Understanding Options
What is an Option?
An option is a contract that gives you the right, but not the obligation, to buy or sell a stock at a specific price (strike price) by a certain date (expiration date). Think of it as a reservation to buy or sell a stock – you pay a small fee (premium) for this right, but you’re not required to use it.
Types of Options
Call Options
- Right to buy stock at the strike price
- Profit when stock price rises above strike price plus premium paid
- Used when bullish (expecting price to rise)
- Maximum loss is limited to premium paid
- Potential profit is unlimited
Put Options
- Right to sell stock at the strike price
- Profit when stock price falls below strike price minus premium paid
- Used when bearish (expecting price to fall)
- Maximum loss is limited to premium paid
- Maximum profit is strike price minus premium (if stock goes to zero)
Key Components of Options
- Strike Price: The price at which you can buy (call) or sell (put) the stock
- Expiration Date: When the option contract ends
- Premium: Cost to buy the option
- Underlying Asset: The stock or security the option is based on
- Contract Size: Standard is 100 shares per contract
Basic Options Strategies
Buying Calls (Long Call)
- Most basic bullish strategy
- Limited risk, unlimited potential profit
- Good for beginners learning options
- Example: Buy $50 strike call for $2 premium
- Break-even at $52 ($50 + $2)
- Profit above $52
- Maximum loss = $200 ($2 × 100 shares)
Buying Puts (Long Put)
- Most basic bearish strategy
- Limited risk, large potential profit
- Good for portfolio protection
- Example: Buy $50 strike put for $2 premium
- Break-even at $48 ($50 – $2)
- Profit below $48
- Maximum loss = $200 ($2 × 100 shares)
Advanced Strategies
Covered Calls
- Sell calls against owned stock
- Generate income from existing positions
- Reduces potential upside
- Lower risk than naked calls
Cash-Secured Puts
- Sell puts with cash to cover assignment
- Generate income while waiting to buy stocks
- Defines entry price for stocks you want to own
- Regular income strategy
Spreads
- Combine buying and selling options
- Defined risk and reward
- Lower cost than single options
- Requires more advanced understanding
Options Greeks
Essential metrics for understanding option behavior:
- Delta: Change in option price per $1 stock move
- Theta: Time decay effect on option value
- Gamma: Rate of change in delta
- Vega: Impact of volatility changes
- Rho: Effect of interest rate changes
Risk Management
Key Risk Principles
- Never risk more than you can afford to lose
- Understand all possible outcomes before trading
- Use position sizing appropriate to account size
- Have an exit strategy before entering trades
Common Mistakes to Avoid
- Overleveraging your account
- Not understanding the Greeks
- Ignoring implied volatility
- Holding too close to expiration
- Trading illiquid options
Getting Started with Options
Prerequisites
Broker Requirements
- Options approval level needed
- Margin account may be required
- Additional agreements to sign
Knowledge Requirements
- Understanding of stock market basics
- Options mechanics and pricing
- Risk management principles
- Technical/fundamental analysis
Steps to Begin
- Study options thoroughly
- Paper trade to practice
- Start with simple strategies
- Keep position sizes small
- Learn from each trade
Important Considerations
- Options expire worthless if not in-the-money
- Time decay accelerates near expiration
- Implied volatility affects option prices
- Liquidity varies significantly between options
- Assignment risk with short options
Additional Resources
- Options Clearing Corporation (OCC)
- CBOE Options Institute
- Options Playbook
- Options risk disclosure documents
- Professional options education courses