This article will go over several options basics: what options are, how they function, their strengths and weaknesses, and when they should be used. Currently, options exist for many types of commodities, currency pairs, equities, and even debt. A key point in trading options successfully is to understand just one underlying asset. Don’t try to trade across assets, since the economic logic and variables that greatly influence one asset class may have a surprisingly small effect on another asset class. Options offer flexibility in trading, but not novelty in terms of what is in trade.
Concept of an Option
The existence of organized options contracts dates back to 17th century Japanese agricultural trading. Options basics first appeared with regard to farm products. When purchased, options gave the buyer the choice to buy or sell a specific quantity of an item, such as rice, at or before a specific time. Before modern financial markets emerged, options were in use mostly by agriculture workers and traders to protect against potentially large farming losses.
Options basics revolve around the following important variables:
•Type – Call or Put.
•Identified underlying. A stock or ETF, commodity or currency pair.
•Price – bid price, ask price, quoted price. Quoted price is an average of the bid and ask prices.
•Exercise of the option.
Two other concepts need an explanation when dealing with options basics. The first is time decay. Options that have an expiration date in the near future cost less, but their time value declines faster. Options that have an expiration date in the far future cost more. However, their time value declines slowly until about last 1/3 of the time between purchase day and expiration day.
Money designation is also important. Options basics refers to out of the money, at the money, or in the money classification. A call option is out of the money when the underlying is at a price below the strike price. The option is at the money when market price of underlying matches the strike price. It is in the money when the strike price is lower than the underlying market price. Put options mirror this designation. Out of the money puts have strike prices below the underlying market price, at the money when underlying matches the strike price, and in the money when underlying is lower than the strike price.
Put options mirror this designation. Out of the money puts have strike prices below the underlying market price, at the money when underlying matches the strike price, and in the money when underlying is lower than the strike price.
Options and Spread
Options have higher trading costs than the underlying security to which they correspond. This is a staple of options basics and is due to the larger bid-ask spread on options. An example with stock ETF options illustrates this point.
Assume that the highly liquid S&P 500 SPY equity ETF is quoted at $233.90. This price is an average of a bid price of $233.89 and ask price of 233.91. Assume the same nominal spread at a higher price. If a trader expected SPY to gain a nominal ten percent from current stated price of $233.90, he would expect to sell at $257.29. Realistically, he would purchase 100 SPY shares at the current ask price of $233.91. Ten percent from the stated average ($257.29) would still be subject to spread, meaning at selling point, the trader sells 100 SPY shares at hypothetical bid price of $257.28. Instead of gaining ten percent in an ideal scenario, the trader gains 9.99 percent when factoring in the spread.
Here, the influence of bid-ask spread is trivial since direct buying and selling of liquid securities like SPY has very little financial “friction.”
A call option that expires on March 16, 2018 has a quoted price of $13.10. Ten percent rise from that value would give a target price of $14.41. However, the starting bid price is listed as $12.95, and ask is $13.26. Right away, we see that the trader would not be buying at $13.10, but at $13.26. Assuming the same nominal spread at anticipated quoted price of $14.41 gives a bid price of $14.26. This would be the trader’s selling price. The realistic exit/entry profile becomes:
•Buy at $13.26
•Sell at $14.26
•Gain: 7.5 percent
Techniques to Profit
Options Basics: Underlying Price Rising
A trader that anticipates a rise in price of the underlying on or before an expiration date can profit in three several ways.
Buy call options, sell them for profit as they rise in value in line with the underlying security. This method works if time decay is not significant. Otherwise, the call option’s value will have significant erosion due to time decay.
Buy call options, exercise them on or before their expiration date. Here, time decay is not as important. Therefore, if a trader anticipates a price move in the underlying soon, a cheaper short-term option would be sufficient. Upon exercising the call option, the trader can immediately re-sell the underlying on the open market to generate profit.
Sell put options with the strike price below the lowest price the underlying will reach. Ideally, the put option will never be exercised, and the seller collects the premium. Here, gain is limited to the premium another trader pays, minus (maybe) buying to close at a lower price if the trade is starting to look risky.
Options Basics: Underlying Price Falling
Options let traders benefit from falling underlying prices without the limitations of a typical short sale. There are three ways to use options in a falling market.
Buy put options, re-sell them at higher market price as the underlying falls. As with the first call option technique, time decay works against the trader most viciously so do not try to go “on the cheap” by buying low-priced puts that are far out of the money or will expire soon.
Buy put options and when underlying is priced less than the strike price, buy the underlying on the open market. Upon completing the purchase, immediately exercise the put to re-sell the underlying at the designated strike price.
Sell call options with the strike price above the highest anticipated market price of the underlying security within the expiration date time frame. Ideally, sold options will expire never having been exercised, and the seller keeps the option premium.
Advantages and Disadvantages of Options
The major disadvantage to buying options is that the underlying doesn’t move as expected before the option expires. In that case, the trader can lose up to the full price of the option with nothing to show for it.
When selling options, the danger is to be caught in an unfavorable position and being forced to buy or sell at a loss potentially much more than 100 percent. Also, options selling has a limit when it comes to profit potential. Bought options can give returns much higher than 100 percent. Sold options, even in the best circumstances, can give only a relatively small profit margin from collected premium.
Options give the potential for large profits and limited loss when used correctly. Additionally, selling options can mitigate an unfavorable outcome. The key difference with options is an expiration date that infuses time decay into options pricing. Traders and others are welcome to comment with their opinions and experiences with options.