If you want to enter into options trading, the first step is understanding what an option really means. This post will give you all the knowledge and expertise needed to properly conceptualize options in your mind and translate it into something that can be realistically applied on a brokerage platform. As traders, we strive for sustainable returns from our investments of both time and capital; thus having a comprehensive grasp of this fundamental concept is vital for success. Get ready to learn the basics of how to effectively trade options!
Fundamentally speaking, options are a type of financial asset. They do not possess any advantage over stocks, futures, forex or bonds; they merely fulfill an alternate role in the market. It is their potential to grant access to a variety of investments that has made them so popular among wise retail traders.
To understand how you can benefit financially from trading options, it is essential to gain an understanding of what they are and the various ways they can be used. Options are particularly advantageous because they enable traders to express any opinion or belief in the marketplace. To begin your journey into options, let’s start by exploring what these instruments actually are!
Regardless of the type of option you are trading, all options share 6 common traits which form their definition. These 6 characteristics include:
- An option is a contract
- Created between two people
- That gives the purchaser the right to buy or sell a stock
- At a set price
- In a set time frame
- For a premium
Once you familiarize yourself with these 6 traits of an option, understanding how they work and their significance is only a few steps away. Let’s explore each characteristic in depth!
1) An option is a contract..
Rather than exchanging an actual stake in a company when you buy or sell options, you enter into a contractual agreement. Trading stocks requires direct involvement with the stock market whereas trading options occurs within a separate realm of its own – the Options Market. When investing on the stock exchange, your trades are genuine transactions of corporate ownership; however, in terms of option investments, these exchanges represent legally binding agreements between two parties.
2) Created between two people..
Many believe that option trading is a battle of “them VS the market”. This isn’t wrong, since it’s the market which sets options prices. But I think people misconstrue this concept in their minds. When we say “you VS the market”, we aren’t talking about something similar to playing blackjack against a casino house–where all players are pitted directly against each other. Instead, what comes to mind more closely resembles poker; where everyone is contending with one another at the same table while betting on upcoming events.
So whenever you are placing a trade, if you break a market down to it’s micro transactions, there is actually someone on the other side of that trade.
In the options market, there are two players in every transaction: The person who writes/creates the contract (seller) and the person who purchases the contract (buyer).
Whether you are the buyer or the seller, there are many different players that could be on the other side of your option contract, but we will save that for another post.
3) That gives the purchaser the right to buy or sell a stock..
When an option buyer acquires a contract, they are granted the right to buy or sell a stock. Therefore, by selling such an option you have an obligation to fulfill the request if the purchaser decides to exercise their contractual rights.
4) At a set price..
In the options market, this is known as a strike price. Say for example, you purchase an option contract from someone that entitles you to buy Apple stock at $160 – this is written into the arrangement. Depending on the agreement, different contracts may have varying strike prices. The next thing for us to consider is how long these contracts are in effect. Are they forever? If so then there would be no incentive for people to sell them (the risk vs reward isn’t balanced!) which makes us wonder how long these contracts should actually run for?
So that brings us to the next characteristic of an option.
5) In a set time frame..
Options are not permanent; they have an expiration date. Let’s use Apple as an example. If you buy an option, you would be given the right to purchase Apple stocks at $160 in 30 days.
But why would someone sell this type of contract? Why should anyone give another person the power to buy or sell their stock at a certain price within a set amount of time? The answer lies in understanding that individuals who choose to do so stand potentially receive considerable benefits from doing so, which brings us to our final point.
6) For a premium!
It’s important to remember that nothing is ever free – even when it comes to purchasing options. The people who offer option contracts are willing to do so because they get paid for it. For instance, consider the hypothetical example of Apple stock- if you wanted the right to purchase Apple at $160 in 30 days, you’d have to pay a fee of $10 for an option contract from someone selling them. Ultimately, this would be your full picture on what buying options looks like!
Now that we can get a glimpse of what an option looks like, let’s explore some industry terminology. Let’s convert the image we conjured up into how it truly appears when you investigate the options market.
1. Contract = option chain.
When you’re looking to purchase or sell a contract, your brokerage is where you go. Here, you will find a complete list of all contracts related to any stock currently on the market – simply select which one is right for you and complete the transaction!
2. Two people = bid/ask.
The way you can really understand that there is someone on the other side of you trade is the bid and ask. these are the prices that someone is willing to either buy a contract at (bid) or sell a contract at (ask). Every contract has a bid and an ask price.
Imagine you are at a market, and someone is offering to buy an apple contract for $1 while another person offers to sell the same contract for $2. If you wish to purchase an option, then engage with the person on the ask side; if your intent is to sell one, then connect with the individual on the bid side. Surprisingly enough, sometimes people may even meet in-between those two prices!As buyers and sellers serve as both the demand and supply for a contract, it is through their buying and selling pressure that we are able to determine its “market price”. By tracking this market activity, we can make more informed decisions on when to invest.
3. Right to buy, right to sell = calls and puts.
A call option contract allows its buyer the right to purchase a stock, while a put provides them with the ability to sell one. Generally speaking, calls can be found on the left side of an option chain and puts occupy their counterpart’s place at the right.
4. A given price = strike price
When you view an option chain, each row represents a distinct contract. In the middle of the chain lies a number which is the price at which these contracts offer buyers to purchase or sell their stocks – $115, $120, $125 and so on. Every strike price displays its own unique stock rate for respective options found in that row.
5. Time frame = expiration date
When researching options, you’ll notice that they don’t all expire at the same date. Depending on the stock in question, some may expire within a day while others could last up to two years! All these expirations will be highlighted when accessing an option chain – simply click the expiration listed and it will bring up all of its respective contracts. Whether your investing short-term or long-term, there’s something for everyone with option chains!
6. Premium = Price
On each contract, there is a listed price that indicates what someone would be willing to buy or sell it for. You can find this information on the option chain – simply look for the bid and ask prices! These are clearly displayed in your brokerage platform so you can easily see how much people are offering to purchase or exchange contracts.When considering pricing options, it’s important to remember that choices do not come without cost. Think of a bustling marketplace—the bid is like someone else buying the call option for $11.90 (as seen in the image below).If someone in the marketplace is selling a certain item for $12.60, then you can attempt to purchase or sell it at a price somewhere between what the buyer wants and seller will accept; this technique of getting something for an ideal amount is known as “working your order”. Whenever there’s an apparent gap between these two figures, make sure you take advantage by putting forth some kind of middle offer!
Conclusion
To summarize the 6 characteristics of an option, let’s consider an example related to Apple. You can purchase a call on Apple with a strike price of $160 and expiration date in December 2021 that someone is willing to sell you at the ask price for $15 as premium. Having examined this product’s fundamental functions, it is now possible to move forward with exploring its complexities and opportunities. I am confident that this post has clarified what options contracts entail.