Options – A Beginners Guide

A Blueprint for Options Trading for Market Newcomers

Uncertainty has long plagued both product producers and the end-users of those products. Going back thousands of years, early players developed a system of contractual arrangements to promote certainty in product pricing.

These early contracts were “derivatives,” meaning the value of the contract depended on or was derived from an underlying asset. Once largely limited to agricultural products as the underlying asset, today‘s derivates rely on a host of underlying assets, from stocks and bonds to currencies and commodities to interest rates and market indices.

Today the  most popular derivatives for retail investors are options contracts with stocks as the underlying asset.

What Are Options?

An option is a financial contract between two share market participants – the option holder and the writer or seller. The holder is the buyer of an option contract written by another investor. The contract typically is for the rights to buy or sell a 100 share block of a particular stock within a specific time frame, usually short-term.

Unlike certain other derivative financial contracts, option holders are not required to fulfill the contract, allowing he option to expire if executing the option at the expiration date would not return a profit. However, investors who write and sell an option contract are required to meet its obligations at expiration.

There are three terms key for beginning options traders.

First, the option premium is the actual price paid for the option.

Second, the expiration date is the point of time when the option becomes worthless if not executed.

Third, the strike price is the fixed price at which an option contract can be executed. The strike price determines whether the options contract can be executed “in the money” (profitable) or should be allowed to expire without execution if the strike price is “out of the money.”

There are two classes of investors attracted to options – speculators and hedgers, An investor with a large holding of a particular stock concerned about volatility in the stock price can buy option contracts to hedge against the risk of the price moving up or down.

Speculators are investors who buy options contracts on stocks likely to see significant changes in the stock price that would be attractive to investors who own the stock, selling the contract at a higher premium.

Types of Options

There are two types of options –Call Options and Put Options. Essentially, both Call and Put Options are bets between two investors on the future movement of the stock price. With Call options, the option buyer thinks the price of the underlying stock will go up while with Put Options the holder thinks the price of the underlying stock will go down.

Covered Calls are written by investors looking to generate income from existing holdings. The option seller pockets the premium paid by the option buyer. If the stock price at expiration is below the strike price in the contract, the option is said to be ‘out of the money” and expires worthless. If the stock price at expiration is above the stock price, the option seller must sell the amount of the stock to the option buyer at the stock price, with the buyer profiting from a stock purchase below market value, and the seller losing their shares. Naked Calls are written options where the option seller does not own the quantity of stock specified in the contract, requiring the seller to buy shares on the open market to fulfill the requirement of the options contract.

For option buyers, the risk involved is limited to the premium paid for the option, which the buyer loses if the option expires out of the money. For option sellers, the risk is selling the stock at below market value.

Put options opposites are the opposite of Call options, given the option buyer the right to sell the option shares at the strike price by the expiration of the contract. Investors use Put Options as a hedge for a holding in their portfolio. If the price of their stock falls below the stock price, the option holder can sell the stock at the higher strike price.

Option speculators are betting that the price movement of the underlying asset will attract buyers for the options contract prior to expiration.

Options vs Futures vs Warrants

Options, Futures, and Warrants are all examples of derivative instruments, relying on the value of the underlying asset. Options are contracts between two investors trading on the open market, while Warrants are issued directly by the company owning the stock using new stock rather than existing stock, or by a financial institutions from their holdings.

One key difference between options and warrants is the timing of the expiration date. Options expiration dates are short term, usually lasting a maximum of one year. Warrants can extend as long as fifteen years.

Unlike options and warrants where there is no obligation for the buyer to execute the contract, futures contracts obligates the buyer to purchase the asset specified in the contract and obligates the seller to sell the asset by the expiration date.

The most common use of futures contracts is with commodities. As an example, airlines may buy futures contracts as a hedge against rising oil prices. Speculators buy futures contracts inn anticipation price movements will make the option contract attractive for purchase at a higher premium.

The Pros and Cons of Options

Options contracts allow buyers potential access to a significant number of shares at a fraction of the market price of the stock. The only risk to the buyer is the loss of the premium paid for the option should it expire “out of the money” with the stock price falling below the stock price at expiration.

Speculators following the potential outlook for stocks buy options with the intention of selling the option contract at a higher premium should the stock price rising above the strike price.

Options contracts can get complicated and most market experts advise newcomers to share market investing to avoid options prior to gaining experience with stock market operations. In addition, brokerage firms can charge significant commission fees as well as high margin requirements – the amount of money in the account allowing options trading.

While the risk for buyers is low, for option sellers the risk is potentially limitless, should the share price keep rising above the strike price. A strike price of $100 means the seller must sell the stock at that price even if the market price has risen to $500, $1,000 or more.

Options are contracts between two individual investors granting the option buyer or seller the potential to buy of sell an underlying asset at a fixed price – the strike price – by the expiration date of the contract. Option buyers have the right, but not the obligation to execute the contract while option sellers are required to fulfill the requirements of the contract.

Profit is made or lost based on the asset finishing “in the money” where the stock price is lower or higher than the stock price. With Call options, a stock price above the stock price at expiration allows the option buyer to buy the stock at the lower stock price while the seller must sell the stock at the lower stock price.

Put options are the direct opposite, with an “in the money” stock price falling below the stock price, allowing the buyer to sell the shares at the higher price and the option seller to sell at the higher price.