What are Options and Why Trade Them?

When it comes to trading and investing, there are a number of products and tools you can use to achieve your goals. You’re likely familiar with stocks; owning a stock means you own a fraction of a public company. As a benefit of ownership, you are entitled to voting rights and any dividend payments (if a company chooses to issue them).

Options are another tradeable product, but unlike stock, an option is a contract. If you buy an option, you own the right to buy (or sell) shares at a predetermined price by a certain date; it’s a choice, meaning you don’t have to buy (or sell) the shares if you don’t want to. If you sell an option, you are selling the right to buy (or sell) shares at that set price – this means you do have an obligation.

Options are a type of derivative product because the price of an option is derived from or tethered to the performance of another security, known as the underlying asset. For the purposes of this article, we will look at options on stocks (the underlying). It’s worth noting that there are options on various other products you may be familiar with like indices, currencies, ETFs, commodities, and fixed income.

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Why Trade Options?

There’s more to options than just the rights to buy or sell underlying assets at future dates and preset prices. Options offer choice and flexibility. Because of this inherent optionality, traders use options to accomplish various goals in their portfolio. Here are five primary reasons why people trade options:

1. Trading Profit and Income Generation: Option buyers can generate trading profits by speculating on price movements. Option sellers generate income by collecting a premium in exchange for the right to buy or sell the underlying.

2. Capital Protection: Options can be used like insurance policies to protect other assets in a portfolio, like stock. For example, imagine you own shares of a stock that you think may go down in price. Buying a put option on that stock gives you the right to sell shares at a price that could be higher than the current market price at a specific period of time.

3. Risk Management: Options can help isolate or reduce portfolio risk, such as the fluctuations in an underlying asset’s price or the volatility of a sector or asset class more broadly.

4. Efficient Exposure: A single stock option controls 100 shares of the underlying stock. Because of this embedded leverage, options can help an investor efficiently gain exposure to 100 shares without having to buy that stock outright.

5. Manage Cashflows: Options can be used to manage the cash flows of a portfolio. Sometimes a company may choose not to pay a dividend. Selling options can help generate cash flow when such payments gaps occur.

Despite these benefits, investors can still lose their principal trading options, so it's important to understand how they work and their associated risks.

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The Language of Options

We’ll look at an example to help walk through the basic components of an options order and the language used when trading a contract.

“Buy one XYZ November 120 strike call for $3.”

In every trade, you are either buying or selling the option. This is known as your side. In our example, we are buying (“Buy”) the option.

Next, we see a quantity of contracts to buy or sell. In this case, we are purchasing one option. As mentioned earlier, a single stock options contract controls 100 shares of the underlying stock; this is known as the contract multiplier. If you exercised this contract, you would buy 100 shares of stock.

The underlier or underlying asset is shown next (“XYZ”). This is the security whose performance the option’s value is derived from; they are the shares we would buy if we exercised the option. In our example, we are buying an option on XYZ company’s stock.

Every option contract has an expiration date, sometimes referred to as the expiry. This is the date when the contract expires or ends and the right to buy or sell ceases to exist.

The contract must also specify a strike price. This is a predetermined price at which you can buy (or sell) the shares. In this example, we have the right to buy 100 shares at $120 per share if we exercise the option.

There are two types of option contracts: calls and puts. Call options give the buyer (or owner) the right to buy the underlier at the strike price. Calls have value at expiration if the underlying price is higher than the call’s strike price. Put options give the buyer (or owner) the right to sell the underlier at the strike price. Puts have value at expiration if the underlying price is less than the put strike price. [For more, see “Moneyness” below]

Our example concludes with the premium (“$3”), the price you paid to own the option. Alternatively, if we were selling the option, this is the amount of money we would collect for the contract. The price you pay for an option or sell an option for impacts the potential profit or loss in your trade.

Putting it all together, we are buying the right to buy 100 shares of XYZ stock at $120 per share before the November expiration date. We paid $3 dollars for this opportunity. *Note: in our example, we did not include fees or transaction costs, which should always be factored in accordingly.

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Other Features

There are a few other noteworthy option features to keep in mind when learning the language of options. Though they aren’t stated explicitly in the option order, they are key components to understand before trading options.

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Exercise Style

Stock options are American-style options. As a buyer of the stock option, you can exercise your option any time at or before the contract’s expiration date.

Index options are typically European-style options; they can only be exercised on their expiration date.

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Moneyness

An option’s value at expiration is typically discussed in terms of its moneyness. We determine an option’s moneyness, or intrinsic value, by looking at the difference between the stock price and the strike price. For a call, the higher the price of the stock above the option’s strike price, the more value the option has. This is also referred to as its intrinsic value. The reverse is true for puts; we look at the difference between the strike price and the stock price.

Options are in-the-money (ITM) if they have value at expiration, at-the-money (ATM) if the strike price and underlying price are equal at expiration, or out-of-the-money (OTM) if they do not have any value at expiration.

Settlement Type

Settlement describes what happens after expiration. The type of underlier determines how an option settles at expiration.

With stock options, the contract settles to physical shares after expiration. For example, if you are a buyer of call options and you exercise those options, shares of stock will be added to your portfolio. If you bought a put option and exercised it, you would sell shares and they would be removed from your account. This is known as physical settlement.

Alternatively, options whose underlier is an index typically settle into cash based on the index value at expiration. Cash is transferred from (or into) your account, rather than shares.

-Powered by The Options Institute

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Disclaimer: Cboe and Webull are separate and unaffiliated companies. This content is provided by Cboe and does not reflect the official policy or position of Webull. This content is for educational purposes only and is not investment advice or a recommendation or solicitation to buy or sell securities.

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