Stock Options Trading

Options contracts give the holder the right, not obligation, to buy or sell the underlying security at a selected strike price up to the expiration date. Since options are derivatives, they allow the holder to benefit from the upside of the underlying stock’s price move while capping the losses to the actual cost of the option itself. They provide the leverage of stock ownership at a fraction of the cost with limited downside dollar value risk. Each options contract controls 100 shares of the underlying stock. Therefore a holder of 10 call contracts controls the equivalent of 1,000 shares of the underlying stock.

Options contracts are traded on the various options exchanges including the Chicago Board Options Exchange (CBOE) and International Securities Exchange (ISE), as their prices move with the underlying security price changes. Unlike stocks, options can lose most or all of their value by expiration depending on where the underlying stock is trading. Directional bets are often made with stock options but the majority of the contracts end up expiring worthless.

How Do Options Work?

Keep in mind not every stock has options contracts available. However, the most widely traded stocks usually do. Options contracts are identified by the strike price and expiration month. The strike price is the price level that the underlying stock needs to meet or exceed to maintain intrinsic value. Options expire on the close of the third Friday of the contract month. Therefore, a March 22.50 Call option means the underlying stock needs to close at or above $22.50 by contract expiration at the close of the third Friday in March to maintain any value. When options expire OTM, they expire worthless and the investment is gone.

Options Expiration

When options expire ITM or ATM, the option holder may be assigned the stock at the strike price. For example if a stock closes at $24, the $23 call holder would have to make the decision to sell the option before expiration to lock in a profit, exercise the option to purchase the shares at $23 or rollover the option to the next month. If he lets the contract expire in the money, he runs the risk of being assigned shares at $23. Although he has a $1 profit, he also must have the funds available in the brokerage account to cover the purchase costs. Therefore, it is important to decide whether to cash in the profits before expiration or choose to exercise the option, unless you want to be assigned the shares.

Options Spreads and Liquidity

Like stocks, options contracts have bid and ask prices along with open interest, which are the total number open contracts. The bid/ask spreads can get wide (IE: 2.50 x 3.00) unless there is steady volume and trading activity. Usually the most volume and liquidity are available on the front month ATM and ITM contracts. Tighter spreads equate to more liquidity and volume. However, the most heavily traded stocks tend to also see the most liquidity in their options as well. In fact, most of the widely traded stocks also have weekly options, which trade just like the monthlies but expire on a weekly basis. These options are extremely volatile and should only be traded by seasoned traders.

ITM, ATM and OTM

When a stock trades at or just above the strike price, it is described as being at-the-money (ATM). When a stock trades above the strike price, it is in-the-money (ITM), like a stock trading at $23 on the 22.50 call option. When a stock is trading below the strike price, it is considered out-of-the-money (OTM), like a stock trading at $22 on a 22.50 call option. Call options are bullish bets where the underlying stock is expected to exceed the strike price. Put options are bearish bets where the underlying stock is expected to fall below the strike price. Therefore, a stock trading out $22.75 would be considered ITM for the 23.50 put option since it is trading – 0.75 below the strike price. At the same time, the 22 call option would be ITM as well since the stock is trading + 1.75 above the 22 strike price. However, the 23.50 call option would be OTM since the stock is trading – 0.75 below the 23.50 strike price.

Calls and Puts

As aforementioned, there are two types of options contracts, calls and puts. Call options rise in value when the underlying stock price rises. Call holders seek to profit from a price spike in the underlying stock, a bullish directional bet. Put options rise in value when the underlying stocks price falls. Put holders are making a bearish directional bet looking to profit from a collapse in the underlying stock price. Based on the type of option (call or put), you can determine whether it is ATM, ITM or OTM. Remember that call options need the price to be above the strike and put options need the price to be below the strike.

Writing/Selling Covered Calls

Where do options contracts come from? In order to give someone the right, not the obligation, to purchase shares of the underlying stock at the strike price by expiration, the shares need to be available. Shareholders can sell options on the shares they own. Investors, mutual funds, hedge funds and institutions regularly sell options to generate monthly income. When investors sell a call option on stock they own, it is referred to as writing a covered call or (short) selling the call. The motivation to for sellers is to collect the premium for taking on the risk of assignment, having the stock taken away from you at the strike price.

Intrinsic and Extrinsic Value and Premium Composition

An options price is composed of the intrinsic value and the extrinsic value, which is the combination of the intrinsic value + premium. The premium is composed of mostly of volatility and time decay (days left until expiration) and interest (which is has little bearing in a zero rate environment). The intrinsic value is the difference between the option strike price and the actual price of the underlying stock. For example, the intrinsic value of a 22.50 call option is 0.50 when the underlying stock is trading at $23. It would be zero if the stock is trading at $22.50. However, you will see options in similar situations that may be trading at $1 on the 22.50 calls even when the underlying stock is trading at $21. In this case, the intrinsic value is zero (-1.50), but due to the premium it is trading at $1. If you were to buy the call option at $1, you would need the stock to rise + $1.50 to $22.50 just to get to breakeven on the intrinsic value and then rise another $1 to $23.50 just to breakeven on the trade.

Implied Volatility and Time Decay

Why would anyone overpay for an option like this? Volatility and time left until expiration. When volatility spikes, there is more interest in the options and therefore premium rise. The further away the expiration date, the more time premium exists. Each day that draws closer to expiration erodes the time premium, also known as time decay, also known as Theta. This is a boon for options sellers (shorts) who profit from the time decay and a major problem for options buyers (longs) who lose value every day from holding the option, unless it is deep ITM. Volatility, expressed as Implied Volatility (IV), is measured by the underlying stock’s price action and anticipation of a near-term catalyst event like an earnings release. It is imperative you are aware of what near-term events are scheduled so that you are prepared to react.

Common Newbie Mistake: Earnings Reports

Don’t find out the hard way about the devastating effects of premiums. A common situation that newbie options players find out the hard way is buying calls ahead of an earnings report. Let’s say XYZ is scheduled to report their earnings results after the close. The stock is trading at $27. You are feeling very confident that the earnings will come in strong and purchase the $30 strike calls, which expire in two days, for $2, thereby paying a $2 premium. This means that XYZ stock would need to first rise $3 to $30 for the option to be ATM and then another $2 to $32 for you to breakeven on the trade based on intrinsic value. When the earnings are released after the bell, XYZ blows away the consensus estimates and raises their forward earnings guidance. You nailed it! The stock spikes in the post market to $33. The next morning, the stock shows a nice + $3 gain on the day as it trades at $30. However, you notice that even though the stock has gained $3 since the close, your call option has dropped in value to $0.25. What gives? The implied volatility was already priced into the option premium. Once the news was released, the volatility collapses. Buy the rumor; sell the news applies in this case. Although you were right on the idea, you were wrong on the trade. You end up selling the call at $0.25 for a – $1.75 loss even though the stock gained $3. You overpaid for the call option due to the implied volatility that was baked into the extrinsic value. This is a common mistake that new options traders make when they want to bet on earnings releases.

Opening and Closing a Covered Call Trade

Brokers allow this for customers with options level 1 permissions activated. To perform this, you would first need to own the stock in your trading account. Then you would select the call strike price and expiration month. To execute, you would select the “Sell to Open” button on your trading platform. This will sell the call option on the bid price after verifying your own the necessary shares. It will appear like a short-sell on the options position. For example, if you sold 10 calls, your position minder may show “-10 XYZ Mar 23 Calls @ 2.50”. If the price of the stock takes a tumble, you may consider buying back the call at the cheaper discount price. For this transaction, you would select to “Buy to Close” button to execute the trade, which in essence closes out your option position and frees up your stock again. If the stock closes above 23 on expiration, the stock will be assigned and taken from your account at $23 per share regardless of how high it closed at on the expiration Friday. 

Long and Short Options

Unlike stocks, long and short options positions pertain to the type of options trade, not the direction of the underlying stock. When placing options orders, you must first determine if you are taking a long position, meaning holding the options contract, or a short position, meaning short-selling the options contract. Again, this doesn’t necessary apply to the direction of the underlying stock but the actual type of trade you are making with the option.

A long call position gains from a rise in the underlying stock price at which point the call can be sold to close the position for a profit. A short call position gains when the underlying stock price falls, at which point the call can be bought back at a cheaper price to cover the short and close the position at a profit.

A long put position gains from a drop in the underlying stock price, at which point the put can be sold for a higher price for a profit to close the position. A short put positions gains from a rise in the underlying stock price, at which point it can be bought back cheaper to cover the position at a profit.

Buy and Sell to Open and Close

When you are buying a call option, you are in essentially buying to open a long position until you sell the option, which then closes out the position (sell to close). Keep in mind that when you are long an options position, you will suffer premium erosion from time decay the longer you hold the open position. Options sellers benefit from the time decay. The loss for the holder is a gain for the seller. Therefore, playing a directional long position on either a call or put option, requires a sharp price move in the shortest amount of time. For this reason, it is prudent to carefully time entries to keep holding times limited to avoid suffering too much time decay.

How Do Options Differ from Trading Stocks?

While options can be traded like stocks, they run the risk of complete investment loss. Options differ from stocks because they track the underlying stock price movement and offer the benefits of stock ownership at a fraction of the cost. However, the complete loss of the investment is the most likely scenario when playing the long positions on calls or puts. Most newbies will underestimate the premiums they are overpaying to take a long position and then hold the position too long as time decay chips away at the value. The most common method of profiting on options is to be a seller through covered calls. However, these should only be on stocks that you intend to hold longer-term, which allows you to collect “rent” for taking on event risk. Selling options that you don’t own a position is called a naked position. These are only for professionals, and require at least options level 3 clearances. Losses can theoretically be unlimited with the looming threat of assignment even before expiration is the underlying stock moves deep ITM.