Introduction - Understanding Stocks vs. Options

Stock trading allows traders to speculate on the directional movement of a stock. When compared to trading options, trading stocks is more simple but limited. Entering a stock position gives the investor exposure in either direction, meaning that there is dollar for dollar exposure on both the upside and the downside. On the other hand, exposure on a stock using option contracts is more complex, but with the additional complexity comes more flexibility. Options allow for exposure with direction, magnitude and timing unlike stocks that only allow for exposure on a specific direction:

• Direction - Buying and Selling a Call or a Put
• Magnitude - Options allow traders to gain exposure on how much a stock will move by selecting different strike prices
• Timing - Selection of expiration dates allow for bets on where the stock will move before a certain date

One of the main differences between stock and options trading is the risk profile. Stocks allow for a symmetric risk profile - dollar for dollar exposure in either direction. Options have an asymmetric risk profile - potential for unlimited profits while risk is limited. Because options offer protection from downside risks, a premium is paid by the buyer of an options contract while sellers of option contracts receive the premium. 

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Calls and Puts

There are 2 types of options – a call option and a put option. A call option allows the buyer of the option to buy stock at a specific price (strike price) before the expiry date of the option. A put option allows the buyer of the option to sell stock at a specific price before the expiration date. Each contract represents 100 shares of the stock. Before buying or selling options, there are a few terms that one should know:

• Current price - this is the price that the stock is currently trading at
• Strike price - the price at which the option contract can be exercised
• Expiration date - the date at which the contract expires 

When trading options a trader can do 4 actions:

1. Buying a call option (bullish & speculative strategy) - This involves buying a call option contract and paying a premium. Buying calls is usually done when the trader has a moderate or strong bullish view on the stock. For example - $XYZ stock is currently trading at $100 per share. The trader expects this price to move up to $110 and buys a $100 April call option for a $4 premium (per share). This gives the trader the right, but not the obligation to buy the stock at $100 per share at any time during the life of the contract. If the trader was correct and $XYZ moves to $110, the call option allows the trader to purchase the shares for $100 and then he/she can sell the shares at the current market price of $110 resulting in a profit of $10 per share. However, the premium paid should also be accounted for. Therefore, the actual profit of this trade is $6 per share – the stock must be bullish by a certain amount before this trade is profitable. For example, if $XYZ only moved $1 higher to $101, the trade is not profitable as the premium paid offsets the $1 appreciation. If $XYZ were to be trading below $100 at expiry, the trader would choose not to buy the stock at $98 and lose a maximum of $400 ($4 premium x 100 shares). 
   
   Maximum gain = unlimited
   Maximum loss = $400 (premium paid)
   Breakeven price = $104 (Strike price + premium)

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2. Selling a call option (somewhat bearish & income strategy) - Selling a call option is used to generate income through the premium received by the option buyer. Traders that sell call options have a bearish/neutral sentiment on the stock. The goal of the option seller is for the call option to not be exercised and expire worthless. It is important to note that the further away (Out-of-the-Money) the strike price is from the current price, the less premium will be received by the option seller. Example - $XYZ is currently trading at $100. The trader expects the price to remain neutral or move down and sells a $100 April call option for $4 per share. The seller will immediately receive $400 ($4 x 100 shares) and will only have to sell the shares if the contract is exercised (if $XYZ trades above $100 before expiration). Selling call options can allow the trader to be profitable even if the stock moves in the wrong direction as this strategy only loses when the stock makes a move that is more than $4 to the upside. The bullish move will have to be greater than the premium received for the option seller to make a loss. 
   
   Maximum gain = $4 (premium received)
   Maximum loss = unlimited (stock can keep moving higher)
   Breakeven = $104 (Strike price + premium received)

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3. Buying a put option (bearish & speculative strategy) - Buying a put option gives the trader the right but not the obligation to sell the stock at the strike price. This strategy is used when the investor has a moderate/strong bearish view on the stock. Therefore, the buyer of the put option will start to profit as the current price of the stock moves down. For example - $XYZ stock is currently trading at $100. The trader buys a $100 April put option for $4 per share. This trade is profitable when the current price of $XYZ moves below $96 (strike - premium). The maximum loss is the premium paid of $4 per share. 
   
   Maximum gain = unlimited (until stock reaches zero)
   Maximum loss = $400 (premium paid)
   Breakeven price = $96 (strike price – premium)

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4. Selling a put option (somewhat bullish & income strategy) - Like selling a call option, selling a put option allows the seller to generate an immediate income from the premium paid by the buyer of the contract. If the contract is exercised, the seller has the obligation to buy the shares at a predetermined price (strike price) to the option buyer. In other words, selling a put option means that you are selling someone the right, but not the obligation to make you buy the shares at the strike price from the option buyer. For example, $XYZ is currently trading at $100. The trader expects the price to remain neutral or move higher and sells a $100 April put option for $4 per share. The seller will immediately receive $400 ($4 x 100 shares) and will only have to sell the shares if the contract is exercised (if $XYZ trades below $100 before expiration). Like selling calls, selling a put options can allow the trader to be profitable even if the stock moves in the wrong direction as this strategy only loses when the stock makes a move that is more than $4 lower. The bearish move will have to be greater than the premium received for the option seller to make a loss. 
   
   Maximum gain = $4 (premium received)
   Maximum loss = unlimited (until stock reaches zero)
   Breakeven = $96 (Strike price + premium received)

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The Greeks

The Greeks refer to a set of factors that affect the pricing of an option and the measures the different dimensions of risk involved in an options position. It is important for investors to know how Greeks work at a conceptual level to gain a better understanding of their trades. While there are a few Greeks, Delta and Theta are the most common used by investors to analyze their positions.

Delta – Delta refers to the change in the option price with respect to the change in the underlying stock price. For example, buying a call option with a delta of 0.5 means that the value of the contract will increase by 50 cents if the stock moves $1 higher. Delta is calculated as follows:

Delta = Change in Option Price/Change in Stock Price

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Theta – Theta refers to the change in the option price with respect to time. As options have an expiration date, options will decay in price as time goes by. Theta tells us the rate at which an options price will decay with time. For example, an option with a theta of 0.03 means that the price will reduce my 3 cents per day. Theta is calculated as follows:

Theta = Change in Option Price/Time

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Summary

Trading options comes with additional complexity and flexibility compared to trading stocks as investors can speculate on direction, magnitude and timing. The flexibility of options also allows investors to use them as for either income generation (selling calls and puts) or speculation (buying calls and puts). Before entering an options position, investors should analyze Greeks to see how different factors such as time and the underlying asset price will effect the price of the option.

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