Options are financial contracts whose values are tied to another underlying asset. Options are a complex, risky market and may not be suitable for everyone.
For investors who have experience with risk-taking however, the options market may be a helpful way to take bets or hedge other positions. Here’s a guide to options trading, including basic options terminology and different ways to trade this market.
What Is Options Trading?
Options give holders the right, but not the obligation, to buy or sell an asset like shares of a company stock.
Options holders can buy or sell by a certain date at a set price, while sellers have to deliver the underlying asset. Investors can use options if they think an asset’s price will go up or down or to offset risk elsewhere in their portfolio.
Options are financial derivatives because they’re tied to an underlying asset. Other types of derivatives include futures, swaps, and forwards. Options that exist for futures contracts, such as S&P 500 or oil futures, are also popular among traders and investors.
A stock option typically represents 100 shares of the underlying stock. Stock options are common examples and are tied to shares of a single company. Meanwhile, ETF options give the right to buy or sell shares of an exchange-traded fund.
What Are Calls and Puts?
There are two main types of options: calls vs. puts.
Call Options 101
When purchased, call options give investors the right to buy an asset. Call holders are essentially giving up some profit in exchange for the lower risk of not owning an asset outright, since the price of the asset can potentially fall.
Say for example, an investor who holds a call option for Company Stock X has the right to buy 100 shares until a certain date. If the value of Company Stock X goes up, the value of the call option should correspondingly also go up. The opposite would also be true. If shares of Company Stock X go down, the value of the call would go down.
Meanwhile, if the investor wanted to exercise their call option, they have until the expiration date. When they exercise, they can buy 100 shares at the strike price.
Put Options 101
Meanwhile, puts are options that give investors the right to sell an asset. Investors pay a premium and are more likely to be protected against losses in case the price of the asset falls.
Here’s where a put trade might work. An investor buys put options tied to Stock A with a strike price of $45 and expiration three months from now. Stock A is currently trading at $50 a share.
If the price of Stock A falls to $44, the investor can exercise the put. Alternatively, the value of the option would likely also rise in this scenario, giving the investor the choice of selling the option itself for a profit.
What Is the Put-Call Ratio?
A stock’s put-call ratio—or the number of put options traded in the market relative to calls—is one measure that investors look at to determine sentiment toward the shares. A high put-call ratio indicates bearish market sentiment, whereas a low one signals more bullish views.
Options Trading Terminology
• The strike price is the level at which the option holder can exercise the contract. On the other hand, the seller of the option is obliged to deliver the promised shares if the holder decides to exercise the option.
• For calls, if the shares of the underlying stock are higher than the strike price, then the options are considered “in the money.”. For puts, options are in the money when the shares are trading below the strike price.
• “At the money” is when the options strike price is equal to the price of the asset in the market. Contracts that are at the money tend to see more volume or trading activity, as investors are looking to exercise the options.
• “Out of the money” is when the security’s price is below a call option’s strike price or above a put option’s strike level. For example, if shares are trading at $50 each and the call option’s strike price is at $60, the contracts are out of the money. For an out-of-the-money put, the shares may be trading at $10, while the put’s strike price is $5, so therefore, not yet exercisable.
• The expiration is the date by which the contract needs to be exercised. The closer an option is to its expiration, the lower the value of the contract.
• Premiums are the cost of the options. The Black Scholes model is the mathematical formula for determining the price of options. The model takes into account factors such as the price of the underlying stock and the option’s strike price.
• Investors also look at a stock’s implied volatility, which is the expected volatility of the stock in the future based on the prices of its options.
“The Greeks” in Options Trading
Traders use a range of figures known as “The Greeks” to gauge the value of options.
• Delta is the measure of the impact of the price of the underlying asset on the option’s value.
• Beta is how much a single stock moves relative to the overall equity market.
• Gamma tracks the sensitivity of an option’s Delta.
• Theta is the sensitivity of the option to time.
• Vega is the sensitivity of the option to implied volatility.
• Rho is the sensitivity of the option to interest rates.
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How to Trade Options
The market for equity options is typically open from 9:30 a.m. to 4 p.m. ET, Monday through Friday, while futures options can usually be traded almost 24 hours.
People can use options when they think an asset’s price will go up or down. Investors also use options to hedge or offset risk from other assets that they own. Here are some important options trading strategies to know:
Selling Options
Investors have also turned to selling options as a way to collect income. Selling put options in particular, when markets are calm, has been a source of income in recent years, as investors collected premiums for the contracts with the hope that they don’t get exercised.
Covered Calls
A trade in which an investor sells bullish calls while also owning the underlying security. The selling of options helps the investor generate an additional stream of income while running the risk of having to deliver the shares they own if the security rises and the strike price is triggered.
An investor might do this trade when it seems there’s not much upside left in the security they hold. Uncovered calls also exist, when investors sell contracts without owning the underlying asset. However, this is a much riskier trade since the investors would then be obligated to buy the underlying asset in the open market.
Spreads
Option spread trades involve buying or selling an equal number of options for the same underlying asset but at different strikes or expirations. Horizontal spreads involve different strike prices, while vertical spreads use different expiration dates.
Strangles and Straddles
Strangles and straddles in options trading allow investors to profit from a move in the asset, rather than the direction of the move. In a straddle, an investor buys both bullish calls and bearish puts with the same strike prices and expiration dates.
The investor would pocket a profit if the asset price posts a big move, regardless of whether it rises or falls. In a strangle, the investor also buys both calls and puts but with different strike prices.
Pros & Cons of Options Trading
Pros of Options Trading
• Options trading is complex and involves risks, but once investors understand the fundamentals of the contracts and how to trade them, options can be an important tool to make investments while putting up a smaller amount of money.
• Options can also be an important way to protect a portfolio. Some investors offset risk for a company stock with options. For instance, an investor with a big position in a bank stock can also hold puts for an ETF that gives exposure to a broad swath of financial companies. If the price of the bank stock falls, the investor can sell the put options for the ETF and therefore mitigate some losses.
• The practice of selling options to collect income can also be a way for investors who are seeking income to collect premiums consistently. This was a popular strategy particularly in the years leading up to 2020 as the stock market tended to be quiet and interest rates were low.
Cons of Options Trading
• Expirations are a risk in options. Securities like stocks don’t have expirations, but options contracts can expire without getting exercised by their buyer. While premium costs are generally low, they can still add up.
• Another risk that options investors face is liquidity. Because options often have multiple different strike prices as well as expirations, there are many contracts that are outstanding in the market. The multitude of contracts means investors may encounter issues with trading easily without moving prices.
• The cost of options premiums can eat away at an investor’s profits. For instance, while an investor may net a profit from a stock holding, if they used options to purchase the shares, they’d have to subtract the cost of the premiums when calculating the stock profit.
The Takeaway
Options are derivative contracts that give the right, but not the obligation, to buy or sell an asset, making them a potentially useful tool if investors want to trade or hedge their portfolios. Sellers of options may be obligated to buy or sell shares however, if the investor on the other side of the trade exercises their contracts.
If you’re ready to keep learning about options and try your hand at options trading, you may consider checking out SoFi’s options trading platform. The platform’s user-friendly design allows investors to trade through the mobile app or web platform. Plus, there are a number of educational resources available to support you as you continue to learn about options trading.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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