What are Options? Options Trading Explained

What are Options?

Options: Trading Fundamentals and Applications

Options are a useful leverage tool for trading and hedging. As currently established by the Chicago Board of Options (CBOE), options are derivatives that give a holder the right to buy or sell a security at a specific price (called the Strike Price) before the option’s expiration date. Calls are the right to buy and Puts are the right to sell. Options in the US markets are traded for both underlying stocks listed on the NYSE, AMEX and NASDAQ as well as for indexes such as the S&P 500.

Positions are considered Open or Closed depending upon whether or not active options are still in a trader’s possession. One can open a position by either buying or writing an option, which is selling an option against a current position or either other options, underlying stock, or in some cases, as a “naked” position, which is the same as being short. Closing a position involves selling a long position to become flat or buying to cover a short position. One can be long or short on calls or puts, depending upon the direction the trader thinks that the market for the particular security will go.

Each option is ordinarily equivalent to 100 shares, so, for example, 10 options would equate to 1000 shares. The maturity date is usually the 3rd Friday of each month. However, depending upon demand, option series for a stock can run quarterly, bi-monthly, monthly, or even weekly if frequently traded. Long term maturities, called Leaps, allow one to buy an option that can go out for a year or possibly longer.

Option premiums are predicated upon Time Value, which is the amount of time left prior to expiration, and Intrinsic Value, which is the relative price of the underlying stock versus the Strike Price. Call options with strike prices below the underlying price and Put Options above the underlying price are considered “in the money” and have relative intrinsic value. At expiration, these options would usually be sold or exercised at the trader’s discretion. Conversely, calls with higher strike prices and puts with lower strike prices than the underlying security are considered “out of the money” and can expire worthless upon expiration.

From a trading perspective, options allow a trader to leverage cash for larger equivalent positions relative to a stock. For example if someone is trading Apple (AAPL) and wanted to take advantage of a recent move that the stock made from 360 on August 22nd to 400 on September 16th , purchasing 100 shares would have equated to a cash outlay of $36,000. Comparatively, the cost of 1 AAPL September 370 call option in August might have been at 11.00, which would have been $1,100. If the trader wanted to speculate on 1000 shares, that would have cost $360,000, whereas 10 call options would cost $11,000.

Traders can also use options against long positions as a way to either lower a base cost and increase income or as a hedge against a market downturn. For example a trader is holding a position of 1000 shares of XYZ stock, which is now fairly stable and has a substantial paper profit. If the trader wants to gain extra premium and a lower base cost and does not think that XYZ will rise much in the next month, writing at the money or out of the money calls against the XYZ position will allow extra income to be derived. If the trader bets correctly and XYZ remains stable or drops by expiration, the calls will expire worthless and the process can be repeated. If XYZ rises, then the trader may wind up selling the stock at the strike price, hence locking in the profit.

Conversely, buying at or out of the money puts can be a cheap way to hedge a long position in case there is a fear that XYZ may drop unexpectedly. If XYZ fell 10 points but the trader was long at the money puts, the puts would gain equivalent value for each point that XYZ fell.