Understanding what options are, how options are used, and why options may be appealing in a successful trading strategy never used to be easy to understand for me (and I don’t think for many others for that matter). After doing a course in financial mathematics a couple of years ago, I could calculate the value of options, their likely cost price and I’m sure I understood their relationship with interest rates and other market factors.

That said, as I was not regularly trading options and thus not crystallising my knowledge of them, my knowledge slipped over time until I recently read “Finance – The Options Course – High Profit And Low Stress Trading Methods” by George Fontanills and The Bible of Options Strategies – The Definitive Guide for Practical Trading Strategies by Guy Cohen. I have sourced much of the below information from these books.


Understanding options

My reading uncovered that options are probably the most versatile trading instrument ever invented. They provide a high-leverage approach to trading that can significantly limit the overall risk of a trade, especially when combined with trading stock (shares) or trading futures. In essence, understanding how to best use options can obviously be very beneficial.

The key is to develop an appreciation about how these investment vehicles work, what risks are involved, and the vast reward potential that is available through well-conceived and proven trading strategies.

Options and Option rights (and futures)

First, it is important to differentiate between futures and options. A futures contract is a legally binding agreement that gives the holder the obligation to actually buy (and take delivery of) or sell (be obligated to deliver) a commodity or financial instrument at a specific price. Common futures contracts are made over commodities like Oil and a variety of different produce.

In contrast, purchasing an option is the right, but not the obligation, to buy or sell a financial instrument (stock, index, futures contract, etc.) at a specific price. The key here is that buying an option is not a legally binding contract. In contrast, selling (writing or shorting) an option obligates the seller to provide (or buy) the instrument at the agreed-upon price if asked to do so.

Option buyers have rights and option sellers have obligations. Option buyers have the right, but not the obligation, to buy or sell a stock, index, or futures contract at a predetermined price before a predefined expiration date. In contrast, option sellers, sometimes called writers, have the obligation to buy or sell the underlying stock shares (or futures contract) if an assigned option buyer or holder exercises the option.

The key here is that in buying an option you have a limited risk potential equal to the price you paid for the option. Whereas, when selling an option you’re risk is theoretically unlimited if the price of the instrument the option relates to moves in the ‘wrong’ direction for you and the buyer of the options exercises his right.

Types of Options

There are two types of options contracts; puts and calls. Click to open some examples of options in a new window.

A put option is an options contract that gives the owner the right to sell (or put) the underlying asset at a specific price for a predetermined period of time. A call option gives the option holder the right, but not the obligation, to buy a stock at a predetermined price for a specific period of time.

It must also be remembered that you can both buy and sell both option puts and option calls leaving you with 4 fundamental options trading positions that will be anlaysed in detail in a later blog on option risk profiles. These are known as:

1. long put (buying a put option)
2. short put (selling a put option)
3. long call (buying a call option)
4. short call (selling a call option)

Option strike price

In addition to understanding the underlying asset, traders must also understand the trading terms used to describe an options contract. For example, every option has a strike price, which is the price at which the stock or future can be bought or sold until the option’s expiration date. Options are available in several strike prices depending on the current price of the underlying asset and have varying costs based on the strike price.

As a result, the profitability of an option depends primarily on the rise or fall in the price of the underlying stock or futures contract in relation the strike price of the option. Determining an option’s premium also depends on the time left until expiration, volatility, and other factors which will be discussed in a later options blog.

I found the following summary very useful in understanding options. There will also be many more blogs coming on options and if you wish to stay in touch, please subscribe to my RSS feed below.


12 guidelines to understanding options

1. Options give you the right to buy or sell an underlying instrument at a specific price.

2. If you buy an option, you are not obligated to buy the underlying instrument; you simply have the right to exercise the option.

3. If you sell a call option, you are obligated to deliver the underlying asset at the price at which the call option was sold if the buyer exercises his or her right to take delivery. If you sell a put you must buy the underlying if exercised.

4. Options are good for a specified period of time after which they expire and the holder loses the right to buy or sell the underlying instrument at the specified price.

5. Buying options is completed at a debit to the buyer. That is, the money is debited from the brokerage account.

6. Selling options is completed at a credit to the seller. Money is added to the brokerage account.

7. Options are available in several strike prices at or near the price of the underlying instrument.

8. The cost of an option is referred to as the option premium. The price reflects a variety of factors including the option’s volatility, time left until expiration, and the price of the underlying asset.

9. There are two kinds of options: calls and puts. Calls give you the right to buy the underlying asset and puts give you the right to sell the underlying asset.

10. All the put or call options with the same underlying security are called a class of options. For example, all the calls for IBM constitute an option class.

11. All put and call options that are in one class and have the same strike price and expiration are called an option series.

12. Options are available on a variety of different underlying assets including stocks, futures, and indexes.