If you’re one of these retail traders who’s curious about options, here’s a quick example to set the stage.
Let’s say you believe Apple’s stock is going up in value over the coming month and want to invest. Perhaps you think a 10% gain is realistic, from its current price of $150 to $165. With a regular stock trade, you would simply buy shares of Apple at $150 and hope they go up over the next few weeks.
Now, you could also choose to buy an option on Apple stock. Because of your time horizon on this particular trade, you would pick an option that expires in a month. The option gives you the right to buy Apple shares at a certain price within this month. You could pick the one that lets you buy Apple shares at $155, for instance. If Apple stock goes to $165 as you expect, this would let you buy shares at a $10 discount compared to the market price. That’s a pretty sweet deal!
Options enable you to trade stocks and other assets without actually owning the assets themselves. The above is just one simple way of doing it. Before we get further into different option types and how to use them though, let’s first unpack what an options contract is made up of.
Components of an option contract
1. Underlying asset
An option is always tied to an underlying asset, such as a stock, a commodity, or a currency pair. The value of your option and the success of your trade is dependent on this underlying asset. Apple stock was the underlying asset in our example above.
Not all financial assets have an options market though, and the selection of options within a given market is also limited. You won’t be able to trade options on all stocks for instance, and some are so thinly traded that you may want to stay away from them anyway.
2. The right to buy or sell
As the name implies, an option is essentially a contract that gives you the right to buy or sell an underlying asset at a specific price, at or before the option’s expiration date. Buying or selling the underlying asset is referred to as “exercising” your option. There are two important things to note here.
First, an option gives you the right to buy or sell the underlying asset — but not the obligation to do so! You can also sell the option itself, let it expire, or do a range of other things. In fact, the vast majority of options are never exercised.
Second, you can either choose an option that lets you buy the underlying asset or one that lets you sell the underlying asset. Generally speaking, you would choose the former when you expect the underlying asset to go up in value, and the latter when you expect it to go down. We’ll cover this in detail in an upcoming post. For now, just know that options enable you to make money whether the market goes up or down, or even sideways for that matter.
3. Strike price
An option lets you buy or sell the underlying asset at a specific price. This price is called the strike price. The strike price can both be higher or lower than the current price of the asset, also known as its fair value.
In our example from earlier, the fair value of Apple stock was $150 while our strike price was $155.
4. Expiration date
All good things must come to an end, and so your right to buy an asset at a specific price won’t last forever. Every option has an expiration date, although they vary a lot. For any given asset, such as Apple stock, you’ll be able to buy options that expire in a week, a month, or a quarter, for instance.
The expiration date is the time by which your thesis must have played out. If Apple hasn’t reached a certain price by then, and you don’t extend your option, you will essentially have lost your whole investment.
5. Option premium
Now, speaking of “your whole investment”. Where does your money actually go if you’re not buying the underlying asset?
Well, your money is in the option itself. The option contract, with all the components and rights described above, comes at a price. This price is known as the premium.
The size of an option’s premium is determined by a series of factors that we’ll get into in an upcoming post. For now, all we need to know is that you generally pay a larger premium for the more “safe bets” whereas the more speculative option contracts may be relatively cheap to acquire because of your low odds of winning.
The Option Contract Multiplier
One of the most important things to understand before getting into options trading is the Option Contract Multiplier. Buying 1 option on Apple shares does not give you exposure to 1 share of Apple. Rather, it gives you exposure to 100 shares! That’s because stock options in the US market have a multiplier of 100. Note that the multiplier may vary for other assets and jurisdictions, so make sure you do your research before getting into any market.
It’s also important to note that the option premium is always shown per share, not per option contract. Let’s say the premium on a given option is $1. Because of the option contract multiplier, buying 1 of these options would give you exposure to 100 shares of the underlying stock, thus costing you $100.
When buying an option, the premium you pay is also the maximum amount of money you risk losing on the trade. Contrary to most people’s approach to investing in stocks and other assets, your risk is limited and clearly defined upfront. Also contrary to most people’s experience, when you buy an option you risk losing everything.
However, because of the Option Contract Multiplier, your exposure to the underlying asset will be significantly larger than the amount of money you pay for the premium. So even if the move in the underlying asset would have cost you $1k had you owned the stock, you will only lose $200 on the trade if that’s the premium you paid.
Because of the option contract multiplier, options are an inherently leveraged financial instrument. If you’re not familiar with leverage in financial trading, let’s explore it a little further.
The inherent leverage in options
Trading with leverage essentially means trading with borrowed money. If you’re trading with 2x leverage you’re getting $2k worth of stock for your $1k investment. Doing this is very common in many financial markets, and often with much higher leverage than 2x.
Trading with leverage is usually a choice though, something each individual trader can choose to do in order to maximize their returns — while simultaneously also increasing their risk, of course. Because of the higher risk, many experts advise against the use of leverage, at least among beginners. In the options market, however, the leverage is inherent in any trade you make.
Let’s say a given stock is trading at $50 per share. An option contract may be sold at a premium of $2 per share. Buying 1 option contract would cost you $200 because of the option contract multiplier, but would give you exposure to shares worth $5k!
Leverage enables you to make a greater return on your investment if you’re right. If you’re wrong, however, you can also risk losing a lot more than you normally would. Leverage is a double-edged sword. Because leverage is inherent when trading options, it’s essential to fully understand and get comfortable with this fact.
One key benefit of trading with options though is that your downside is limited and well-defined before you enter a trade.
Resources
I will be covering the basics of options trading in a short series of articles. However, I encourage you to really dig in and educate yourself as much as possible. Below I’ve listed some of the resources I’ve personally found to be the most helpful. Let me know what you think if you decide to check them out, or if you have other suggestions for me to add to the list 👇
Option Alpha University
Easily the most beautiful website with the best overview and easiest navigation. I love their short written explanations accompanied by videos.
projectoption
This site really helped me with some specific topics that I had a hard time wrapping my head around. The comprehensive articles are supported by awesome visuals that really help with the understanding of more complex concepts.
tastytrade
One of the most popular go-to places for all-things-trading. They have a huge catalog of educational content in various formats, best practices, glossaries, and more.
