I’ve been getting a lot of questions from students lately related to specific options trading topics.
Some of these questions may seem basic, but I noticed many have been asked more than once. So it seems there may be more confusion around these concepts than I initially thought.
With that in mind, I decided to forego our regular lesson plan to cover some frequently asked questions about options. Let’s dive right in…
What Are the Different Types of Options?
There are nearly infinite variations on how you can trade them but only two types of options contracts: calls and puts.
Calls are directionally bullish — you buy them if you think a stock will go up.
Conversely, puts are directionally bearish — you buy them if you think a stock is heading lower.
What’s the Strike Price of an Option?
Every options contract has an attached strike price. This is the price level the stock needs to reach for your contracts to pay out.
If you’re trading calls, you want the stock to exceed your strike price.
If you’re trading puts, you want the stock to stay below your strike price.
What’s the Expiration Date of an Option?
Along with a strike price, every contract comes with an expiration date — think of it as the lifespan of your contract.
Options are depreciating assets, meaning that they start losing intrinsic value from the moment the contracts are written. The expiration date determines how quickly that intrinsic value decays.
Additionally, expiration dates have a profound effect on the way options contracts react to the moves of the underlying stock. Shorter contracts will change value faster (and more dramatically) than their longer-dated counterparts.
What Does It Mean If an Option Is In/Out of the Money?
The ‘in/out of the money’ concept circles back to our discussion of strike prices.
Let’s say stock XYZ is trading for $50, but you think it could hit $60 by the end of the month.
If you buy a $60 call, that contract is out of the money because the underlying stock isn’t trading at or above $50 (yet).
Now let’s say you were right — two days later, XYZ is trading for $62.
At that point, your $60 call would be in the money. The stock increased beyond your strike price.
What Does It Mean to Exercise an Options Contract?
Let’s return to our hypothetical XYZ trade. If the contract’s about to expire and your $50 strike is in the money, you have two choices…
The first choice is to sell the contracts outright. This is the simplest and most common way to lock in gains without any confusion. Your account will be credited the difference between the premium you paid to put the trade on and the premium for which you sold the contracts.
But there’s another choice, which is to exercise the contracts.
If you choose to exercise, you’ll need to purchase all of the shares that the contract represents. Remember that each options contract represents 100 shares of the underlying stock.
That means to exercise just one of your XYZ $50 calls, it would cost $5,000. You can imagine how expensive this can get if you have 10, 50, or 100 contracts.
So if you truly love the stock and want to own the shares beyond the life of your options contract, know that exercising is a choice you have.
But whatever you do, make sure you have the capital in your account required to purchase the underlying shares. If you don’t, you could risk receiving a margin call — and potentially blowing up your entire account.
Can I Trade options on Any Stock or ETF?
The short answer is no. Stocks only have options attached if market makers believe there’s enough liquidity, or demand, to support derivatives on the name.
So pretty much any blue-chip or index-held stock will have options.
On the other hand … smaller, newer, or less liquid stocks often won’t have any options offered at all.
Are There Neutral Options Contracts?
Yes, you can create a neutral options trading strategy that bets on general volatility rather than direction.
This is a great strategy if you think a certain catalyst has a high probability of moving the share price up or down … but you don’t have a strong conviction on which way it will move.
The most common neutral options trading strategies are straddles and strangles.
When trading a straddle, you buy a put and a call simultaneously at the same strike price (often at the money).
When trading a strangle, you buy a put and a call simultaneously at two different strike prices of your choosing.
These strategies allow you to potentially profit off general volatility in either direction. But keep in mind that the overall upside on these trades is less than that of straight directional bets.
This is because if you’re right — and the stock blasts off in one direction or another — one of the two strikes in your spread will expire worthless.
That being said, if you plan the trade correctly, the gains from the strike that pays out should exceed the losses from the strike that expires worthless.
This is the beautiful thing about options contracts — you can organize trading them to fit nearly any strategy or trading plan.
The options market is a strange place. There are weird names like strangles and straddles. Then you have confusing differences in expiration dates. And there are serious risks on the other side if you don’t know what you’re doing.
Sometimes it’s embarrassing or awkward to ask someone outright about a topic you aren’t familiar with. But getting these questions made it obvious that I needed to clarify a few things.
These concepts may be basic for some, but I guarantee others will be happy I clarified specifics.
Even if you were familiar with these ideas before reading this … as options traders, it’s always a good idea to brush up on the fundamentals of trading strategies.
I’ll say it again … That’s why I think options are so great. If you learn all of the different ways to trade them, you can weaponize a variety of the derivatives market to serve your end goals.
Editor-in-Chief, Evolved Trader Daily
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