Everything You Need To Know To Start Options Trading

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If you’ve been regularly trading and investing in Canadian stocks, you might be ready to try your hand at options. Make no mistake; options are not for the person who is a complete newbie here. But if you have some background, and subscribe to the adage of “nothing ventured, nothing gained,” step into to the world of options.

Here’s a roundup of the essentials of options trading. In this article, you’ll learn what options are, the types of options, option strategies, and how to get started in options trading.

First, a clarification. Options can be based on a vast array of ‘underlying’ instruments such as commodities, indices, currencies, ETFs, stocks, and more. This article, however, will focus on stock options.

What are options? 

Options are a kind of financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset (a stock, for example) at an agreed-upon price and date.

A call option gives its buyer the right to buy the stock at a specific price (the ‘strike’ price) within an agreed time frame (the expiry period of the option).

However, a put option gives its buyer the right to sell the stock at a specific price (the ‘strike’ price) within an agreed time frame (the expiry period of the option).

Buyers of options are known as holders, whereas sellers of options are known as writers.

These option mechanisms usually cost little money to buy (typically referred to as the ‘premium’), but they allow the investor to control the profits on the underlying stocks as if they actually owned those stocks.

A call option is said to be in-the-money if the stock’s current market price is higher than the option’s strike price. A put option is said to be in-the-money if the option’s strike price is higher than the stock’s current market price.

And how do options differ from stocks?

Stock options are different from stocks. That’s because they are contracts to buy or sell the underlying stock within a specific time frame.

Secondly, while stocks may remain with you for years, your option contract will terminate on its expiry date. For the same reason, the amount you paid for the option (the premium) could also vanish into thin air if the price did not move as expected by the time of the option’s expiry.

Options are amenable to many different strategies that singly or in combination, achieve profit from the price movement of a stock in any direction – up, down or sideways.

It is tricky to short a stock if you expect it to move down. Shorting requires a margin deposit, and many brokers do not allow shorting. On the other hand, you can easily ride the stock’s slide downwards by simply buying a put option.

Lastly, options can be used to hedge one’s risks from holding stocks.

Why trade options?

The number one reason for trading stock options is the efficiency of capital. An options trader can effectively take on the same position as a stock investor by purchasing calls at a much lower outlay, freeing up capital for other purposes. However, because of the leverage that options provide, the risk is much higher. So, the options trader must know his stuff.

Also valuable is the inbuilt ‘maximum-loss’ feature of options. In the above example, the stock price could fall sharply and cause a substantial loss to investors if they had a position in the stocks. But if they held a call option, their loss would be limited to the premium paid on the option.

As mentioned above, options are useful vehicles for hedging stocks. By buying a put option, investors can shield their stockholding from a sudden collapse in prices due to unforeseen factors.

Imagine, a gap down open in a stock due to overnight developments. A stop order will kick in at the open price, exposing the investor to most of the overnight loss. However, a put option would be unaffected by the overnight closure of the market and will save the investor from that huge loss.

Apart from hedging, many players use options as a handy means of generating recurring income.

Options – the long and short of it

We discussed above the two kinds of options contracts known as a call and a put. Well, you can either buy or sell both of them, depending on your view of the trajectory of the underlying stock.

Here’s a table to understand the permutations:

Options-tables.png

Holders of options (buyers) have a choice whether to exercise their rights. They are not obliged to buy or sell anything. Their maximum loss is only the amount of premium they have paid.

Writers of options (sellers) are obliged to buy or sell the underlying stock and may have to do so in the event the stock’s price exceeds the strike price. Their maximum loss can be more than the premium earned, and sometimes even be unlimited.

Taking an option premium apart

Note that an option premium (the price you pay to acquire the option) has two components of value. One is its intrinsic value, the other its time value.

Intrinsic value is the difference between the strike price and the stock’s current market price if the stock price is above the strike.

Time value is the balance amount. This value takes into account the volatility of the stock, the time to expiration, and interest rates, among other factors.

To illustrate this concept, let us take an option with a strike price of $100 and a current premium of $15. If the underlying stock is trading at @110, the intrinsic value of the option is (110-100) = $10.

The remainder (15-10) = $5 is the time value.

This time value (hence also the premium) declines nearer to expiry date. So to preserve the value of the option, it is better to go for longer expiration periods if circumstances permit.

Expiration periods can start at Days and go out as far as Years.

Daily and weekly options tend to be highly volatile and difficult to trade. These are best traded by experienced and highly skilled option traders. If you opt for longer time frames, you have better chances for your strategy to play out and end up with gains instead of a loss of the premium.

Call options – Example

The current price of Home Capital Group Inc. (Ticker symbol: HCG) is $26.47.

homecaptial-options.png

You are bullish on the prospects of the stock and expect its price to rally to $30.00 as it has broken out of a rectangle pattern, and oscillators have lined up very bullishly.

You can :

1. Buy 100 shares of HCG stock for $26.47 x 100 = $2647

OR

2. Buy 1 contract of its call options (November 15 Expiry/Strike Price $27.00) for only $0.86 x 100 = $86

In the second option, you conserve your cash flow yet have a good chance of achieving the substantially same profit. So you take the call option route.

Now let’s see what happens near November 15, the expiry day of the call option you purchased.

Let’s say you turned out to be a master technical analyst, and HCG performed exactly as you predicted by touching $30.

The call option will now trade at $3.00 because the stock price ($30) is higher than the strike price ($27) by that amount.

You can now sell your call option at the new price of $3.00 and cash in profits of (3.00-0.86)x100 = $214.

What would you have made had you bought the stock?

You would have gained (30-26.47)*100 = $353

So you made approximately 60% of the same gains without spending a load of dollars.

But here’s the kicker: What if, after you purchased the stock, but before the expiry date, the stock tanked to $20 due to some unforeseen event?

Your loss on the stockholding would be (26.47-20)*100 = $647.

However, on the call option, you can’t lose more than the premium you paid. So the maximum loss would be only $86.

Put options – Example

The current price of Barrick Gold Corporation (Ticker Symbol: ABX) is $22.440. Let’s say you own 100 shares of Barrick in your portfolio.

ABX-options.png

You are bearish on the prospects of the stock because technically, it is likely to fall out of a descending triangle, and the momentum oscillators have started declining. You expect Barrick to correct to $19.50 and want to protect yourself from this downside.

You can:

Sell your holding of 100 shares at $22.44, realizing $2,244

OR 

Buy 1 contract of its put options (November 15 Expiry/Strike Price $23.00) for $1.38 x 100 = $138

You guessed it – you bought the put option.

Let’s say you were right again (you might like to write a book on technical analysis!), and around November 15, Barrick slumped to $19.50.

The put option will now trade at $3.50 because its strike price ($23.00) is higher than the current market price of Barrick of $19.50.

You can now sell your put option at $3.50 and cash in the difference of (3.50-1.38)*100 = $212.

What if you had sold your stockholding?

You have saved losses amounting (22.44-19.50)*100 = $290.

However, the stock stayed in your portfolio, but your put option protected it from the downturn.

There’s always the chance that POTUS could let loose a tweet, and gold could be heading north again. Lucky you!

Other strategies

The two illustrations above were the simplest option contract examples of a long call and long put.

But it is perfectly legal to combine one or more options contracts and create a more customized option strategy.

There is no limit to the kind of strategies available on equity options, and these vary in complexity and their intended usage. Here is a list, though it is outside the scope of this article to discuss them. Please refer to the resources section for further knowledge.

  • Bear Call Spread (Credit Call Spread)

  • Bear Put Spread

  • Bear Spread Spread (Double Bear Spread, Combination Bear Spread)

  • Bull Call Spread (Debit Call Spread)

  • Bull Put Spread (Credit Put Spread)

  • Bull Spread Spread (Double Bull Spread, Combination Bull Spread)

  • Buying Call Options as Protection for Future Purchases

  • Buying Call Options Instead of Buying Stocks

  • Buying Put Options Instead of Short Selling Stocks

  • Cash-Backed Call (Cash-Secured Call)

  • Cash-Secured Put

  • Collar (Protective Collar)

  • Covered Call (Buy/Write)

  • Covered Put

  • Covered Ratio Spread (Covered Combination)

  • Covered Strangle

  • Long Call Butterfly

  • Long Call Calendar Spread (Call Horizontal)

  • Long Call Condor

  • Long Condor

  • Long Iron Butterfly

  • Long Put Butterfly

  • Long Put Calendar Spread (Put Horizontal)

  • Long Put Condor

  • Long Ratio Call Spread

  • Long Ratio Put Spread

  • Long Straddle

  • Long Strangle (Long Combination)

  • Naked Call (Uncovered Call, Short Call)

  • Naked Put (Uncovered Put, Short Put)

  • Protective Put (Married Put)

  • Repair Strategy

  • Short Call Butterfly

  • Short Call Calendar Spread (Short Call Time Spread)

  • Short Condor (Iron Condor)

  • Short Iron Butterfly

  • Short Put Butterfly

  • Short Put Calendar Spread (Short Put Time Spread)

  • Short Ratio Call Spread

  • Short Ratio Put Spread

  • Short Straddle

  • Synthetic Long Put

Options – Getting started

The first step to take in options trading is to get an education. By choosing to read this article, you’re well on your way already. But do also check out the helpful resources given at the end.

Next, find a suitable broker that is reasonable in commissions on option trades.

Paper trade before diving into the deep end.

Find your risk tolerance and fix the amount of capital you want to invest in options trading.

Trade with a plan.

Resources

The TMX Montreal Exchange has really useful resources on options.

  • Video library – educational videos

  • Trading simulator – try out any option strategy, risk-free. Set up an options trade and monitor how it evolves

  • Guides and Strategies

  • OptionsPlay – an all-in-one stock and options analysis suite that simplifies trading analysis and makes it more visual. A tool to help you come up with actionable ideas for trading and income strategies

  • Option webinars – held in collaboration with online trading firms, these sessions are open to both clients and non-clients of the respective brokers. Free.

Optiontradingpedia.com is also a useful and comprehensive site for education on options.

 

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