What is Options Trading?

Options are a type of financial transaction used to trade financial investment products derived from futures trading . Options give buyers the right , but not the obligation, to buy or sell the underlying asset at a specific price at a certain time in the future.

The underlying asset here can be a stock , commodity , currency or index , etc. The person who buys the option needs to pay a certain fee, which is called the option premium . The size of the option premium depends on many factors, including the option exercise price , option expiration time , volatility of the underlying asset , etc.

What is options trading?

Options trading is a financial derivative of futures trading .

“Futures” means that the trading process is carried out around futures contracts, and “rights” refers to the right to buy or sell futures contracts.

Therefore, option trading is simply a process in which investors buy or sell rights for futures contracts.

Compared with futures trading, the risk of options trading has been adjusted and it is a unilateral rights model, which is different from most financial transactions.

Options trading is widely used for speculation and risk management. Speculators can make profits by buying or selling options, while risk managers can protect their portfolios from unexpected price fluctuations through options trading. Options trading is also highly flexible, and investors can conduct many different types of options trading strategies depending on market conditions.

Let’s use a simple example to explain: “Bill wants to buy a car from Zoe”

Zoe has a car, and Bill offers Zoe the right to purchase the car for $15,000 within one month.

Zoe agreed to the deal and asked Bill to pay 2%, or $300 (option fee), first. Zoe would then fulfill her obligation not to sell the car within the next month. At the same time, when Bill asked to buy the car, she would sell the car to him as agreed before without any additional conditions.

This process is the basic process of an option contract, in which:

The commitment reached between Zoe and Bill is the “Option Contract”;

Zoe is the seller, also known as the “Originator”, “Option Writer”, or “Option Seller”;

Bill is the buyer, also known as the “Option Holder” or “Option Buyer”;

Bill has obtained the right to buy Zoe’s car, which is called “recipient the right”. The option contract that obtains the right to buy is called “call option”.

One month is the option term, which is a known pre-defined time frame, or Option’s Term, Option’s Duration;

The car is the “underlying asset” of this option contract, which is also known as “a known asset”;

$15,000 is the “strike price” of this contract, which is called “strike” in English, which means “a known price”;

$300 is the fee paid by both parties for mutual trust when they reach this contract, which is also the fee of this option contract, called “option premium”, in English, the price of the option;

From this example, we can see that an option is a contract that gives the buyer the right but does not make any obligations, allowing the buyer to exercise the right to sell or buy a specific underlying asset at a proposed price within a certain period of time in the future.

When the underlying asset of an option contract is a certain stock, that is, the two parties agree that before a certain time in the future, the buyer has the right to buy the seller’s stock or sell the buyer’s stock from the seller at a certain price, this contract is a “stock option contract.”

Similarly, when the underlying asset is an ETF , the transaction is an “ETF option transaction.”

Regarding the option term, the US market stipulates that the buyer can exercise the right at any time before the expiration date; while the EU market stipulates that the buyer can only exercise the right on the expiration date.

Option contracts are a very practical financial instrument that also meets the needs of various trading models, the most important of which are call options and put options.

What is a call option?

Call option, in English, is called Call Options.

A call option is the right of the buyer to buy the underlying asset at a specified price and quantity during the validity period of the option contract. The buyer usually believes that the value of the underlying asset will increase and earn the difference between the actual value and the specified value on the exercise date.

When you buy a call option, you acquire the right to buy an asset at a specific price on or before a certain date.

In the stock world, call options are also called “contract options” or “buy options . “

The contract means that the buyer believes that the stock price will rise in the future, so he signs a call option contract with the seller.

During the validity period of the contract, if the stock price does rise and exceeds the proposed price of the contract, the buyer can exercise the purchase right and buy the stock at the proposed price. If the stock is sold after purchase, the difference between the actual price and the proposed price can be earned.

When the stock price does not rise, or the increase does not exceed the total amount of the proposed price plus the option premium, if the buyer exercises the option contract, there may be a certain loss. At this time, the buyer can choose not to exercise the purchase right. At this time, the buyer’s maximum loss is the option premium paid previously.

Here is an example of a call option:

Assume that the current market price of ABC Company’s stock is $100 per share. You believe that ABC Company’s stock price will rise in the future, so you buy a call option with an expiration date of 3 months in the future and an exercise price of $110. You pay $5 for the option.

If the stock price of ABC Company rises to $120 or above in the next 3 months, you can exercise your option and buy ABC Company stock at $110. This means you will receive $10 per share (after deducting the option fee you paid).

Conversely, if the stock price of ABC Company does not rise to $110 or above within the next 3 months, you will not exercise your option and you will only lose the $5 option premium you paid.

What is a Put Option?

Put option, in English, is called Put Options.

A put option means that the option buyer has the right to sell a certain amount of the underlying asset at a proposed price during the validity period of the option contract. During the price formulation process, the buyer often believes that the value of the underlying asset will fall, and earns the difference between the proposed price and the actual price on the exercise date.

When you buy a put option, you get the right to sell an asset at a specific price on or before a specific date. Generally, it means that you predict that a stock will fall in the future, so you hold the stock and sign a put option with the seller.

In the stock world, put options are also called “put options” or “sell options” .

During the validity period of the contract, if the stock price falls and drops below the proposed price, the buyer can exercise the right to sell, and the seller must buy the stock at the proposed price. At this time, the buyer can earn the difference between the proposed price and the actual price of the stock.

Of course, if the stock does not fall, or the falling price does not fall below the proposed price, then there is no point in exercising this put option, so the buyer will choose to give up exercising the option contract and only lose the option fee.

Here is an example of a put option:

Assume that the current market price of XYZ Company’s stock is $50 per share. You believe that the stock price of XYZ Company will fall in the future, so you buy a put option with an expiration date of 3 months in the future and a strike price of $40. You pay $3 for the option.

If the stock price of XYZ Corp. drops to $30 or below within the next 3 months, you can exercise your option and sell XYZ Corp. stock for $40. This means you will receive $10 per share (after deducting the cost of the option you paid).

Conversely, if the stock price of XYZ Corp. does not drop to $40 or below within the next 3 months, you will not exercise your option and you will only lose the $3 option premium you paid.

What are the characteristics of options?

1. Two-way trading

In traditional transactions, investors are merely buyers and can only hope to earn the difference in price if the price goes up. Once the price goes down, they can only accept the loss.

In options trading, investors can invest as buyers or sellers and make profits based on the rise and fall of the value of the underlying asset. Therefore, when the stock price falls, profits can also be made through options trading.

For example, if you predict that a stock is about to fall, traditional investors will either sell to stop losses or continue to hold and wait for it to rise again. Option trading allows investors to buy put options or sell call options to trade, which means that they can also make profits during the stock’s decline. The two-way trading model gives investors more strategic options.

2. Unilateral power

Options trading gives the buyer the right to exercise.

When trading options, buyers can choose to exercise or not exercise the option based on the market conditions of the underlying asset of the futures contract.

When the buyer proposes to exercise the right within the contract period, the seller has the obligation to fulfill the option contract.

3. Profit and loss are not equal

Because the power to exercise option trading is in the hands of the buyer, the buyer will only buy or sell the futures contract when it is beneficial to him.

• If it is in the buyer’s favor, his profit is usually unlimited;
• If the price is unfavorable, the loss will not exceed the option premium. Compared with futures trading, the buyer’s loss in option trading is greatly reduced, and generally the loss is just the option premium.

For the seller of an option contract , the maximum profit is the option premium of the option contract, but the loss will depend on the content of the futures contract, and in most cases the loss may be unlimited.

This characteristic of mismatched profits and losses gives option trading a unique advantage in risk management.

How are options contracts valued?

The valuation of an option contract can essentially be considered as a probabilistic prediction of future price changes of the underlying asset.

1. Probability

When the probability of the estimated situation occurring is high, the valuation of the option contract will naturally increase. For example, the value of a call option will increase as the underlying stock rises. In this way, the value of the option contract can, to a certain extent, become a reference item for judging stock market conditions.

2. Duration

As an option contract approaches its expiration date, its value will gradually decrease. This is because the time for the underlying asset to change in value is limited, and the room for change will gradually decrease. The possibility of making a profit through a high price difference will decrease. Therefore, the value of an option contract that expires in one year will be higher than that of an option contract that expires in one month.

3. Fluctuation Range

Large fluctuations are what investors are willing to see but are also afraid of seeing. Large fluctuations in a favorable direction mean increased profits, while large fluctuations in a negative direction mean increased losses.

For buyers of option contracts, due to the existence of a two-way trading model, large fluctuations mean an expansion of profit margins. Therefore, the greater the volatility, the greater the value of the option contract.

How to play options? What are the strategies for options trading?

Below are some common options trading strategies , among which the most used by investors are call options and put options .

Buying a long call option : Thinking that the stock price will rise, buy a call option to gain profit when the price rises.

Long put : Believe that the stock price will fall, buy a put option to gain profit when the price falls.

Selling a short call option : Holding a stock and expecting the price to remain stable or rise slightly, sell a call option to earn the option fee.

Selling a put option (Short put) : Hoping to buy a stock and expecting the price to remain stable or rise slightly, sell a put option to earn the option fee and buy the stock at the strike price when the option expires.

Protective put : Holding a stock and worrying about a drop in price, buy a put option to protect your investment.

Iron butterfly strategy : Buying a call option and a put option at the same time, and selling two call and put options with a strike price slightly lower or slightly higher, in the expectation that the stock price will remain stable.

Long straddle : Expecting large stock price fluctuations, buying both call and put options to gain profits when prices rise or fall.

Due to the two-way trading model, options trading has a variety of trading strategies, which is more flexible and also tests the investor’s strategy-making ability. You can start by understanding the basic four strategies.

1. Buying a Long Call Option

Buying a call option is one of the most popular trading strategies. It gives the option holder the right, but not the obligation, to buy the underlying asset at a specific price on or before the option expiration date. By buying a call option, the option holder believes that the price of the underlying asset (such as stocks, commodities, currencies, etc.) will rise, thereby gaining benefits when the price rises in the future.

For example, let’s say Company XYZ’s stock is currently trading at $100. You believe the company has good prospects and the stock price is likely to rise, so you buy a call option with an expiration date of three months in the future and a strike price of $110 for a premium of $3.

If XYZ stock rises to $120 before the option expiration date, you can exercise your call option and buy XYZ stock at $110 and sell it at the current market price of $120, earning $10 per share (minus the option premium you paid).

If the stock price of XYZ does not rise to $110 or above by the option expiration date, you will not exercise your option and you will only lose the $3 option premium you paid. Therefore, buying a call option has a fixed loss and unlimited gain potential.

Judgment basis: The market is bullish and profits can be earned from the rising prices of the underlying securities.

Profit and loss situation:

• Maximum profit: unlimited, derived from the difference in stock prices
• Maximum loss: option premium
• Breakeven point: Strike price + option premium

Volatility: An increase in volatility is positive, and a decrease in volatility is negative.

Time reduction: negative effects

2. Buy a put option (Long Put )

Buying put options is an ideal strategy for investors to profit from a decline in the price of the underlying stock.

Investors can buy this option contract to sell the underlying asset at a specific price at a certain time in the future. This option contract allows investors to earn income if the price of the underlying asset falls.

As an example, suppose an investor believes that a stock price will fall and wants to protect his portfolio from losses. The investor can buy a put option contract on the stock, which provides for the sale of the stock at a specific price at a specific time in the future.

Suppose the investor purchased a stock put option with an exercise price of $100, an expiration date of three months, and paid a premium of $2. If the stock price falls to $90 within three months, the investor can exercise the option and sell the stock at $100, earning $10. Since the investor has paid a premium of $2, his net gain is $8.

However, if the stock price is still above $100 after three months, the investor can choose not to exercise the option and lose only the $2 premium he paid. This strategy enables the investor to gain if the stock price falls, while losing only the premium paid if the stock price rises or remains unchanged.

Judgment basis: When the market falls, you can earn profits from the decline in the price of the underlying securities.

Profit and loss situation:

• Maximum profit: Very large, but with an upper limit, that is, the stock price drops to zero yuan
• Maximum loss: option premium
• Breakeven point: Strike price – option premium

Volatility: An increase in volatility is positive, and a decrease in volatility is negative.

Time reduction: negative effects

3. Selling Call Options (Short Call )

The strategy of selling call options means that investors sell a call option contract and hold an equal number of shares of the underlying stock at the same time. It is suitable for investors who are optimistic about the underlying stock but believe that the market may enter a small volatile market before the option expires.

It is the right given by a sold option contract to the option buyer to buy the underlying asset at a specific price on or before the expiration date. The holder of a sold call option believes that the price of the underlying asset may fall or remain stable, thereby hoping to earn the option premium while facing possible future losses.

For example, let’s say Company XYZ’s stock is currently trading at $100. You believe the company’s prospects are stable or declining and the stock price will not rise above a certain price, so you sell a call option expiring three months in the future with a strike price of $110 for a $3 premium.

If the price of XYZ stock does not rise to $110 or above before the option expires, the option buyer will not exercise the option and you will receive the $3 option premium while keeping the XYZ stock. If the price of XYZ stock rises to $120 before the option expires, the option buyer will exercise the option and you will need to buy XYZ stock at $110 and sell it at the current market price of $120, thus facing a loss of $10 per share (minus the $3 option premium you received).

Selling call options has limited gain and unlimited loss potential because the price of the underlying asset may rise above the strike price before the option expires, causing the holder to purchase the underlying asset at a higher price or face higher losses. Therefore, selling call options is a high-risk, high-reward option trading strategy that requires in-depth knowledge and risks of option trading.

Judgment basis: neutral or bullish attitude towards the target stock.

Profit and loss situation:

• Maximum profit: Limited, option premium + difference between exercise price and stock purchase price
• Maximum loss: The extent of the loss corresponds to the extent of the stock price decline
• Break-even point: stock purchase price – option premium received

Volatility: An increase in volatility is negative, a decrease is positive

Time reduction: positive impact

4. Selling Put Options (Short Put)

Selling a put option (Short Put) means that the investor sells a contract that gives the buyer the right and the seller the obligation to buy the underlying asset at a specific price at a specific time in the future. The seller receives the premium and assumes the obligation to buy the underlying asset at the agreed price at a specific time in the future.

Let’s take an example to explain the principle of selling a put option. Assume that the current market price of a company’s stock is $100. An investor expects the stock price to remain stable or increase. He can choose to sell a put option, that is, sell a put option.

The investor sells a put option with an exercise price of $90 and receives a premium of $2. If the stock price is above $90 when the option expires, the buyer will not exercise the option and the seller can keep the $2 premium received. However, if the stock price is below $90 when the option expires, the buyer will exercise the option and the seller will need to buy the stock at $90, even if the market price is below $90 at the time.

In this case, the seller will face a loss. For example, if the stock price drops to $80 when the option expires, the seller will need to buy the stock at $90 and then sell it in the market at $80, resulting in a loss of $10.

In summary, selling put options is an investment strategy that allows investors to gain from stock prices remaining stable or rising, but may carry the risk of being limited and may need to buy the stock at a higher price if the stock price falls, resulting in a loss.

Is trading options risky?

Any investment has certain risks, the difference is the type of risk and the severity of the risk. As far as option trading is concerned, the risks that may exist in the trading process are:

1. Price Fluctuation Risk

Options trading, like futures trading, is a leveraged financial derivative product. There are many factors that affect option prices, such as the price and time of the futures underlying, which can lead to large price fluctuations. This is one of the important risks that investors need to pay attention to.

2. Risk of forced liquidation

Forced liquidation means that option trading adopts a same-day zero-liability settlement system similar to futures trading. After the daily close, a margin will be calculated and collected from the option obligor based on the contract settlement price.

If the obligated party has insufficient available funds in its margin account, it will be required to pay additional margin. If it fails to pay the additional margin within the prescribed time and fails to close the position on its own, its position will be forcibly closed.

3. Contract expiration risk

Options trading has a contract validity period, and different option contracts have different expiration dates. If the right holder does not exercise the option on the expiration date, the contract will automatically become invalid and no longer have any value. The investor’s option contract account will no longer display the expired contract position.

4. Risk of Failure to Exercise Options

The risk of failed exercise means that if there is no sufficient option premium in the account after the investor proposes to exercise the option, it will be judged as a failed exercise and the investor will not be able to exercise the rights granted by the option contract.

What are the similarities and differences between options trading and stock trading?

A. Similarities between options and stocks

• Both are financial investment products;
• They all start trading after making certain judgments about the future stock price trend of the target stock;

B. Differences between options and stocks

Different transaction objects

• Options are the right to buy or sell one or more stocks within a certain period of time in the future;
• Stocks are actual ownership of shares in a company;

Different trading directions

• Options are two-way transactions, which can be bought first and then sold, or sold first and then bought. Investors can be both buyers and sellers.
• In stock trading, investors only act as buyers and purchase stocks from the stock issuing company in a one-way manner;

Different trading methods

• There are two types of fees involved in option trading: the upfront option fee and the contract drafting fee paid later when the option is exercised;
• Stock transactions are one-time full-amount transactions, which means the full cost of actually purchasing the stock;

Different transaction settlement methods

• The settlement method of option trading is that the buyer exercises the right before the contract expiration date. If the buyer does not exercise the right, the contract will automatically terminate on the expiration date and the option fee will belong to the seller.
• In stock trading, investors do not need to settle before the transaction is completed;

Different transaction expiry dates

• The contract expiration date of option trading is the transaction expiration date.
• Stock trading has no trading expiry date unless the company is delisted

Different rights and obligations in transactions

• In option trading, the buyer has the right to exercise the option but has no obligations, while the seller only has the obligation to perform the option but has no rights;
• In stock trading, the seller, that is, the stock issuer, has the right to issue stocks and the obligation to disclose operating information on time. The buyer, that is, the shareholder, has the right to know and the right to audit, but must also fulfill the obligation to bear operating risks.

Frequently asked questions

Question 1: How do you say option in English?

Options in English are characterized by two-way trading, which is more flexible than stock trading and has the characteristic of unequal profits and losses. At the same time, it is safer than futures trading. There are also multiple strategies that can be used in combination, which makes investment and financial management no longer a single linear profit and loss, but full of more variables.

Question 2: How to play options?

Option trading mainly includes: valuation of option contracts and option trading strategies.
The valuation of option contracts can essentially be considered as a probabilistic prediction of future price changes of the underlying asset.
Also due to the two-way trading model, option trading has a variety of trading strategies, which are more flexible and more challenging for investors’ strategy formulation capabilities, mainly including four strategies: buying call options, buying put options, selling call options, and selling put options.

Question 3: What is a put option?

Put options are called put options in English. Put options mean that the option buyer has the right to sell a certain amount of the underlying asset at a proposed price during the validity period of the option contract. During the price formulation process, the buyer often believes that the value of the underlying asset will fall, and earns the difference between the proposed price and the actual price on the exercise date.

Question 4: What is a call option?

Call options are called call options in English. Call options mean that the option buyer has the right to buy the underlying asset at a proposed price and quantity during the validity period of the option contract. Usually, the buyer believes that the value of the underlying asset will increase and earn the difference between the actual value and the proposed value on the exercise date.