What Are Options? A Beginners’ Guide To Options Trading

Options are financial instruments that give a party the “right” but not the obligation to buy or sell an underlying financial asset at a predetermined price and date. This article will cover the key facts about options, how they function, the different types, and the respective usage of such options. Furthermore, we will explore how options trading works, its pros and cons, applicable strategies, the risks involved, and whether you should participate in it or not.

Key Facts Options Trading

• Origin: The modern options market began to develop with the establishment of the Chicago Board Options Exchange in 1973, providing a standardized and regulated trading environment.
• Development: In the same year, 1973, Fischer Black and Myron Scholes introduced the “Black-Scholes” model, which provided a framework for valuing options, particularly European.
• Underlying Asset: As a derivative, options can be based on various financial assets, including stocks, indexes, commodities, and currencies.
• Use Case: One of the primary purposes of options is to act as a risk management (hedging) tool against unfavorable market movements to protect a party from a potential massive loss.
• Trading Opportunities: Options are also used to speculate on future market movements and trends due to domestic or global macroeconomic situations.

How does Options Trading work?

Options trading involves the buying and selling of option contracts on a public market. The value of these options is derived from their underlying asset, which is why they are classified as financial derivatives. Therefore, it’s essential to remember that you’re not directly trading the underlying asset (such as a specific stock) in options trading. Instead, you’re merely trading the privilege to buy or sell that asset at a specified price and date.

With this said, here are the two main types of options contracts: call options and put options.

Call Options 

A call option gives the holder the right to buy an asset at a specific price within a predetermined period of time. Hence, investors or traders buy call options if they are bullish that the price of the underlying asset (such as a stock or commodity) will go up in the foreseeable future.

Put Options 

On the other hand, a “put” option grants the holder the right to sell an asset at a specific price within a predetermined period of time. Therefore, investors or traders purchase put options if they are bearish and anticipate the value of an underlying asset will go down.

Pros and Cons of Options Trading

Pros	Cons
✅ Cost-Efficient	❌ Sensitive to Volatility
✅ High Liquidity	❌ Potential for Total Loss
✅ Risk Management Tool	❌ Complexity
✅ Diversification	❌ Dependent on Accurate Forecast
✅ Flexible Nature	❌ Opportunity Cost

Pros

1. Cost-Efficient: Options need less capital than buying the underlying asset outright, making it easier for retail investors to gain exposure to relatively pricey assets.
2. High Liquidity: The options market is highly liquid, particularly on popular financial instruments (such as stocks and indices). Hence, entering and exiting positions is relatively easier than other asset types.
3. Risk Management Tool: Options can be a hedging tool to protect you from a substantial downside from your other investments (if they are inversely correlated), helping you better manage your risks.
4. Diversification: Due to its cost efficiency, options allow you to gain exposure to a wide range of asset classes and markets, enhancing your overall portfolio diversification and reducing correlation risks.
5. Flexible Nature: Options trading is highly versatile in terms of trading strategies and the markets and assets you can trade. Besides hedging, you can trade options to capitalize on a forecasted market movement or trend.

Cons

1. Sensitive to Volatility: Options prices are susceptible to changes in the underlying asset’s volatility. Dramatic and sudden shifts in volatility can negatively affect the value of your options.
2. Potential for Total Loss: Despite requiring less capital than buying the underlying asset, if the market does not move in your anticipated direction, the option can expire worthless, leading to the complete loss of your entire position.
3. Complexity: Options trading is relatively more complex than trading other financial instruments. This complexity results in a higher barrier to entry for beginners who want to learn and consistently profit from options trading.
4. Dependent on Accurate Forecast: Profitable options trading requires a higher “hit rate,” which is the number of your winning trades compared to your losing ones. Therefore, although difficult, accurately forecasting the market movement is crucial.
5. Opportunity Cost: If you have limited capital, pouring it into options trading may be a wasted opportunity to invest in more productive and less complex asset types. This is especially true if you are a total beginner in trading.

How does Options Trading Work?

A. The Most Important Terms

1. Leverage – In options trading, you can hold a large amount of the underlying asset with a relatively small investment (the premium you paid for the option). This allows for a potentially higher return on investment (ROI) but also increases your risk of substantial or total losses.

2. Holder / Writer – The investors with options are referred to as “Holders.” On the other hand, the party that created the options and has an obligation to buy (in the case of a put option) or sell (in the case of a call option) if the Holder exercises his/her options are called “Writers.”

3. Strike Price – the predetermined price at which an option holder can buy (call option) or sell (put option) the underlying asset if they decide to exercise their right to the option.

4. Expiry Date – the date and time when an options contract becomes void. Hence, after this date, the option holder no longer has the right to buy or sell the underlying asset at the strike price, and the option loses all its value.

5. In the Money (ITM) – A situation in which if you exercise your option, you will make a net profit. For call options, this means the underlying asset’s price is above the strike price. For put options, the underlying asset’s price is below the strike price.

6. Out of the Money (OTM) – This happens when exercising the option will not result in a profit and, therefore, expires worthless. For call options, this means the underlying asset’s price is below the strike price. For put options, the underlying asset’s price is above the strike price.

7. At the Money (ATM) – A situation where the market price is equivalent to the option’s strike price. Essentially, ATM options are on the threshold between ITM and OTM and are sensitive to any change in the underlying asset’s price.

B. Broker Selection

When it comes to options brokers, it’s crucial to find a reputable broker to start trading options. With this said, we recommend Freedom24 as it is one of the most highly acclaimed and reputable brokers facilitating options trading. It offers professional and advanced options trading tools and analytics on more than 800,000 available stock options on its 2,500 supported US assets with a $0 order commission fee. 

To learn more, you can visit https://lp.freedom24.com/en/us-options. Also, for the complete step-by-step process of trading options in Freedom24’s platform (both web & mobile app), you can visit: https://www.freedom24.com/faq/13574-how-to-trade-options.

C. What determines the price of an Option? 

The price of an option, which is more commonly referred to as the “premium,” is influenced by several key factors, including:

1. Underlying Asset Price

The current price of the option’s underlying asset (such as a stock) directly influences the option’s premium. If all factors remain unchanged besides the asset’s price, the following can be observed:

• Asset Price Increases = Premium tends to go up for call options and go down for put options
• Asset Price Decreases = Premium tends to go up for put options and go down for call options

This is because the intrinsic value of the options increases as the difference between the underlying asset’s market price and the strike price becomes more significant, making call options more valuable when the asset price rises and put options more valuable when the asset price falls.

2.  Strike Price

All things held equal, options with strike prices that are “favorable” relative to the current market price of the underlying asset are more expensive. 

• Favorable Strike Price (Call Option ITM) = Market Price (MP) exceeds Strike Price (SP)
• Favorable Strike Price (Put Option ITM) = Strike Price (SP) exceeds Market Price (MP)

An option with an ITM strike price holds a higher premium because it has intrinsic value (when MP is higher than SP for call options and SP is higher than MP for put options).

3.  Time to Expiration

The time remaining until the option’s expiry date also impacts the premium. Overall, the following can be observed:

• Longer Time Until Expiration = The Premium is Higher
• Shorter Time Until Expiration = The Premium is Lower

This is because the longer the time horizon, the more opportunities for the underlying asset’s price to move in a favorable direction. Conversely, as the expiration date approaches, the time value decreases due to the diminishing probability of a significant price move — a phenomenon known as “time decay.”

4.  Volatility

Volatility measures the degree to which the underlying asset’s price is anticipated to fluctuate over time. Overall, the following can be observed:

• Higher Volatility = Premium tends to go up
• Lower Volatility = Premium tends to go down

This is because the higher the volatility, the higher the chance that the option will move ITM before expiration.

5.  Market Demand and Supply

Lastly, market demand also influences an option’s price. This factor is perhaps the most intuitive to understand. Essentially, a higher market demand for an option increases its premium while the opposite lowers it. Nevertheless, the overall demand can be influenced by external elements such as the overall market sentiment and other macroeconomic events, both local and international.

D. Options Trading Process

After choosing an options trading broker, the following are the steps you may consider taking in the options trading process:

Step 1: Market Selection

First, you need to choose the underlying asset and market where you will trade options. Remember that this primarily depends on the broker you choose. Nevertheless, here are the primary assets and markets you can trade:

• For Stock Options – Options traded on exchanges such as the Chicago Board Options Exchange (CBOE) or their international equivalents. They offer you the ability to bet on individual stocks.
• For Index Options – Options on market indices, like the S&P 500 or NASDAQ 100, can be traded on exchanges such as the NYSE and NASDAQ. These options allow you to speculate on or hedge against prevailing market movements.
• For Commodity Options – Options traded on commodity exchanges such as the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX), where gold and oil are among the top underlying assets.
• For Forex Options – Options on major currency pairs in the Forex market, including five of the most traded pairs: EUR/USD, USD/JPY, GBP/USD, USD/CHF, and AUD/USD.

Step 2: Buying Options (Multiple Examples)

After selecting your preferred market and underlying assets, you can now begin to buy options. Here are some buying scenarios to help you:

Scenario 1: Speculative Trade on a Stock

Suppose you believe ABC stock, currently trading at $100, will decline. You can buy a put option with a strike price of $95 for a premium of $2. Then, you can exercise the option profitably if the stock falls below $95. However, the put option will be out of the money (OTM) if the stock’s price is above $95 at the expiry date.

Scenario 2: Hedging on existing investment

Suppose you already own shares of DEF stock; you can buy put options as insurance against a substantial drop in the stock’s price. This limits your potential losses without requiring you to sell your DEF shares.

Scenario 3: Industry Forecast

Suppose you anticipate a downturn in the tech industry in the US. You can buy put options on a major tech index (such as NASDAQ). If the sector indeed drops, your index options will increase in value.

Step 3: Opening a Trade

After considering your preferred buying scenario, you can formally open a live options trade. Here are some aspects you may want to consider:

1. Market Analysis: Assess the market and the underlying asset to determine whether you will take a bullish or bearish stance.
2. Selection: Depending on your analysis and strategy, choose the suitable option type (call or put), strike price, and expiration date.
3. Order Placement: Decide your specific order type (such as a market or a limit order) and specify your number of option contracts.
4. Execution: Lastly, your trade will be executed once a matching order becomes available. Afterward, you now have the rights granted by your purchased option contract.

Step 4: Managing Positions

Managing your options positions involves monitoring the overall market movement, evaluating the performance of your open positions, and making adjustments as needed.

Here are some specific ways to manage your positions:

1. Rolling Over – This involves closing your existing position and opening a new one with a different expiration date or strike price to manage risk or secure profits.
2. Putting Limits – You can set a maximum number of options you will hold at any given time to avoid overtrading and ensure you can effectively monitor your trades.
3. Risk Management – You can establish hard rules for when to take profits or cut losses, as well as limit your exposure to a given asset or market.

Step 5: Closing Options Positions

Lastly, here are several ways to close your specific options position depending on your trade objective and strategy. 

Method 1: Selling the Option – As a holder, you can sell some or all of your options to another party in the open market to secure profit when the option gains value from the favorable movements in the underlying asset’s price.

Method 2: Exercise the Option – Alternatively, as a holder, you can buy the underlying asset at the strike price (in a call option) or sell it at the strike price (in a put option). This approach is typically exercised when the option is in the money (ITM) and close to expiration.

Method 3: Wait for Expiration – Lastly, if the option is out of the money and nearing its expiration date, you may just leave it to expire worthless, resulting in losing the premium you paid for that specific option.

Strategies for Options Trading 

Here are five of the most prominent strategies in options trading, together with an example to illustrate how they work:

1. Long Call

This strategy takes advantage of an underlying asset’s bullish sentiment without the full cost of buying the asset outright. One way to do this is by buying call options with a strike price close to or slightly above the current asset’s price. The trade will be profitable if the asset price increases above the strike price plus the premium you paid.

Example: ABC stock is trading at $150. You purchase a call option with a strike price of $160 for a premium of $5, expiring in two months. If ABC stock climbs to $170, your option will be worth at least $10 (excluding time value), netting you a profit if you exercise or sell the option.

Risk: If ABC stock remains below $160, the option expires worthless, and you lose the $5 premium you paid.

2. Long Put

A long put strategy tries to capitalize on an asset’s bearish sentiment and profit from a decline in its price. One way to do this is by buying put options with a strike price close to or slightly lower than the current asset price. The trade will be profitable if the asset’s price falls below the strike price minus the premium paid.

Example: Assume ABC stock is at $500. Anticipating a drop, you purchase a put option with a strike price of $490 for a $10 premium, expiring in three months. If ABC stock falls to $470, your put is worth at least $20 minus the premium paid.

Risk: If ABC stock remains above $490, the option expires, and you lose the $10 premium you put in.

3. Covered Call

A covered call strategy aims to generate income on your current asset or investment holdings with a neutral to slightly bullish outlook. You can employ this strategy by owning the underlying asset and selling call options against that asset. Hence, if the asset price remains lower than the strike price, you keep the premium as income. 

Example: Assume you have 100 outstanding shares of GHI stock purchased at $600 each. GHI is now worth $650/share. You sell a call option with a strike price of $700 for a $50 premium. If GHI stays below $700, you keep the premium. If it exceeds $700, your shares may be “called away” (where you are forced to sell them to the option holder). Regardless, you benefit from the appreciation plus the premium.

Risk: You will miss out on potential profits if GHI rallies above $700.

4. Protective Put

As the name suggests, this strategy’s primary objective is to protect you against a significant drop in an asset you already own (particularly those you have substantial holdings). This is done by buying put options on the underlying asset as insurance. Thus, if the asset price falls significantly, the put option increases in value, offsetting some of your asset’s losses.

Example: You currently own 1000 shares of UVW at $1,000 each. To hedge against a drop, you buy a put option with a strike price of $900 for a $100 premium. If UVW drops to $800, the put technically offsets the loss on your UVW investments.

Risk: The $100 premium reduces your overall return if UVW does not fall.

5. Iron Condor

Lastly, Iron Condor tries to capitalize on an asset’s sideways or consolidation phase. This strategy profits from assets trading within a distinct range. One way to do this is by selling an OTM call and an OTM put while simultaneously buying a further OTM call and a further OTM put. The objective is for the asset to stay within the range of the options sold, allowing the trader to keep the premium received.

Example: XYZ stock is at $50. If you believe it will stay near this price range, you can sell a call option at $55 and a put option at $45, both for $2 each and buy a call at $60 and a put at $40 for $1 each. If XYZ stock stays between $45 and $55, you keep the $2 net premium.

Risk: If XYZ moves outside the $45-$55 range, you will incur losses (limited by the amount of your bought options).

What are the “Option Greeks,” and how do they affect trading?

The “Options Greeks” are mathematical criteria expressing an option’s price sensitivity to various market factors. As a trading tool, traders use these to assess risk and manage their options portfolios more effectively and objectively. Here’s an overview of the five options greeks and their impact on options trading:

1. Delta (Δ)

First, Delta measures the rate of change in an option’s price for a $1 change in the underlying asset’s price. The Delta is between 0 and 1 for call options, while put options are between -1 and 0.

Impact on Trading: Delta helps traders understand and project how much the price of an option may move relative to the underlying asset’s movement. A high delta suggests the option price will move substantially with the asset price, making it crucial for high-conviction option trades.

2. Gamma (Γ)

Second, Gamma estimates the rate of change in delta for a $1 change in the underlying asset’s price. It displays how stable an option’s delta is; higher gamma values mean it could change more rapidly.

Impact on Trading: Gamma is essential for gauging the stability of an option’s delta. High gamma options can expect quick price changes, making them riskier but potentially more profitable.

3. Theta (Θ)

Third, Theta measures the rate of change in an option’s price over time, supposing all other variables stay constant. Theta is also often called the “time decay” of an option.

Impact on Trading: Theta is crucial for options strategies over time. As we have explored, options lose value as expiration nears — which you need to account for — particularly in trading strategies where time decay can be employed as an advantage.

4. Vega (V)

Fourth, Vega calculates the rate of change in an option’s price for every 1% change in the underlying asset’s implied volatility. Technically, it’s not a Greek letter but included with the Greeks, mainly for convenience.

Impact on Trading: Vega is essential for evaluating how sensitive an option is to changes in market volatility. Broadly speaking, options with high vega are more sensitive to changes in volatility, significantly affecting their pricing, particularly in volatile markets.

5. Rho (ρ)

Lastly, Rho measures the rate of change in an option’s price for every 1% change in interest rates. Rho is more relevant for long-term options since interest rates have a more noticeable effect over extended periods.

Impact on Trading: Compared to the other Greeks, Rho is less commonly used. Nevertheless, it’s valuable for long-dated options or in market environments with significant interest rate changes (such as during and after the COVID-19 pandemic). 

Key Risks of Options Trading

1. Market Risk – Market movements directly influence options. An incorrect outlook on the market direction can lead to partial and total losses. 

2. Volatility Risk – Options prices are susceptible to volatility in the underlying asset they are derived from. A higher volatility indicates a higher inherent risk.

3. Time Decay (Theta) – All options are subject to time decay. Therefore, their value diminishes as the expiration date approaches.

4. Leverage Risk – a relatively small options position can hold a significant amount of the underlying asset. While this can boost profits, it can also magnify losses.

5. Interest Rate Risk – Interest rate changes can affect options’ overall valuation. This can be particularly detrimental to long-term strategies where “Rho” becomes influential.

Leverage in Options Trading

Leverage in options trading refers to holding a larger amount of the underlying asset with a relatively small investment. The cost to buy an option is a fraction of the cost of owning the underlying asset outright. This characteristic is, in fact, one of the most attractive aspects of options trading, as it allows traders to amplify their potential returns. Nevertheless, it also augments the risk of significant losses, making it a double-edged sword.

As an example, suppose you are looking to buy a stock trading at $100 per share, buying 100 shares would need an initial investment of $10,000. On the contrary, a call option giving the right to purchase those shares at $100 each may only cost $5 per share or $500 for a contract covering 100 shares. 

Thus, in this scenario, with just a $500 investment, you can hold $10,000 worth of stock, illustrating a leverage factor of 20:1. However, if you are not careful, you can also quickly lose a substantial portion, if not all, of your $500 initial investment.

Different Types of Options

1. European Options – options contracts that can only be exercised at the expiration date, not before. This constraint for holders makes it relatively less expensive than American Options.

2. American Options – options contracts that can be exercised at any time up to the expiration date. This flexibility gives the holders relatively higher priced options compared to European.

3. Vanilla Options – the most basic and traditional form of options, including straightforward call and put options with standard features. This option is widely used in speculative trading.

4. Digital Options – also called as “binary options,” have a predetermined payout rate and expiry date. In this option type, the trade outcome is binary: you get the entire payout or nothing at all. 

5. Barrier Options –  considered “exotic” options whose existence relies on the underlying asset’s price reaching a certain price level (the barrier) during the option’s life.

Using Options Trading for Hedging 

As we have explored earlier, one of the primary use cases of options is for hedging. Hedging involves taking an “offsetting” position in a derivative (in this case, options) to counteract any potential losses in the underlying asset. However, note that, unlike other strategies, the goal of hedging isn’t necessarily to profit but to protect your primary investments (commonly stocks and indices) against substantial losses due to unfavorable market movements. 

How is Options Trading Regulated?

Options trading is regulated by financial authorities and regulatory bodies to ensure fair practices, protect investors, and promote orderly markets. Commonly, the principles of oversight and enforcement share familiar themes globally, but the specific regulatory framework can vary significantly by country. 

In the US, the agencies with oversight and regulatory responsibilities include the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), and the Commodity Futures Trading Commission (CFTC). Additionally, the Options Clearing Corporation (OCC) acts as a central clearinghouse for options trades in the country.

Why do we not offer options trading coaching at Witzel Trading?

Lastly, although options trading offers noteworthy benefits compared to buying its underlying asset outright, we do not offer options trading coaching at Witzel Trading. We believe Contracts for Difference (CFDs) and Futures have inherent benefits over options that make them more practical and intuitive financial derivatives, especially for beginners. Here are some key benefits of CFDs and Futures compared to options:

Benefits of CFDs over Options:

• No Expiration Date – compared to options with a limited lifespan ending at expiration, CFDs do not expire. 
• Direct Reflection of Price – CFD prices directly mirror the underlying asset’s market prices, making it more straightforward.
• No Premiums – Trading CFDs does not involve paying premiums. Instead, costs are typically limited to the spread and commission, if any.

Benefits of Futures over Options:

• Standardization – Futures contracts are standardized regarding contract sizes and expiration dates, enabling a simpler trading environment. 
• Hedging Efficiency – more straightforward since it directly reflects the underlying asset’s price direction without requiring complex calculation of the option’s time value and volatility.
• No Time Decay – Unlike options, the value of futures contracts does not decay with time. Instead, it is primarily affected by the underlying asset’s price movements.

Conclusion: Options offer multiple trading approaches

Overall, options are a great way to diversify and hedge your existing position for a more optimized investment portfolio. As a trading instrument, options offer attractive payouts, especially for experienced and advanced traders who can fully leverage their unique characteristics. Nevertheless, it also requires a relatively higher degree of financial market understanding than other assets. Additionally, it’s worth considering whether other derivatives, such as CFDs and Futures, might better align with your trading objectives and profile. Thus, doing your due diligence is essential before diving into options trading.

Frequently asked questions on Options Trading: