Options Overview
Navigating the Seas of Option Contract Trading
Diving into the vast landscape of option contract trading can initially seem like trying to navigate an ocean without a compass. However, setting clear goals can be your North Star, making the process much more manageable and less daunting.
Charting Your Course
The first step in your journey through the labyrinth of option trading is to clearly define your goals. Option contracts can be a versatile tool, serving different purposes across various portfolio types. By articulating your aims, you can easily select the most appropriate strategies tailored to your needs. The most effective route will depend on your personal trading objectives.
Plotting Your Path
With your trading goals in sight, the next step is to explore the universe of option strategies that can propel you towards your target. For instance, if your mission is to enhance the returns from your real estate investment trusts (REITs), you might consider employing strategies such as selling put options. If, on the other hand, your objective is to hedge your tech stocks against a potential market bubble burst, acquiring put options on an index that mirrors the tech sector could be a smart move.
More Than Just a Broker
When you're equipped and ready to embark on your option trading journey, the selection of an apt brokerage firm is crucial. Such firms not only process trade orders but can also provide strategic advice. Some firms work closely with clients to weave option contract trading into their unique financial plans. They offer insights about potential goals, strategies, and help clients weigh the risks and rewards of different transactions. Alternatively, some firms might not offer personalized advisory services but compensate with lower transaction fees. Regardless of whether you're a rookie or a seasoned trader, discussing your plans with your broker before initiating or terminating a position can be beneficial.
Do You Make the Cut?
Your chosen brokerage firm will evaluate your profile and grant you a specific level of option contract trading approval. Given the significant risks attached to certain strategies, not all investors are granted the green light to trade every type of strategy. This policy shields brokerage firms from potential defaults on margin accounts due to inexperienced or underfunded investors. It also helps prevent investors from straying beyond their financial capacity or trading expertise. While the approval tiers and prerequisites differ among firms, most offer four or five tiers. Your trading experience and the liquid assets at your disposal play a significant role in determining your approval level. Firms may also require you to confirm your awareness of the potential risks associated with option contract trading.
Checking off the Administrative Boxes
Launching your trading requires a few additional steps. You'll be required to complete an option contract agreement form, enabling investment firms to assess your knowledge of options, trading strategies, and your investment experience. Reviewing the document "Characteristics and Risks of Standardized Option Contracts" is also advisable to understand the basics of option contract trading. This document, which firms must provide to all potential option contract investors, includes in-depth examples of the risks linked to specific contracts and strategies.
Watch Your Account Balance
Unlike commodities, option contracts cannot be purchased on margin. However, most firms mandate that specific option contract transactions, like writing naked calls, must be conducted in a margin account. This means you need to maintain a robust balance in your account to cover the cost of buying the underlying equities, should the option contract be exercised.
If the asset value in your margin account falls below the minimum maintenance level, your brokerage firm may issue a margin call - an alert that you need to infuse more capital to meet the minimum requirements. If you fail to respond appropriately, the firm reserves the right to liquidate assets in your account without prior consent.
Demystifying Option Contracts
An option contract is a binding agreement that provides the right to buy or sell a specific financial commodity, known as the underlying asset. For equity options, the underlying asset is typically a stock, an Exchange-Traded Fund (ETF), or a similar product. The agreement is explicit, setting a specified price, referred to as the strike price, at which the contract can be exercised. Each contract also carries an expiration date, after this date it no longer holds value.
Option contracts are split into two categories: calls and puts. Both can be either bought or sold, depending on your objectives as an investor.
Trading Option Contracts
When you purchase a call, you're buying the right to purchase the underlying asset at the strike price on or before the expiration date. Purchasing a put, on the other hand, gives you the right to sell the underlying asset on or before the expiration date. In both scenarios, the holder of the option contract can sell the option to another buyer during its term or let it expire without any value.
The dynamics are slightly different if you write or sell an option contract to open a position. Selling an option obligates the writer to deliver the underlying asset should it be exercised.
Selling a call as an opening transaction obligates you to sell the underlying asset at the strike price if assigned. Similarly, selling a put as an opening transaction requires you to buy the underlying asset if assigned.
Similar to how a buyer can sell an option back into the market instead of exercising it, a writer can buy or cover an offsetting contract to end their obligation to meet the terms of a contract, as long as they have not been assigned. This is done by executing a buy to close transaction.
Option Pricing
The purchase price of an option contract is referred to as the premium. The buyer pays the premium, and the seller/writer collects the premium. The bid/ask spread constantly fluctuates as buyers and sellers negotiate price.
If you're buying options, you start with a net debit, meaning you've expended money that may not be recoverable unless you sell your option at a profit or exercise it. If you manage to make a profit on a transaction, the cost of the premium must be subtracted from any income to calculate the net profit.
Selling option contracts opens a net credit for you as you collect the premium. If the option is never exercised, the money is yours to keep. If the option is exercised, the premium is still yours, but you are obligated to buy or sell the underlying asset if assigned.
Evaluating Option Contracts
The value of a specific option contract to a buyer or seller is gauged by its potential to meet their expectations. This is determined by whether the option is, or is expected to be, in-the-money or out-of-the-money at expiration.
A call option is considered in-the-money if the current market value of the underlying stock is above the strike price of the option. Conversely, it is out-of-the-money if the stock's value is below the strike price. For a put option, it is in-the-money if the current market value of the underlying stock is below the strike price, and out-of-the-money if the underlying price is above the strike price. If an option is not in-the-money at expiration, the option is assumed worthless.
An option's premium can comprise two parts: an intrinsic value and a time value. Intrinsic value refers to the amount by which the option is in-the-money. Time value is the difference between the intrinsic value and the premium.
Factors Impacting Option Prices
Several elements influence the price of an option. Some of those include supply and demand, time value, strike price, volatility and interest rates.
This labyrinth of option contracts might seem daunting, but once you grasp these principles and combine them with your trading objectives, navigating it becomes significantly easier.
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