The fundamentals of option trading

Is there a choice? It's a contract that gives an investor the right to buy or sell an underlying security in simple words (generally meaning a stock, index or exchange-traded fund). We'll refer to the "stock" that options are based on throughout this course to keep things easy. Depending on your trading style, "stock" can often be replaced with a different underlying security. Keep it in mind as you proceed.

Option trading is not a new concept; in fact, it predates the stock market. There are two main types of options: calls and puts. A call option gives the contract buyer the right to acquire a stock at a predetermined price (known as the strike price) by a specific date. A put option gives a contract buyer the right to sell a stock at a predetermined price by a specific date.

There must be a seller of an option contract for every buyer of the contract. When someone sells an option contract, they are paid a premium, which is the price paid by an investor to purchase the contract. In exchange for such payment, the seller must agree to sell (if a call) or purchase (if a put) the underlying stock from the contract buyer. The seller is frequently referred to as the option contract's writer.

When it comes to options trading, you should be familiar with concepts like calls, puts, strike price, and premium. Understanding these phrases can help you decipher an option quote, which contains a wealth of information about the option contract's terms and conditions. There are three parts to a stock option quote:

• The symbol for the stock. This is the term used to describe the underlying asset of an option contract.
• The date on which the product will expire. This is the deadline for the option to be exercised.
• The cost of the strike. The price at which the option can be exercised.

Now that you've learned the fundamentals of options trading, it's time to go deeper into how call and put options work.

What is the definition of a call option?

Purchasing a call option grants you the right to purchase a stock at a predetermined price (called the strike price). If you, as the owner, decide to exercise the right embedded in the call option, the seller or writer of the option is compelled to sell the stock to you at that fixed price.

The owner of a call option wants the stock to rise in price after the option contract is purchased since he or she has the option to acquire the shares at a particular price.

What is the difference between a put and a call option?

The opposite of a call option is a put option. When you purchase a put option, you are granting yourself the right to sell the stock at a predetermined price (again, called the strike price). If you, as the owner, decide to exercise the put option's right to acquire the stock, the seller or writer of the option is compelled to do so.

Because the owner of a put option has the option to sell the stock at a set price, the owner of the put option wishes for the stock's price to fall after the option contract is purchased.

Note: Buying a put option instead of selling a stock short can be a good idea.

When it comes to having alternatives, you have a lot of choices.

So, what do you do with a contract that you possess as an option? You can choose from three options:

• Allow the option contract to expire worthless by selling to close the market position before the contract expires.

• Exercise the option and make use of the contract's right.

This is where knowing a few more words, such as in, at, and out of the money option contracts, come in handy.

These are straightforward phrases that refer to the difference between the strike price of the option and the current market price of the underlying stock.

• In-the-money (ITM): When the strike price of an option is higher than the stock's market price, the option has intrinsic value.

• At-the-Money (ATM): When the strike price of an option is equal to the stock's current market price.

• Out-of-the-money (OTM): When an option's strike price isn't beneficial in comparison to the stock's market price; thus, it lacks intrinsic value.

Where do option prices originate?

Understanding the various classifications (In, At, Out) of an option contract is critical to comprehending where option prices come from. The premium for an option contract is calculated by adding the intrinsic and time values of the option. The difference between the strike price and the stock's market price is known as intrinsic value. The difference between the option's price and its inherent value is called time value (if ITM). Of course, if the option is OTM, the price is regarded to be all-time value.

What is an option chain and how can I interpret it?

You can read an option chain using what you've learned about option prices. It allows you to view all of the option contracts linked to a stock. There will usually be a section for calls and another for puts. Within the chain, you may keep track of:

• Each option contract's strike price and expiration date
• Which options are in-the-money, at-the-money, or out-of-the-money
• The most recent price at which an option traded
• Bid price, ask price, and volume

You can also look at open interest, or OI, which displays how many contracts are available for a specific option. In general, the higher the open interest, the better, because it signifies more trading activity and liquidity in the option market.

Trading techniques for options As an option trader, you have a variety of tactics at your disposal. Some people are bearish, while others are bullish.

It's critical to avoid some of the most typical options trading blunders when executing option methods. These are some of them:

• Not having a plan for getting out of the situation • Trading illiquid options to try to make up for previous losses • Taking too long to repurchase short-term plans • Spread deals by "legging in" • There is a fair level of speculation involved in buying puts and calls. Based on the strike price and the type of option, you must be quite sure that the stock's price will move in a favourable direction.

. Understanding the various options trading techniques might assist you in deciding which ones to use. A covered call strategy, for example, includes selling call options while concurrently owning stock. Married puts and protective collars are two other options trading methods based on stocks you already own.

• There are a few factors to consider before implementing any options trading strategies: To begin, pick what type of options you want to purchase based on which direction you believe the stock's price will move. After that, you'll examine the strike price to determine how it corresponds to your expectations for the asset's market price. Finally, you should think about how long you want to keep the option contract. All of these can aid in risk management and potential profit maximization while trading options.

Put Options Explained: Buying or Selling Puts

When it comes to the end of a bull market in the stock market, you've probably heard words like "what goes up, must come down" and "all good things must come to an end."

Both of those phrases imply that your investments can only increase in value in a rising market. But what if you could make money even while the market was down? There are, in fact, a lot of them. A put option is one of those approaches.

What is a put option?

When it comes to the end of a bull market in the stock market, you've probably heard words like "what goes up must come down" and "all good things must come to an end."

Both of those phrases imply that your investments can only increase in value in a rising market. But what if you could make money even while the market was down? There are, in fact, a lot of them. A put option is one of those approaches.

Changes in market conditions affect option trades, so investors should be aware of the factors that drive changes in option prices, such as intrinsic value and time value. When you use the Greeks, a set of useful variables, you may be able to better position yourself accordingly.

Calls vs. puts

Put options are the polar opposite of call options, which provide the option buyer the right to purchase a certain securities at a predetermined price at any time before expiration. Here's a quick method to recall the distinction:

Puts are when you take the security away from yourself (selling)
Calls imply that the security is being summoned to you (buying)

What are put options and how do they work?

Put options contracts can be purchased in 100-share increments through a brokerage like Ally Invest. (Non-standard options are usually priced in increments of 100 shares.)

Let's say you believe the market value of XYZ technology business will fall in three months from its current level of $100 per share. A put option allows you to sell at your strike price of $100 within three months, even if the stock price drops below that level.

Assume you exercise your put option at a price of $90: Your earnings are equal to $10 per share multiplied by 100 shares, which is $1,000. Because your options contract carries a $2 premium per share, you'll need to reduce $200 ($2 x 100 shares) from your profit to get at $800, less any brokerage commissions.

Pro Tip : It's lucrative to sell your underlying stock when the market price falls below break-even (the strike price minus the premium you paid, excluding commissions).

However, if the underlying stock price rises, your put option may become worthless, and exercising it will be futile. You'll lose money in this circumstance since you'll be out the $200 premium you paid for the put option contract, as well as the commission.

Strategies and examples for buying and selling puts

Put options, like call options, have their own set of strategies. It's also popular to combine them with call options, other put options, and/or existing equity positions. Protective puts, put spreads, covered puts, and naked puts are some of the most frequent techniques.

Protective measures are taken.

A protective put (also known as a married put) allows you to protect your investments from price drops. What do you mean by that? You keep your existing shares (take a long position), but you also have put options, which can be thought of as an insurance policy (or a hedge) against price drops.

For example, say you bought 300 shares of XYZ Technology Company for $75 a share and three put option contracts with a strike price of $70, a premium of $1 per share and an expiration date six months from now. After four months, the market price drops to $50 per share. As an option holder, you can exercise the put option and sell your stock at the strike price of $70, and you’ll only lose $1,800 ($5 per share multiplied by 300 shares equals $1,500, plus the premium cost of $300, or 3 contracts x 100 x 1).

What if the stock’s price falls even further, to just $35 per share? Your losses are still capped at $5 per share, or $1,800, since you can sell your stock at the strike price of $70. That’s referred to as your maximum loss.

With no put options contract in place, the loss would be greater, since there’s no cap. For instance, if the price dropped to $50 per share, you’d lose $7,500, and if the price dropped to $35 per share, you’d lose $12,000.

What happens if the stock’s price per share increases? Assume the same tech stock rises to $90 per share. That’s $20 per share more than your strike price, so you wouldn’t want to exercise your put option — you’d just let it expire.

(Since you bought the options contract, though, you’ll lose the $300 premium paid: $1 per share multiplied by 300 shares.) Instead, you’ll sell your stock at the market price, netting you a profit of $4,200. ($15 multiplied by 300 shares, minus the premium cost of $300).

Since potential growth of a stock is limitless, you can say that the profit potential of a protected put is also limitless, minus the premium paid.

Spreads on put options

Bull put spreads and bear put spreads are the two types of put spreads. You are both a buyer and a seller when you execute a spread.

A bull put spread is an options strategy that you might utilize if you foresee a moderate price increase in the underlying asset. To use this method, you first pay a premium for a put option, then sell a put option with a higher strike price than the one you bought, collecting a premium for the sale. The difference between what you get for selling the put and what you pay for buying the other is your maximum net profit.

A bear put spread, on the other hand, is a strategy that is employed when you anticipate a moderate to big price fall in the underlying asset. You buy and sell the same amount of put options for the same security and expiration date, but at a lower strike price, for the same security and expiration date. The difference between the strike prices, less the cost of acquiring the puts, is the maximum profit.

Naked entails

If you believe the price of a stock will stay the same or climb, you might want to consider a naked put option (or uncovered put or short put).

If you receive the underlying securities as a result of a naked put, they will be at the strike price. Here's how it works with a bare put. Remember XYZ tech company? Let’s say you think the stock will stay flat or go up, so you sell a naked put option with a strike price of $90. In exchange for accepting the obligation to buy 100 shares of XYZ at $90, if XYZ drops below the strike price, you receive an option premium of $1 a share, or $100.

If the share price is above the strike price of $90/share and the option expires, you keep the option premium you received, and you are relieved of your obligation.

Pro tip: Because the primary purpose of trading naked put options is to profit from the option premium, you should avoid using this method if you believe the stock's price is declining.

If the underlying stock price falls below $90, the situation changes. In principle, the price could drop to zero, forcing you to purchase 100 shares of XYZ at the strike price of $90.