Options trading

What Is Options Trading?

What is options trading?

Options trading gives the buyer of the option the right but not the obligation to buy or sell an underlying security at a specific price at (or up to) a specific expiration date.

The underlying security can be any type of financial asset. In options trading the specific price mentioned above is referred to as the strike price.

There are two styles of options. American and European.

There are a few key differences between American and European style options:

  • A European style option can only be exercised at the expiration date of the option
  • An American style option can be exercised at any time before the expiration date

The term exercised means that the option buyer chooses to buy or sell the underlying security that the option relates to.

There are two types of options. Call options and put options.

Someone who purchases an option is known as an option buyer. The opposing party in the transaction is known as the option writer. The option writer is sometimes referred to as the option seller.

What is a call option?

A call option gives the buyer the option to buy an underlying security at a specific price.

The call option buyer purchases a call option when they expect the price of the underlying security to rise.

The call option seller writes a call option when they expect the price of the underlying security to stay at or below a specific price.

Example.

I expect the price of XYZ stock to increase from £10 over the next 3 months. I could therefore buy a call option in XYZ stock with a strike price of £10 and an expiration date 3 months in the future (December). This call option would be referred to as an “XYZ Dec 10 call”.

The call option may cost me £50 for the right to purchase 100 shares of XYZ stock at £10. The call options seller receives the £50.

If the price of XYZ stock increases to £12 by the expiration date then I could exercise the option. This means that I can purchase XYZ stock from the call option seller at £10, even though the price has risen to £12. An alternative would be to sell the call option and receive approximately £200.

If the price of XYZ stock does not increase above £10 by the expiration date then I would not exercise the option. I would have lost the £50 cost of purchasing the call option.

What is a put option?

A put option gives the buyer the option to sell an underlying security as a specific price.

The put option buyer purchases a put option when they expect the price of the underlying security to fall.

The put option seller writes a put option when they expect the price of the underlying security to stay at or above a specific price.

Example.

I expect the price of XYZ stock to decrease from £10 over the next 3 months. I could therefore by a put option in XYZ stock with a strike price of £10 and an expiration date 3 months in the future (December). This put option would be referred to as an “XYZ Dec 10 put”.

The put option may cost me £50 for the right to sell 100 shares of XYZ stock at £10. The put option seller receives the £50.

if the price of XYZ stock decreases to £8 by the expiration date then I could exercise the option. This means that I can sell XYZ stock to the put option seller for £10, even though the price has fallen to £8. An alternative would be to sell the put option and receive approximately £200.

If the price of XYZ does not fall below £10 by the expiration date then I would not exercise the option. I would have lost the £50 cost of purchasing the put option.

Call options vs put options

An options trader has to decide what the best approach is to trading a specific scenario.

Generally, if you expect price to rise then you would buy a call option. If you expect price to fall you would buy a put option. This approach gives the highest profit potential but with a fixed maximum loss. The maximum loss relates to the purchase cost of the option.

An alternative is to be the option writer. If you expect price to rise you could write a put option. If you expect price to fall you could write a call option. This gives a higher potential loss with a fixed maximum profit. The maximum profit profit relates to the price received for the option.

What is options writing?

We have already discussed option writing briefly but what does it actually mean to write an option?

Like any other financial transaction there must be two sides to an options trade. The option writer is effectively offering a contract to others to buy.

When an option writer thinks a price will be flat or fall they may decide to write a call option. This process is known as call writing. An option buyer that thinks the price will rise could then purchase this call option for a price.

When an option writer thinks a price will be flat or rise they may decide to write a put option. This process is known as put writing. An option buyer that thinks the price will fall could then purchase this put option for a price.

What are naked options?

A naked options position occurs when a trader writes an options contract without also owning the underlying asset. A naked options position can occur with put options and call options.

A trader writing a put option is defined as holding a naked put option when they do not own an equivalent short position in the underlying asset. If the put option is exercised then the naked put option writer would be forced to purchase the asset at a significant loss. The theoretical maximum loss for naked put options is equal to the strike price of the put option.

A trader writing a call option is defined as holding a naked call option when they do not own an equivalent long position in the underlying asset. If the call option is exercised then the naked call option writer would be forced to sell the asset at a significant loss. The theoretical maximum loss for naked call options is unlimited as the price could rise far beyond the strike price.

Naked options are also referred to as uncovered positions.

Why do traders open naked option positions?

Trading naked options is highly speculative as your losses are theoretically unlimited. They must be traded using very controlled risk management and position sizing strategies.

We will address naked options on our options trading strategies page.

What are covered options?

A covered options position is the opposite of naked options position. A trader owning a covered options position also owns the underlying asset.

A trader writing a put option is defined as holding a covered put option when they also own an equivalent short position in the underlying asset. If the put option is exercised then the covered put option writer would purchase the asset at a loss. They would also have made a similar profit from their short position in the underlying asset.

A trader writing a call option is defined as holding a covered call option when they also own an equivalent long position in the underlying asset. If the call option is exercised then the covered call option writer would sell the asset at a loss. They would also have made a similar profit from their long position in the underlying asset.

Why do traders open covered option positions?

A traders may choose to create a covered option position if they do not expect much movement in the price of an asset that they already own (long or short). The theory is that while the price is static they can still earn income from the premiums received by writing an option. Their risk is limited as they also own the underlying asset. The disadvantage of covered options positions is that if the price breaks then their profit will be capped.

We will address covered options on our options trading strategies page.

Types of options

The majority of high volume financial assets have equivalent options contracts.

  • Option contracts that are traded on futures exchanges are usually American style options
  • Option contracts that are traded over the counter are mainly European style options
  • The majority of stock and equity options are American style options
  • The majority of index options are European style options
  • Option contracts that relate to commodities can be either American or European style options

Stock options allow traders to profit from movements in the price of stocks and shares. If a stock option is exercised then the underlying shares are bought or sold.

Futures options allow traders to profit from movements in the price of futures contracts. If a futures option is exercised then the underlying futures contract is bought or sold.

Index options allow traders to profit from movements in the price of an index. If an index option exercised then a cash equivalent is exchanged between the option writer and option buyer.

Binary options trading is a modern concept and is not a true form of options trading. When a binary option expires it is not possible to take ownership of the underlying asset. The maximum payout and loss is also limited for binary option transactions. For these reasons we treat binary options trading as a form of gambling and do not recommend it.