OTM)by $5. If you were to exercise the option, you would be able to buy the stock for $170 per share.  So this trade will only become profitable for you if AAPL rises in prices to above $175/share.At this price the option is now in-the-money(ITM).

Why $175/share, you might ask?  Above we discussed that it makes financial sense to exercise the call option if the stock is above the strike price?  The reason for this, is that you also need to recoup the cost of the premium you paid to the option writer.  Here’s an example:

1. Exercise the call at the strike price (170): $170 × 100 = $17,000
2. Sell the stock in the market at its current price (let’s assume AAPL appreciates to $176 per share prior to January expiration): $176 × 100 = $17,600Difference: $17,600 - $17,000 = $600
3. Net Profit/Loss (based on $500 in premiums paid): $600 - $500 = $100

Note:  You don’t actually need to exercise the stock to profit $100.  One of the beautiful features of options is that you would stand to profit about the same if you simply sold the call to someone else.  This closes your position and allows you to book your profits.

Example 2: Sell 1 AAPL JAN 170 CALL (Market Price of AAPL is $165) @ 5.00

This time, instead of a bullish outlook for AAPL, you feel that the market price is going to drop. You decide that you want to collect premium income by selling a call when the market price is below the strike price.  If the market price stays below $170 by January expiration, the call will expire worthless and you as the writer will pocket the $500 in premiums collected. Should the price of the stock go up, you have a $5 cushion to breakeven (exercise price + premium = breakeven) before you lose in this strategy.  Notice this is the opposite risk profile of the buyer.  Except in this case, your obligation is unlimited.  The buyer can only lose the premium paid.  The seller is on the hook for much more.

Therefore, it’s very important to note that, in theory, AAPL could continue to increase in value endlessly within the expiration period, therefore, this type of trade is not suitable for beginner options traders.  In fact, most brokers will not give you permission to execute this type of trade without demonstrating that you have adequate experience and capital.

Example 3: Sell 1 AAPL 160 PUT (Market Price of AAPL is $165) @$4.25

Another basic position to take is to sell a put. Where selling a call is bearish, writing puts are considered a bullish strategy as well. If the price remains above the exercise price (165), you will pocket the $425 in premiums received. In a falling market, the holder will ‘put’ the stock to you at $165 as prices fall; your breakeven in this position is the exercise price less the premium you received ($165 - $4.25 = $160.75 breakeven).

Other more intermediate/advanced options strategies include covered call writing, vertical spreads, and calendar (time) spreads. This is where we really get to harness the power of options trading.

WRAPPING UP

Options trading involves risks.  You must take on risk to make a profit.  However, after reading this article, I hope you have less risk tied to “beginner mistakes” in your initial trading.  A sound understand of the mechanics and basics will help you avoid a sticky situation.  Your next step is to understand the effects of implied and historical volatility on options pricing before getting your feet wet with very small, risk-defined trades.

Happy to answer any questions you have in the comment section below.

Drew Hilleshiem is the Co-Founder and CEO of OptionAutomator, an options trading technology startup offering a free options screener that leverages Multi-Criteria Decision Making (MCDM) algorithms to force-rank relevancy of daily options opportunities against user’s individual trading criteria. He is passionate to help close the gap between Wall Street and Main Street with both technology and blogging.  You can follow Drew via @OptionAutomator on Twitter.

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• Understanding Option Trading
• Options Strategies: An Introduction
• Top 10 Options Trading Strategies
• 10 Basic Facts About Options Trading
• Beginner's Guide To Options Trading
• The Life Of An Options Contract
• 10 Tips: Trade Options Like a Pro and Keep Your Day Job