When I first learned about options, it was in a class at business school. Over the years that followed, I took the CFA (Chartered Financial Analyst) exams and got even deeper into the world of finance. However, during all this time I never traded a single option. On paper, I was very well versed with options theory but when it came to the real world, I didn’t know the first thing about executing options trades.
Slowly but surely I found my footing in the world of options trading. I still consider myself a novice by all measures but I’d like to help others avoid the pain of learning how to execute options trade.
The basics (feel free to skip if you understand calls and puts)
Options come in two forms – puts and calls. Put options give you the right (but not the obligation) to sell an underlying asset at the strike price. In english, this means you bought the right to sell something (usually a share/stock) in the future at a certain price. However, it’s up to you on that day whether you want to go through with the trade. Like any rational person, you’d only sell the stock on that day if the market price is lower than what you’d agreed to (so you can pocket the difference). If the market price is higher, then you’d be better off selling in the market.
An analogy: Very similar to an insurance policy (which you may or may not use), buying an option has a premium which you pay upfront. So, even if you don’t exercise (i.e. use) the option, you still pay the premium. As a real world example, think of a corn farmer who wants to lock in the price of their crop before they harvest. They’d buy a put option on the harvest. This allows them to know ahead of time how much the crop would be worth or sell for at a minimum after they harvest.
Call options are the converse i.e. they give you the right to buy an underlying asset at a pre-determined strike price. So, on the last day, you’d typically only exercise the option if the stock is trading above the strike price (so you can buy it cheap at strike price and sell it at market price).
Types of trades
Now, one common point of confusion for a lot of folks is that you can both buy and sell options. i.e. you have 4 possible plays here – you could sell a put, buy a put, sell a call or buy a call. As with any other purchase, the seller collects money (premium) and the buyer pays money (premium) when the option is traded. Settlement time is a different story – the buyer may or may not exercise, and if they do, then the seller is obligated to buy the shares. In doing so, the seller may incur a large loss if the stock has moved away from the strike price whereas the buyer may make a handsome profit.
Typically selling is also referred to as ‘being short’ whereas buying is referred to as ‘being long’. So, you could be short a put (sell a put) and someone else would be long the put (bought that put from you).
Data points when trading
- Premium: As noted above, when buying you pay a premium. When selling, you receive a premium. Stock options trade in units of 100 i.e. each option contract is the right to buy/sell a 100 stocks. So buying one option contract gives you the right to buy a 100 shares at expiration
- Strike price: Price you’re pre-selling or pre-buying at. The closer to the current market price this is, the higher the premium. You could also buy/sell for more than market price, in this case the premium will incorporate the difference and be even higher
- Expiration date: Date when the option expires. Seller is obligated to buy/sell if buyer decides to exercise option on this date. Slight nuance – American options (a type of option) can be exercised before expiration date (but this is seldom done as you could sell the option for more to someone else on the exchange rather than exercise) whereas European options can only be exercised on the expiration date itself
- Delta: A risk measure that tells you how sensitive the option price is to change in the underlying stock. i.e. how much does the option premium change when the stock price changes. An easier risk metric is probability OTM (out of money) – this is essentially a percentage likelihood that the option will NOT be exercised. So, if you’re selling an option you want high OTM probability whereas if you’re buying an option you want low OTM probability. Another technical term: in the money means that the option buyer is set to make money (i.e. they’re in positive money/territory)
For beginners, the best trading platform is TD Ameritrade’s thinkorswim. The interface is very intuitive plus you get access to excellent analyst reports as part of the platform. The best part is there is no minimum monthly activity requirement etc. The biggest downside is that you pay fairly high commission per trade. But, if you’re just starting out, you’re unlikely to be trading a too much. If you just want to practice, open a paper money account on TD Ameritrade’s website. This lets you simulate trades and open a fake portfolio. There is also no minimum balance requirements so you may start with as low an amount as you’d prefer.
Most advanced investors trade on Interactive Brokers (aka IB). While the commissions are super low here, you do need to know what you are doing. I’ve executed some pretty bad trades myself here. Small things such as missing a negative sign on the premium can cost you a pretty penny (I sold and option plus paid a premium!).
Executing the trades
In our next post, we’ll cover the actual setting of trades including everything from logging in to your broker account to submitting your first order and tracking gain/loss. If this is something you seek, please leave a comment and encourage us to expedite!