This article attempts to set out the basic features that you will need to know in order to learn options trading. By the time you finish this article, you should understand what an option is, how option contracts work and how you could potentially incorporate this into your overall trading strategy.
Back to basics: what’s an option?
An option is a contract between an option buyer (the “holder”) and an option seller (the “writer”) that gives the holder the right, but not the obligation, to:
Buy or sell the underlying asset which is the subject of the option (i.e. exercise the option) within a fixed period of time (i.e. typically before the option’s expiration date); and
Carry out the above transaction at a predetermined price (the “strike price”).
As payment (consideration) for granting the option, the holder typically pays a premium to the writer (which in theory compensates the writer for the risk he/she has taken on in accepting the legal obligation/s that the option imposes on him/her). One potential financial “driver” that may encourage the writer to enter into an option contract is the possibility that the option will expire prior to being exercised (allowing the writer to simply “pocket” the premium). So the holder and the writer are effectively making a “bet”: for the holder, that market conditions will change such that it becomes advantageous for him/her to exercise the option, and that he/she will then do so; for the writer, that this will not happen.
While the option is “live” (i.e. once the contract has been entered into but before the option has been exercised or has expired), the holder is said to have a “long position” and the writer a “short position”.
So how do options work?
There are two main types of options (depending on whether the option confers the right to buy or sell an underlying asset), namely “put” and “call” options.
“Put Options”
Under a put option, the writer grants the holder the right to sell the underlying asset at the strike price before the option’s expiration date.
“Call Options”
Under a call option, the writer grants the holder the right to buy the underlying asset at the strike price before the option’s expiration date.
Various property can be the subject of an option, including securities, currencies, derivatives, indices and commodities. In the event that the option contract is exercised, in the case of a put option, the writer must fulfil the terms of the contract by delivering the property which is the subject of the option to the given party. (In the case where such property cannot be delivered (e.g. an index), cash is often used to settle the contract. “Stock options” relate to the shares of a specific company; In the case of a call option, the writer must purchase the underlying asset for the strike price. A “contract multiplier” is often used to describe the asset in question – it is the multiple of the amount of the asset (which is the subject of the option) that the writer has to deliver to the holder in the event that the option is exercised (e.g. groups of 100 shares.)
As above, all options have an “expiration date”, that is, a date after which they cannot be exercised. However, there is a difference between so-called “European-style options” and “American-style options” in this regard: European-style options can only be exercised on the expiration date itself, whereas American-style options can be exercised anytime between the commencement of the contract and the expiration date. Most options used in the U.S. are American-style.
Some of the main option types include exchange traded options (ETO’s) and over-the-counter options (OTC options). ETOs have standard form contracts and can be traded on public exchanges, whereas OTC options are typically bespoke and are traded between private parties (usually large institutions).
These are just some of the characteristics of options one needs to understand to learn options trading. It is also imperative that a potential trader should grasp the advantages and disadvantages of various option types in seeking to formulate effective trading strategies.
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