Options Trading - The Basics
All options have four specific characteristics that make them unique.
1. The option is either a call or put
2. There is an underlying security
3. Options have an exercise price (strike price)
4. There is a fixed expiry date for the option
A ‘call option’ gives the buyer the right to buy the underlying security at the exercise price of the option. For this right the buyer of the option pays a premium.
A ‘put option’ gives the buyer the right to sell the underlying security at the exercise price of the option. For this right the buyer of the option pays a premium.
A Simple Directional Strategy using Put and Call Options
If you thought that the market was headed higher, you could buy a call option and sell it after the market went up for a profit.
If you thought the market was headed lower, you could buy a put option and sell it after the market went down for a profit.
Example: Buying an XYZ Call Option
Let’s look at an example of buying a call option on XYZ stock and break down the trade into its various components:
Buy 1 XYZ March 22.00 Call Option
Premium Paid = $750
|Buy 1||Buying 1 XYZ call option contract would give you the right to buy 1000* shares of XYZ if you so choose, or you can sell the option at any time up until the expiry date of the option in March|
|XYZ||Underlying Security that the option is based on|
|March||Month in which the option expires|
|22.00||Exercise price (also known as strike price). Owning this option gives you the right to buy 1000* XYZ shares at $22.00 at or before March|
|Call Option||Gives the buyer the right but not the obligation to buy the underlying commodity at the exercise price of $22.00|
|Premium||Cost of the Option which in this case is $750|
(* this entitlement varies from market to market. 1 contract = 1000 shares in Australia but only 100 in the US.)
All option trades regardless of the underlying commodity, stock or index have the above attributes in common. The only thing that changes is the variables that go into each trade.
Options Offer High Leverage
A $22.00 call option on XYZ gives the same leverage as holding $22,000 worth of XYZ shares (in this case, 1 option = 1000 shares). However, you only paid $750 to get the same leverage. A $750 profit on the option means a 100% return. The same profit using 1000 XYZ shares would mean a return of approximately 3.5%.
Of course the leverage that gives you such potentially large returns can also work against you. Although you can make quick money with a short, sharp move of the market in your favour, you can also lose just as quick if the market moves significantly against your position before expiry of the option.
The advantage is in knowing that your risk is limited to what you paid for the option (in this example $750). If you are comfortable with this risk, then you have the potential for unlimited profit.
Options Offer Flexibility
Trading stocks can only be profitable if the market goes up. Futures can be profitable either up or down depending on whether you initially buy or sell a futures contract. Options can be profitable up, down, or sideways, depending on the strategy that is employed.
Options are an extremely flexible trading tool. You can use strategies that will accurately fit your view of the market, whilst tailoring it closely to your personal level of risk tolerance, from conservative to highly speculative.