Options trading: How does it work?

What are options?

Options are financial instruments that give the option buyer the right to buy or sell an underlying asset at a predetermined price and at a future fixed date, for a fee or premium. An option is a contract or agreement. It is also a particular kind of derivative security because the value of an option is linked or derived from the changing value of an underlying stock, ETF, bond, currency, or commodity.

One of the most important differences between a stock and an option is that, with options, you are paying for the right to buy or sell a security at a particular price and within a set timeframe. This is unlike a stock or ETF, where you are buying a piece of a company or part of a pool of assets.

There are two basic types of options:

• Call options – These give the owner of the option the right, but not the obligation, to buy the underlying asset at a fixed price (the call’s strike price). A call buyer benefits when the price of the underlying asset increases.
• Put options – These give the owner of the option the right, but not the obligation, to sell the underlying asset at a fixed price (the put’s strike price). A put buyer benefits when the price of the underlying asset decreases.

Options can be used to speculate on the underlying asset in different ways. Prior to their expiration date, options contracts can also be traded on an options exchange in the same way that stocks are traded on a stock exchange. The major North American options exchange is in Chicago, and the smallest one is in Montreal (external source).

Remember that, when you purchase an option, you’re paying a premium for the right to buy or sell an underlying asset. If the option premium has gone up in value, you can sell or ‘close out’ your position for a profit and avoid having to exercise the option on maturity.

How do options work?

In exchange for a premium, an option lets you speculate that the price of an underlying asset will rise or fall within a fixed period of time. Unlike purchasing the actual security, which can cost hundreds of dollars per unit, an option lets you benefit from the changing value of a call (buy) or put (sell) option on the options exchange – sidestepping the significant sums involved in trading the underlying asset.

Note that a single options contract represents 100 shares in the underlying security.

Why buy options

The benefits of trading options can be broken down into 4 broad categories.

• Speculation – If you have a hunch about the direction that a security might take, you can speculate by purchasing a call or put option. If you’re right about the price movement, you can make money by selling your option for an amount greater than the premium you paid.
• Leveraging – An option makes it possible to use a smaller amount of money to capture the changing value of a larger and more expensive asset. The call or put option lets you benefit from price shifts in the underlying asset without having to own it.
• Hedging – You can use an option to protect a stock position you hold in your portfolio. The option payoffs let you offset price fluctuations in the value of the underlying asset.
• Income generation – Use call and put options by selling them (writing) to generate additional investment income.

Key terms

When reading an option quote or completing an order ticket, it is important to be familiar with the following terms:

• Expiration date – This is the date on which an option contract ends and after which it can no longer be exercised. The expiration date comes into effect at the end of the trading day.
• Moneyness – An option’s ‘moneyness’ refers to the difference between the underlying asset price and the option’s strike price.
• In the money (ITM) – A call option is ‘in the money’ when the market price of the underlying asset is higher than the strike price. A put option is ‘in the money’ when the market price of the underlying asset is lower than the strike price.
• At the money (ATM) – A call or put option is ‘at the money’ if the market price of the security is equal to the strike price. An ATM option has no intrinsic value.
• Out of the money (OTM) – A call option is ‘out of money’ when the market price of the underlying asset is lower than the strike price. A put option is ‘out of money’ when the market price of the underlying asset is higher than the strike price. A OTM option has no intrinsic value.
• Exercise – Exercising an option refers to the act of invoking the right, granted by the option contract, of the holder to buy or sell the underlying asset at the predetermined price (the strike price) before or at the option’s expiration date. If an option expires in the money and the holder does not sell it before the end of the trading day on expiration date, it will be automatically exercised, and the holder will buy or sell the underlying asset at the strike price.
• Assignment – An option assignment occurs when the seller (writer) of an option is obligated to fulfill the terms of the option contract. This happens when the buyer of the option contract exercises their right to buy or sell the underlying asset.
• Premium – The premium is the amount you pay to purchase an option, or the amount you receive for selling an option. Premiums are quoted per share, and options usually cover 100 shares. Therefore, you usually have to multiply the premium by 100 to determine the cost of one option.
• Bid-Ask spread – The option bid/ask spread is the difference in price between the quoted bid and ask price of the option. A small bid/ask spread is indicative of the increasing liquidity or value of the option.
• Strike price – The predetermined price at which the option may be exercised – buying the underlying asset in the case of a call option or selling the underlying asset in the case of a put option.
• Intrinsic value – Intrinsic value is the difference between the strike price and the market value of the security. A call option has intrinsic value when strike price is below the current market price. A put option has intrinsic value when the strike price is above the current market price. If an option has intrinsic value, it is ‘in the money.’
• Time value – Time value is the difference between the option's premium and intrinsic value. Time value is the amount an investor is willing to pay above the intrinsic value. An option’s time value will decay as it approaches expiration because there is less time available to generate a profit.
• Hedge – Options hedging is a strategy that uses options to offset price fluctuations of a stock or ETF that you hold in your portfolio. A protective put is a type of hedging strategy.
• Leverage – Refers to the ability to control a large contract value with a relatively small amount of money.

How to read an options quote

An options quote on the NBDB online brokerage platform is very different from a stock quote. For each stock or ETF, you will find a list of dates. These are different option maturity or expiration dates, and they can extend years in the future.

For each maturity date, there is an accompanying table with detailed information divided into a call and a put section, separated by a strike price.

The information in each row of the call and put section is called a series. Each series is linked to a strike price on the underlying asset.

Each series contains valuable information about the price of an option that matures on that day at a particular strike price. A series highlighted in yellow is an indication that it is 'in the money.'

What happens to my option at expiration?

When the markets close on the expiration date of the option there are two possible outcomes for the option holder:

1. The option expires worthless because it was out of the money (OTM) and has no intrinsic value, or
   
   
2. The option expires in the money (ITM) and has intrinsic value.

In the second scenario, the option will be automatically exercised. This means that the buyer would have to purchase, at the strike price, the underlying asset if they held a call option, or sell the underlying asset, at the strike price, if they held a put option. This can be a serious problem if the option holder doesn’t have the necessary cash or shares.

Prior to expiration, the option will have time value and could also have intrinsic value. In this case, the option holder might sell or “close out” their call or put option. As a result, they will receive a cash payment at a profit or a loss but will also avoid having to exercise the option on the expiration date.

If the option holder does not have the funds or holdings to meet their obligation, they can close their option prior to expiry or contact NBDB, before 4:30 EST, to request the option not be exercised.

Call vs. put options – What is the difference?

Buying a call option or a put option represents two different outlooks on the future movement of the underlying stock, bond, ETF, or commodity. This table explains some of the key differences.

Note that investors should have a solid understanding of the underlying asset when they are buying and selling options.

Pros and cons of options

Options trading can offer a range of advantages and disadvantages, making it crucial for investors to understand both sides before diving in. On one hand, the flexibility and potential for high returns can be appealing, but there are risks and complexities that should be considered. By exploring the pros and cons, you can better assess if this strategy is aligned with your investment goals and risk tolerance.

Pros of trading options

• Smaller financial commitment – With just a few hundred dollars or less, you can take advantage of the price movement of the underlying asset without having to buy the shares.
• Limited downside for the option buyer – The premium you paid is the maximum loss you will incur if the option expires out of the money.
• Leverage – As mentioned previously, options allow investors to control a large contract value with a relatively small amount of money, amplifying potential returns.
• Flexibility – Depending on the option strategy, the investor can choose to close out their position early if it happens to be profitable to do so.

Cons of trading options

• Time decay – Unlike buying a security, where you might benefit from an increase in value over the long term, time is not on your side when it comes to options. Typically, the closer the option gets to the expiration date, the lower its time value. In the case of options writers (sellers), time decay is advantageous.
• Complexity – Options trading can be complex and requires a thorough understanding of various strategies and market conditions.
• Low liquidity and large spreads – Certain less followed options have larger option price differences, which can make them not as easy to buy or sell.
• Risk – While leverage in options trading can amplify gains, it can also magnify losses. This means that even a minor adverse move in the underlying asset’s price can result in significant losses.

Different option strategies

Investors can employ many different option strategies. Here is a list of some basic option buying and selling strategies:

• Long call – A long call is a standard call option where the option holder pays a premium and has the right, but not the obligation, to buy the underlying asset within a fixed time and strike price in the future.
• Long put – A long put is a position where the option holder pays a premium and has the right, but not the obligation, to sell the underlying asset within a fixed time and strike price in the future.
• Protective put – A protective put is a way for an investor to use a put option to safeguard against a possible decrease in the value of a stock they hold in their portfolio by buying a put. If the investor is wrong and the share goes up or doesn't move, their cost is the price they paid for the premium.
• Covered call – A conservative option and hedging strategy, a covered call involves selling a call option on an asset the investor already owns. In return, the investor agrees to sell the underlying assets should they increase in value. The call is considered “covered” since the investor already owns the shares and can deliver them if the option is exercised.
• Cash secured put – An investor writes a put option and receives a premium and secures an amount equal to the value of the underlying asset at the strike price. If assigned, the seller of the put will be obligated to buy the security at the predetermined strike price.

How to place an options trade?

Once you've decided on your options strategy, you will need to complete a trade ticket on a platform that offers options trading, such as the National Bank Direct Brokerage online brokerage platform. Here are the different order types on options:

• 'Buy to open' means that you are buying an option to create a new position. In the stock world, it corresponds to a buy order.
• 'Sell to close' means that you are selling the option to close your existing position. In the stock world, it corresponds to a sell order.
• 'Sell to open' means that you are writing (or selling) an option that you do not possess.
• 'Buy to close' means that you are buying back the option that you had sold to close your position.
• When 'writing' call or put options, the initial operation is called an 'opening sell' and closing the position is a 'closing buy.'

How to place an option trade

Myths about options trading

We know that starting your option education journey can feel challenging. Here are some common myths about options trading and investing that new options traders should keep in mind.

1. Options add more risk – Many investors believe that options are inherently riskier than stocks. However, options can be used to hedge existing positions and lower risk by using protective puts, as previously mentioned. Options can also be used to minimize risk when taking directional positions. Consequently, the level of risk depends on the strategy used by the investor.
   
   
2. Puts are riskier than calls – The reality is that puts are priced the same way that calls are priced. They are both based on the potential for the underlying asset to move higher or lower.
   
   
3. Options are a zero-sum game – This is a common oversimplification. There isn’t necessarily a defined winner or loser on every options trade. For example, a covered call writer and a call buyer can each successfully accomplish their respective objectives - selling a call for income and delivering shares to the call buyer who wants to own them.
   
   
4. Most options expire worthless – In fact, many options holders choose to exercise their positions or trade out before expiration to cut losses or lock in profits. When options are out of the money and near expiration, many investors let their contracts expire worthless instead of closing them out and incurring commission costs.
   
   
5. Covered call writing underperforms – The profitability of the covered call strategy is a function of the market environment, stock selection, and risk management. As a result, strategic covered call writing can not only increase returns, but can also lower portfolio volatility.

Mistakes to avoid when trading options

All options investors — both new and seasoned — make mistakes. It is simply part of the journey. Though avoiding all errors isn't realistic, here are some important things to keep in mind and watch out for as you move forward.

• Not having a strategy – Options investors need to understand the options market and have a sense of the underlying stock dynamics that impact prices. They need to create an effective and considered strategy. To achieve their financial objectives, they also need to be agile, carefully assess market conditions, and do their research.
• Choosing the wrong strike price and expiration date – Beginners need to learn how to select the ideal strike price based on their conviction that the stock price will move, which in turn is based on the three types of option moneyness:
  • The more ITM the option is, the more expensive it will be because it has intrinsic value and a higher probability of being in the money on expiration date.
  • On the other hand, OTM options have zero intrinsic value and require a stronger move in the stock to be profitable. If not, they will expire worthless.
  • OTM options might be a position to consider for those who have a higher risk tolerance and who are expecting a large swing in the underlying stock price.
• Not considering implied volatility – Implied volatility is one of the most important variables to understand when pricing an option. Simply put, implied volatility is the expected volatility of a stock over the lifespan of the option. As risk and uncertainty increase in a stock, the price of the option can rise to compensate for this risk or go down depending on the nature of the change.

Discipline is key to a successful investment journey for self-directed investors. Knowing the underlying asset well also is a key element of successful option investing. This applies as much to investing in options as it does to investing in other kinds of securities. It is important to always keep a careful eye on your portfolio and your option trades. Using the tools and resources available on the NBDB Learning Centre can help inform and guide your strategic investment decisions.

As Pierre Laroche points out, "It's important to not be lured by high expected returns. We all, even seasoned investors, have to pay close attention to the downside risks." Options are an important and powerful asset in your investment toolkit. Remember that there are always risks involved, but doing your research and taking a thoughtful and disciplined approach can help you make informed investment decisions.