If you're new to trading options, you might be surprised to learn that some of the more basic strategies can provide an effective way for investors to try to generate income or hedge against risk—sometimes both at the same time. While some options strategies can be complicated, the ones that make sense for most investors are often relatively straightforward. Let's start with the basics.
With stocks, you're pretty much limited to buying, selling, and selling short. With options, the possibilities are virtually unlimited. The options markets offer bullish and bearish strategies, hedging and speculative trading opportunities, and varying degrees of potential for risk and profit. Options strategies may be based on time value, volatility or even interest rates.
Combine options with stocks, and there are even more possibilities. Options can help you protect against risk, generate income, increase profits, lower your breakeven point, reverse your strategy without selling your stock, and even potentially let you set a purchase price for a stock below its current market price.
While options do provide a lot of flexibility, it is important to realize that with any option strategy used on dividend-paying stocks, you will not be entitled to any dividends unless you purchase the actual stock before the ex-dividend date. With option strategies, you also will not be entitled to voting rights or any other benefits of stock ownership unless you own the actual stock. Finally, since all options eventually expire, they will generally lose value as their expiration date approaches, and may end up completely worthless, whereas a stock position can often be held for a very long period of time.
What's an option?
An option is a contract giving the owner the right, but not the obligation, to buy (in the case of calls) or sell (in the case of puts) the underlying instrument at a specified price for a specified period of time. The underlying instrument can be a stock, an exchange-traded fund (ETF) or even an index—though you can't actually buy an index, so these options settle in cash.
Unlike shares of stock, an option does not represent ownership in the underlying company. Because it's a contract, it represents the potential for ownership, but it must be exercised (as explained below) to make that happen.
Options have a number of terms and symbols which you should understand.
Key terminology and symbols
- Premium: The price at which an option can be bought or sold.
- Strike price: The price at which the underlying security will be delivered in the event that the option is exercised.
- Expiration: The date and time when an option no longer exists.
- Option descriptions contain a lot more information than stock symbols. For example, in Long 1 XYZ 10/19/2013 55.00 C @ 3.85:
- XYZ represents the underlying security symbol.
- 10/19/2013 represents the exact date of expiration.
- 55.00 represents the strike price.
- 3.85 represents the premium.
Be aware of your rights and obligations
Call options give the holder (buyer) the right to buy a specified number of shares (usually 100) of stock at the strike price, at any time until the contract expires. Put options give the holder the right to sell a specified number of shares of stock at the strike price, at any time until the contract expires. If you own an option, you're considered to be "long" the position. If you've sold an option you did not own at the time of sale, you're considered to be "short" the position.
When you are an option buyer (owner), you have the choice of three possible outcomes: exercise your option (choose to buy or sell the underlying instrument), sell the option to close out your position, or allow the option to expire worthless. When you are an option seller (writer), you've created an obligation for yourself that may have one of three possible outcomes: buy the option back to close out your position, allow the option to expire worthless, or take assignment (be required to buy or sell the underlying instrument).
When you trade shares of stock, there are only three possible order types: buy, sell, and sell short. With options, there are eight (see the chart below). A trade to "open", which establishes a new position in your account, always occurs first. The trade to "close" would be needed to close out your position.
8 order types for options
Source: Schwab Center for Financial Research.
When you place an option order, you must designate whether the trade is a buy or sell, whether the option is a call or put, and whether the trade opens a new position in your account or closes out an existing position. Whether you're establishing a new position or closing one out affects the open interest calculation (explained below) of that option.
If you're trading stocks, you might look at trading volume to gauge the liquidity in the marketplace. With options, volume can be somewhat helpful, but a more important statistic is open interest—the number of outstanding long or short option contracts for a given strike price in a given month.
Here are some things you should know about open interest:
- It's calculated by OCC (formerly the Options Clearing Corporation) at the end of each day.
- Closing trades reduce open interest.
- Opening trades increase open interest.
- It's impossible to determine how daily volume will affect open interest until the next day, because you don't know whether the trades are opening or closing positions.
- Open interest can help gauge liquidity.
- Open interest starts at zero when a new option series is opened, but can increase indefinitely.
The price (or premium) of an option is made up of two main components: intrinsic value and time value. Intrinsic value is the amount by which the option is in the money.
- Call options are in the money if the underlying stock, ETF or index is trading above the strike price.
- Put options are in the money if the underlying stock, ETF or index is trading below the strike price.
- Out-of-the-money options have no intrinsic value.
Assume you bought an XYZ 01/18/2014 25.00 Call @ 3 and XYZ is trading at $27. Because the option is in the money by $2 ($27 stock price – $25 strike price), its intrinsic value is $2.
Time value is the difference between an option's intrinsic value and its market price. If you paid $3 for an XYZ 01/18/2014 25.00 Call and it is in the money by $2, its time value is $1.
If an option is out of the money (it has no intrinsic value), its price is solely time value. So if you bought an XYZ 01/18/2014 30.00 Call @ .50 and XYZ is trading at $27, the time value is .50 because the option is out of the money (by $3). Time value erodes at an ever-increasing rate as expiration approaches.
Historically, "standard" options have expired on the Saturday after the third Friday of each month and they stop trading at the close of business on that Friday (P.M.-settled options). Some index options (A.M.-settled options) stop trading on the preceding Thursday. In recent years, contracts have been introduced with a variety of different expiration dates:
- Weekly options expire on Friday of every week that is not a standard expiration week; the last day to trade them is either that Friday (for P.M.-settled options) or Thursday (for A.M.-settled options).
- Quarterly options expire on the last business day of each calendar quarter, which is also the last day to trade them since all quarterly options are P.M.-settled.
- Volatility options expire either on the Wednesday before (months with four Fridays) or the Wednesday after (months with five Fridays) the standard options expiration.
Option symbols include the exact expiration dates so be sure to take note of them before you trade.
Deliverable and options multiplier
Another important concept is the difference between the deliverable (also known as the contract size or options package) and the options multiplier. In an options transaction, the deliverable defines the shares and the multiplier defines the dollars.
- The deliverable is the underlying security(s) and/or cash that changes hands when an option is assigned or exercised. Historically, it has usually been 100 shares and it may include other securities, cash-in-lieu, warrants, rights, etc.
- The multiplier is used to calculate the cash that changes hands during a trade, assignment or exercise. It converts the quoted price of the option into the cost of the trade, and defines the net debit or credit to your account when there is an assignment or exercise. The multiplier is usually 100 for traditional options.
Unless weekly options are available, standard equity options typically trade four months at a time: the front month (nearest expiration), the next month, and two future "cycle" months. When you look at quotes on an option, you'll typically see the current calendar month (unless the current expiration has already occurred), the next calendar month, and (depending on the cycle) two separate months in the future. All equity options are classified as either first cycle, second cycle, or third cycle. The cycle affects only the two distant months, not the front and next months. Some stocks also trade LEAPS® (Long-term Equity AnticiPation Securities), which are simply longer-term options that expire as far as 2½ years into the future.
Many ETF's and indexes trade more than four months at a time. The option cycles for these products are often the five closest expirations plus LEAPS options.
Bullish vs. bearish
You can take either a bullish or bearish position using either calls or puts; it simply depends on whether you buy or sell them first. In the "Bullish vs. bearish" chart below, a green arrow is bullish and a red arrow is bearish. As you can see, a long call position is bullish, but a short call position is bearish. By contrast, a long put position is bearish, but a short put position is bullish.
Bullish vs. bearish
Source: Schwab Center for Financial Research.
In the article Putting Options to Work, we'll explore these four strategies in more detail, discuss how to select a strike price, and touch on how basic options work with stocks for investors seeking income or downside protection.