What Is Options Trading?

An option is a contract that allows (but doesn't require) an investor to

buy or sell an underlying instrument like a security, ETF or index at a
certain price over a certain period of time. But, what is options
trading?

If you hadn't noticed by now, there are a lot of choices when it comes to investing in
securities.

Whether you prefer to play the stock market or invest in an Exchange Traded Fund
(ETF) or two, you probably know the basics of a variety of securities. But what
exactly are options, and what is options trading?

What Are Options?

An option is a contract that allows (but doesn't require) an investor to buy or sell an
underlying instrument like a security, ETF or even index at a predetermined price over
a certain period of time. Buying and selling options is done on the options market,
which trades contracts based on securities. Buying an option that allows you to buy
shares at a later time is called a "call option," whereas buying an option that allows
you to sell shares at a later time is called a "put option."

However, options are not the same thing as stocks because they do not represent
ownership in a company. And, although futures use contracts just like options do,
options are considered lower risk due to the fact that you can withdraw (or walk away
from) an options contract at any point. The price of the option (its premium) is thus a
percentage of the underlying asset or security.

When buying or selling options, the investor or trader has the right to exercise that
option at any point up until the expiration date - so simply buying or selling an option
doesn't mean you actually have to exercise it at the buy/sell point. Because of this
system, options are considered derivative securities - which means their price is
derived from something else (in this case, from the value of assets like the market,
securities or other underlying instruments). For this reason, options are often
considered less risky than stocks (if used correctly).
But why would an investor use options? Well, buying options is basically betting on
stocks to go up, down or to hedge a trading position in the market.

The price at which you agree to buy the underlying security via the option is called the
"strike price," and the fee you pay for buying that option contract is called the
"premium." When determining the strike price, you are betting that the asset (typically
a stock) will go up or down in price. The price you are paying for that bet is the
premium, which is a percentage of the value of that asset.

There are two different kinds of options - call and put options - which give the
investor the right (but not obligation) to sell or buy securities.

Call Options
A call option is a contract that gives the investor the right to buy a certain amount of
shares (typically 100 per contract) of a certain security or commodity at a specified
price over a certain amount of time. For example, a call option would allow a trader to
buy a certain amount of shares of either stocks, bonds, or even other instruments like
ETFs or indexes at a future time (by the expiration of the contract).

If you're buying a call option, it means you want the stock (or other security) to go up
in price so that you can make a profit off of your contract by exercising your right to
buy those stocks (and usually immediately sell them to cash in on the profit).

The fee you are paying to buy the call option is called the premium (it's essentially the
cost of buying the contract which will allow you to eventually buy the stock or
security). In this sense, the premium of the call option is sort of like a down-payment
like you would place on a house or car. When purchasing a call option, you agree with
the seller on a strike price and are given the option to buy the security at a
predetermined price (which doesn't change until the contract expires).

So, call options are also much like insurance - you are paying for a contract that
expires at a set time but allows you to purchase a security (like a stock) at a
predetermined price (which won't go up even if the price of the stock on the market
does). However, you will have to renew your option (typically on a weekly, monthly
or quarterly basis). For this reason, options are always experiencing what's called time
decay - meaning their value decays over time.
For call options, the lower the strike price, the more intrinsic value the call option
has.

Put Options
Conversely, a put option is a contract that gives the investor the right to sell a certain
amount of shares (again, typically 100 per contract) of a certain security or
commodity at a specified price over a certain amount of time. Just like call options, a
put option allows the trader the right (but not obligation) to sell a security by the
contract's expiration date.

Just like call options, the price at which you agree to sell the stock is called the strike
price, and the premium is the fee you are paying for the put option.

Put options operate in a similar fashion to calls, except you want the security to drop
in price if you are buying a put option in order to make a profit (or sell the put option
if you think the price will go up).

On the contrary to call options, with put options, the higher the strike price, the more
intrinsic value the put option has.

Long vs. Short Options

Unlike other securities like futures contracts, options trading is typically a "long" -
meaning you are buying the option with the hopes of the price going up (in which case
you would buy a call option). However, even if you buy a put option (right to sell the
security), you are still buying a long option.

Shorting an option is selling that option, but the profits of the sale are limited to the
premium of the option - and, the risk is unlimited.

For both call and put options, the more time left on the contract, the higher the
premiums are going to be.

What Is Options Trading?

Well, you've guessed it -- options trading is simply trading options, and is typically
done with securities on the stock or bond market (as well as ETFs and the like).
For starters, you can only buy or sell options through a brokerage like
E*Trade (ETFC) - Get Report or Fidelity (FNF) - Get Report .

When buying a call option, the strike price of an option for a stock, for example, will
be determined based on the current price of that stock. For example, if a share of a
given stock (like Amazon (AMZN) - Get Report ) is $1,748, any strike price (price of
the call option) that is above that share price is considered to be "out of the money."
Conversely, if the strike price is under the current share price of the stock, it's
considered "in the money."

However, for put options (right to sell), the opposite is true - with strike prices below
the current share price being considered "out of the money" and vice versa. And,
what's more important - any "out of the money" options (whether call or put options)
are worthless at expiration (so you really want to have an "in the money" option when
trading on the stock market).

Another way to think of it is that call options are generally bullish, while put options
are generally bearish.

Options typically expire on Fridays with different time frames (for example, monthly,
bi-monthly, quarterly, etc.). Many options contracts are six months.

Trading Call vs. Put Options

Purchasing a call option is essentially betting that the price of the share of security
(like a stock or index) will go up over the course of a predetermined amount of time.
For instance, if you buy a call option for Alphabet (GOOG) - Get Report at, say,
$1,500 and are feeling bullish about the stock, you are predicting that the share price
for Alphabet will increase.

When purchasing put options, you are expecting the price of the underlying security to
go down over time (so, you're bearish on the stock). For example, if you are
purchasing a put option on the S&P 500 I:GSPC index with a current value of $2,100
per share, you are being bearish about the stock market and are assuming the S&P 500
will decline in value over a given period of time (maybe to sit at $1,700). In this case,
because you purchased the put option when the index was at $2,100 per share
(assuming the strike price was at or in the money), you would be able to sell the
option at that same price (not the new, lower price). This would equal a nice "cha-
ching" for you as an investor.
Options trading (especially in the stock market) is affected primarily by the price of
the underlying security, time until the expiration of the option, and the volatility of the
underlying security.

The premium of the option (its price) is determined by intrinsic value plus its time
value (extrinsic value).

Historical vs. Implied Volatility

Volatility in options trading refers to how large the price swings are for a given stock.

Just as you would imagine, high volatility with securities (like stocks) means higher
risk - and conversely, low volatility means lower risk.

When trading options on the stock market, stocks with high volatility (ones whose
share prices fluctuate a lot) are more expensive than those with low volatility
(although due to the erratic nature of the stock market, even low volatility stocks can
become high volatility ones eventually).

Historical volatility is a good measure of volatility since it measures how much a

stock fluctuated day-to-day over a one-year period of time. On the other hand, implied
volatility is an estimation of the volatility of a stock (or security) in the future based
on the market over the time of the option contract.

Value: Time Value and in/at/out of the Money

If you are buying an option that is already "in the money" (meaning the option will
immediately be in profit), its premium will have an extra cost because you can sell it
immediately for a profit. On the other hand, if you have an option that is "at the
money," the option is equal to the current stock price. And, as you may have guessed,
an option that is "out of the money" is one that won't have additional value because it
is currently not in profit.

For call options, "in the money" contracts will be those whose underlying asset's price
(stock, ETF, etc.) is above the strike price. For put options, the contract will be "in the
money" if the strike price is below the current price of the underlying asset (stock,
ETF, etc.).
The time value, which is also called the extrinsic value, is the value of the option
above the intrinsic value (or, above the "in the money" area).

If an option (whether a put or call option) is going to be "out of the money" by its
expiration date, you can sell options in order to collect a time premium.

The longer an option has before its expiration date, the more time it has to actually
make a profit, so its premium (price) is going to be higher because its time value is
higher. Conversely, the less time an options contract has before it expires, the less its
time value will be (the less additional time value will be added to the premium).

So, in other words, if an option has a lot of time before it expires, the more additional
time value will be added to the premium (price) - and the less time it has before
expiration, the less time value will be added to the premium.

Pros and Cons

Some of the major pros of options trading revolve around their supposed safety.

According to Nasdaq's options trading tips, options are often more resilient to changes
(and downturns) in market prices, can help increase income on current and future
investments, can often get you better deals on a variety of equities and, perhaps most
importantly, can help you capitalize on that equity rising or dropping over time
without having to invest in it directly.

Of course, there are cons to trading options - including risk.

There are a variety of ways to interpret risks associated with options trading, but these
risks primarily revolve around the levels of volatility or uncertainty of the market. For
example, expensive options are those whose uncertainty is high - meaning the market
is volatile for that particular asset, and it is more risky to trade it.

Options Trading Strategies

When trading options, the contracts will typically take this form:

Stock ticker (name of the stock), date of expiration (typically in mm/dd/yyyy,

although sometimes dates are flipped with the year first, month second and day last),
the strike price, call or put, and the premium price (for example, $3). So an example
of a call option for Apple stock would look something like this: APPL 01/15/2018 200
Call @ 3.

Still, depending on what platform you are trading on, the option trade will look very
different.

There are numerous strategies you can employ when options trading - all of which
vary on risk, reward and other factors. And while there are dozens of strategies (most
of them fairly complicated), here are a few main strategies that have been
recommended for beginners.

Straddles and strangles

With straddles (long in this example), you as a trader are expecting the asset (like a
stock) to be highly volatile, but don't know the direction in which it will go (up or
down). When using a straddle strategy, you as the trader are buying a call and put
option at the same strike price, underlying price and expiry date. This strategy is often
used when a trader is expecting the stock of a particular company to plummet or
skyrocket, usually following an event like an earnings report. For example, when a
company like Apple (AAPL) - Get Report is getting ready to release their third
quarter earnings on July 31st, an options trader could use a straddle strategy to buy a
call option to expire on that date at the current Apple stock price, and also buy a put
option to expire on the same day for the same price.

For strangles (long in this example), an investor will buy an "out of the money" call
and an "out of the money" put simultaneously for the same expiry date for the same
underlying asset. Investors who use this strategy are assuming the underlying asset
(like a stock) will have a dramatic price movement but don't know in which direction.
What makes a long strangle a somewhat safe trade is that the investor only needs the
stock to move greater than the total premium paid, but it doesn't matter in which
direction.

The upside of a strangle strategy is that there is less risk of loss, since the premiums
are less expensive due to how the options are "out of the money" - meaning they're
cheaper to buy.
Covered Call
If you have long asset investments (like stocks for example), a covered call is a great
option for you. This strategy is typically good for investors who are only neutral or
slightly bullish on a stock.

A covered call works by buying 100 shares of a regular stock and selling one call
option per 100 shares of that stock. This kind of strategy can help reduce the risk of
your current stock investments but also provides you an opportunity to make profit
with the option.

Covered calls can make you money when the stock price increases or stays pretty
constant over the time of the option contract. However, you could lose money with
this kind of trade if the stock price falls too much (but can actually still make money if
it only falls a little bit). But by using this strategy, you are actually protecting your
investment from decreases in share price while giving yourself the opportunity to
make money while the stock price is flat.

Selling Iron Condors

With this strategy, the trader's risk can either be conservative or risky depending on
their preference (which is a definite plus). For iron condors, the position of the trade is
non-directional, which means the asset (like a stock) can either go up or down - so,
there is profit potential for a fairly wide range. To use this kind of strategy, sell a put
and buy another put at a lower strike price (essentially, a put spread), and combine it
by buying a call and selling a call at a higher strike price (a call spread). These calls
and puts are short.

When the stock price stays between the two puts or calls, you make a profit (so, when
the price fluctuates somewhat, you're making money). But the strategy loses money
when the stock price either increases drastically above or drops drastically below the
spreads. For this reason, the iron condor is considered a market neutral position.

Options Trading Examples

There are lots of examples of options trading that largely depend on which strategy
you are using. However, as a basic idea of what a typical call or put option would be,
let's consider a trader buying a call and put option on Microsoft (MSFT) - Get
Report .
For example, if you bought a long call option (remember, a call option is a contract
that gives you the right to buy shares later on) for 100 shares of Microsoft stock at
$110 per share for December 1, you would have the right to buy 100 shares of that
stock at $110 per share regardless of if the stock price changed or not by December 1.
For this long call option, you would be expecting the price of Microsoft to increase,
thereby letting you reap the profits when you are able to buy it at a cheaper cost than
its market value. However, if you decide not to exercise that right to buy the shares,
you would only be losing the premium you paid for the option since you aren't
obligated to buy any shares.

If you were buying a long put option for Microsoft, you would be betting that the
price of Microsoft shares would decrease up until your contract expires, so that, if you
chose to exercise your right to sell those shares, you'd be selling them at a higher price
than their market value.

Another example involves buying a long call option for a $2 premium (so for the 100
shares per contract, that would equal $200 for the whole contract). You buy an option
for 100 shares of Oracle (ORCL) - Get Report for a strike price of $40 per share
which expires in two months, expecting stock to go to $50 by that time. You've spent
$200 on the contract (the $2 premium times 100 shares for the contract). When the
stock price hits $50 as you bet it would, your call option to buy at $40 per share will
be $10 "in the money" (the contract is now worth $1,000, since you have 100 shares
of the stock) - since the difference between 40 and 50 is 10. At this point, you can
exercise your call option and buy the stock at $40 per share instead of the $50 it is
now worth - making your $200 original contract now worth $1,000 - which is an $800
profit and a 400% return.

Common Options Trading Mistakes

There are plenty of mistakes even seasoned traders can make when trading options.

One common mistake for traders to make is that they think they need to hold on to
their call or put option until the expiration date. If your option's underlying stock goes
way up over night (doubling your call or put option's value), you can exercise the
contract immediately to reap the gains (even if you have, say, 29 days left for the
option).

Another common mistake for options traders (especially beginners) is to fail to create
a good exit plan for your option. For example, you may want to plan to exit your
option when you either suffer a loss or when you've reached a profit that is to your
liking (instead of holding out in your contract until the expiration date).

Still other traders can make the mistake of thinking that cheaper is better. For options,
this isn't necessarily true. The cheaper an option's premium is, the more "out of the
money" the option typically is, which can be a riskier investment with less profit
potential if it goes wrong. Buying "out of the money" call or put options means you
want the underlying security to drastically change in value, which isn't always
predictable.

And while there are plenty of other options faux pas, be sure to do your research
before getting into the options trading game.