What are Options Contracts?

If you spend some time doing some research on investing, you have no doubt come across the art of options trading. Options trading has become so popular amongst retail traders that we set a record for daily options contracts traded in 2021. So you might be asking why I keep mentioning the phrase options contracts rather than shares or stocks.

What are Options Contracts?

Options trading is when a trader chooses to buy or sell an options contract. This contract is an agreement that gives them the right, but not the obligation, to buy or sell the underlying security at a specified price on or before a specified date. The world of options trading is a much different philosophy than simply buying and selling stocks.

Every stock options contract accounts for a ‘pack’ of 100 shares of the underlying stock. Before getting involved in trading options, I recommend doing your homework to make sure you know what you are getting into. If you’re considering trading options, we have an on-demand training called “Options 101” available here that’s totally free to take. Let’s take a look at some of the basic terminology that is involved in an options contract:

Underlying Asset

The underlying asset is the stock or ETF that the options contract is being bought or sold for.

Strike Price

Strike Prices

The strike price of an options contract is the specific price at which the contract can be bought or sold when the contract is exercised. The strike price is a predetermined price and does not change during the lifetime of the contract.

Expiration Date

This is the final date that the options contract will be in effect. On this date or sooner, the owner of the options contract will have decided to exercise the contract, let the contract expire worthlessly, or close the position if there was a realized gain on the value of the contract rising.

Premium

The premium paid on an options contract can vary depending on the strike price and the expiration date. It is quite literally the market value of the options contract. The premium can fluctuate during the lifetime of the options contract due to several reasons including changes in the underlying asset’s price and market volatility ahead of the specific expiration date.

Different Types of Options Contracts

Different types of options contracts

In the world of options, there are several different options trading strategies. However, there are only two different types of options contracts: call options and put options. As you can probably imagine, the two types of contracts are opposites of each other. Both call options and put options can be utilized separately or together, depending on which options strategies you are using in your trading.

Call Option Contract

A call option is a type of options contract that rises in value when the underlying security’s price rises as well. When a trader buys a call option of a stock, they are generally considered to be bullish on the underlying asset. If the stock price rises, the trader profits off of the call option contract. Consider a call option contract a leveraged bet that the stock price will appreciate by the expiry date of the contract.

Put Option Contract

If a call option creates profit when the stock price rises, then we can logically deduce that put option contracts profit when the stock price falls. The mechanism behind a call option contract allows the trader to buy an asset for a specific price by the expiration date of the contract. A put option contract allows the trader to sell an asset at the strike price within a specified period. Generally speaking, buying a put contract means that the trader is bearish on the underlying asset and anticipates the stock’s price to fall.

In the Money vs Out of the Money Options Contracts

Perhaps one of the most debated topics when it comes to options contracts is whether to buy them ‘in-the-money’, ‘out-of-the-money’, or ‘at-the-money’. What do these terms mean? They are the three ways in which the strike price for the options contract is determined:

In-the-Money Options Contract

This is generally considered the safest type of options contract to buy. For a call option, when the strike price is in-the-money it means that it is below the current market price of the underlying asset. For a put option, when the strike price is in-the-money it means that it is above the current market price of the underlying asset. Why is this safe for an options trader? Essentially it allows the owner of those options contracts to buy or sell the stock at an advantageous price. For a call option, you can buy the stock at a lower price, and for a put option, you can sell the stock at a higher price.

At-the-Money Options Contract

An at-the-money strike price is exactly what it sounds like: a strike price that matches or is right around the current market price for the underlying stock. Is there any advantage to having an at-the-money strike price rather than an in-the-money strike price? Not really, aside from the fact that the premium paid for each contract will be slightly lower. At-the-money strike prices work well when the trader is anticipating short-term stock price increases.

Out-of-the-Money Options Contract

Out-of-the-money options contracts are the ones that have been attracting new traders to trading options. Why are they so appealing? They are the proverbial home-run swings when it comes to trading and are only for those with higher risk tolerance. Out-of-the-money strike prices are above or below the current market price of the underlying stock, depending on if it is for a call option or a put option. Since out-of-the-money options contracts only hold extrinsic value, the premiums are usually much lower than those of both in-the-money and at-the-money contracts.

The allure of the out-of-the-money options contract is that if the underlying stock does move towards or passes the strike price, the premium for the contract rises along with it. Remember how little of a premium you paid to own the contract? Well, that premium has now skyrocketed as the out-of-the-money contract has now become an in-the-money contract. There is an entire class of traders that will only trade options contracts based on the premiums with no thought to exercising them to own the actual shares.

The Three Outcomes of an Options Contract

When you are ready to buy an options contract for a particular stock, you should know about the three potential outcomes of that trade:

  1. You hold the options contract until the expiration date and exercise if the contract is in-the-money.
  2. You sell the options contract before the expiration date and collect the profit.
  3. The options contract expires worthless.

Is there an advantage or disadvantage to any of these outcomes? Clearly, the third option is one that we are trying to avoid. But the first two options could depend on your trading style and what you ultimately hope to achieve when trading options. Here are some advantages and disadvantages of either outcome.

Holding Until the Expiration Date

When exercising a call option contract at the expiration date is generally considered a long-term investing strategy. It allows a trader to take ownership of 100 shares of the underlying stock per contract, and hold those shares in their trading account. After exercising the contract the trader is free to do as they wish with those shares and can sell them at any time for a profit.

Collecting Premium by Selling Contracts Before the Expiration Date

If you can accurately predict the direction of the stock price’s movement, then selling options contracts to collect the premiums can be a nice way to generate income. Traders can use tools like technical analysis to try and determine when and how a stock will move. This type of options trader has no interest in the shares of the stock and is strictly betting on the price movement within a certain timeframe. Selling put options is the first part of our favorite income trading strategy, “The Wheel.” If you’d like a free hardback copy or Markus’ bestselling book on the strategy, you can get it by just covering $4.95 for shipping and handling here.

Options Contract Expires Worthless

An options contract expiring worthless is frustrating, but it is a fraction of the loss of owning the actual shares of the stock. In the case of an expiring contract, you will only lose the premium you paid to hold that option contract. When this happens, we can often take the opportunity to learn from our mistakes which will make us better traders in the long run.

What are Options Contracts?

As I mentioned earlier, 2021 set a new record for the average volume of options contracts traded in a day with 39 million! This rise in volume represented a 35% year-over-year growth from 2020. Why was there such a sudden surge in options trading in 2021? There are a few catalysts that made this the perfect storm for the options market. At one point in time, options trading was almost entirely the domain of institutional investors like hedge funds. Well in 2021, that narrative flipped as an army of retail investors flooded the markets.

An Influx of Retail Investors

Over the past two years, the US government has handed out trillions of dollars in stimulus checks to Americans struggling during the pandemic. Well, guess where a lot of this money ended up? The stock market. A Forbes article revealed that at one point in 2021, 46% of people who received a stimulus check put some of it into the stock market.

Retail investor-driven brokerages like Robinhood have aimed to democratize finance and make the stock market accessible to everyone. With its online and mobile platform, Robinhood has simplified investing and made it tech-friendly for millennials and younger generations. This has also allowed novice traders access to advanced trading strategies like options contracts.

Gamification and Social Media Sentiment

The spotlight squarely on Reddit groups like r/WallStreetBets, millions of new traders have been lured to the options markets in an attempt to return a maximum profit. Robinhood has faced heavy criticism for allowing new traders to only have access to basic call options and put options, instead of safer option trading strategies like call spreads.

During the short squeezes of stocks like GameStop and AMC, many new traders chose to buy call options as a cheaper alternative to loading up on the volatile stocks. Perhaps most famously, r/WallStreetBets legend Keith Gill, also known as Roaring Kitty, exercised his call options that were at one point valued at over $46 million. It is stories like this that have led to the YOLO or You Only Live Once, style of trading amongst younger investors.

Trading Options is Following the Smart Money

What are Options Contracts?

There has also been a strong narrative that following options flow and dark pool trading charts are a sharp way to trade. Last year, retail traders accounted for 25% of the total options trading volume on the market. While this is significant growth, it does also illustrate that options trading is still primarily executed by institutional funds. So although retail investors are following the right path, the way they are going about trading stock options could be setting them up for failure. As John Foley, the CEO of Options AI, puts it: “Everybody in the business knows that if you’re only buying out-the-money calls, then you’re likely going to lose money over time”.

It’s also hard to blame these new options traders as platforms like Robinhood do not allow access to the options strategies that are used on Wall Street. The result? Robinhood pulled in $164 million in revenues from options trading fees in the third quarter of 2021 alone. I can guarantee you that a lot of those options contracts were worthless by the expiration dates.

Why You Should Invest In Options Contracts? What Are The Benefits of Options Trading?

It’s not all doom and gloom though! As retail traders, there are plenty of benefits to options trading that make this strategy not only safe but lucrative in the long run. So if you are thinking of joining all of the other options investors on the options trading bandwagon, there is no time like the present! Here are a few reasons why options trading can work for you!

Options Trading Requires Less Initial Investment

What I mean by this is that trading options can provide you with great leverage for accessing the underlying securities. Using some simple math, to buy 200 shares of a $100 stock, you will need to put up $20,000 plus any transaction fees. Now if you were a call buyer you would need you could buy two call options, which would give you 200 shares, and still have the flexibility to either exercise those contracts when the option expires, or sell the contracts back for premium. Either way you slice it, a call option transaction is usually a more affordable way to start a position than buying shares at the prevailing market price.

Options Trading Has Much Higher Potential Returns

This is usually what attracts new traders to options trading in the first place. Less upfront investment for greater potential returns? All I have to do is correctly predict which direction the share price will move? Piece of cake! Remember, if we could all predict what the market is going to do, we would all be millionaires. The truth is if you want to YOLO into some way out-of-the-money calls, you will eventually hit on one of them. But for the most part, this trading strategy is going to clear your account faster than you can fill it. The potential gains are massive, but using safer spread strategies is always a more profitable method over the long term. Always remember to live to trade another day!

Options Trading Can Mitigate Risk If Done Properly

Options trading seems to get a bad reputation for being a risky way to play the stock market. I’ll tell you right now that when done correctly, options trading can be far less risky than trying to buy or sell stock and timing the market. Financially, if you trade options the worst that can happen is you lose the premium paid for the contract. If a share price plummets on sudden bad news out of the company, you are left holding a position at a loss. Option contracts are also the perfect hedge to owning the underlying security, especially if you want to lock in a profit at a certain price. This is certainly one of the strategies used by institutional investors, but I will talk more about hedging with options a little later on.

American Style Options vs. European Style Options

Wait, there’s a difference in how option contracts are traded in different parts of the world? Yes, there is one main difference between the two types, albeit a subtle one. In the United States, options traders are free to exercise the stock options at any point before the expiration date of the contract. In Europe, however, the stock option cannot be exercised until the expiration date of the contract. So all European option contracts have a specific expiration date which is the third Friday of every month, which is similar to the Option Expiry or OPEX dates we have for the American markets. You can certainly see how traders would have a much different strategy for options trading in Europe, and also why they are far less popular than they are in the United States.

Option Contracts as a Hedge

Countless strategies can use options contracts as a hedge in your portfolio, but I won’t go over them all here. Why would options contracts act as a hedge? Think about owning a position in any stock on the market. The worst thing that can happen while owning actual shares of a company is that the share price falls. But what if there were some way to profit off of that stock price falling? Enter the put option, one of the simplest ways to hedge positions in your portfolio.

The Art of the Put Option

Buying put options with a strike price that is either at or slightly below the current share price, you can earn a premium on that contract if the share price falls. If the price rises, then you have lost out on a small premium, but the position you hold in your portfolio rises. It’s essentially a win-win situation and buying these long-term put options can certainly help to mitigate the downside of the stock. If you continue to sell that put contract and re-purchase a newer one, you are rolling the put options forward which acts as the perpetual hedge to your account.

There are many other ways you can use options contracts as a hedge to your portfolio holdings, and buying put options is just one of the simpler ones to implement. Remember, you do not have to sell any underlying asset to profit off of an options contract. Some options traders will sell calls to generate additional income for their portfolios. I hope you are starting to see how flexible options contracts can be, and why I think they are not utilized enough by traders.

The Risks Associated with Investing In Options Contracts and How to Manage Them For Success!

At the end of the day, options trading is still trading and nothing is guaranteed on the stock market. Anytime you invest your own hard-earned money into the market, there is a risk of something going sideways. It is widely believed amongst newer traders that a stock’s price generally only goes up over time. This leads to a lot of new options traders focusing only on buying call options.

Time Decay and the Greeks

If you have traded options, you probably already know about things like time decay and the Greeks. This topic can take up another article unto itself, so I won’t go into too much detail here. The gist of it is, time value decay is something that every options trader needs to take into account before buying or selling a contract. The premium of the contract does not stay static at a fixed price until expiration. This means you will see a lot of volatility as the price of the underlying security fluctuates. The closer you get to the expiration date without the contract being in-the-money, the faster the premium will head to zero.

Do Your Research

Like with anything in the financial industry, options trading isn’t something to just jump into with two feet. Without taking the time to do some research and educate yourself on the process you might find yourself quickly burning through your funds. Options are considered derivatives and are not as straightforward as trading stocks or other investments like real estate transactions.

Choosing the Right Brokerage

The fact is not every trading brokerage is ideal for trading options. You will want to ensure that the brokerage you use will allow you to utilize advanced options strategies and not just the basics. If all you can do is buy or sell calls and puts, then you might want to find another brokerage. Most platforms these days will require you to apply to be an options trader. Some previous experience is preferred. Sites like Robinhood limit your ability to use advanced options strategies and will use things like account balance and the number of trades made to determine who has access to these strategies. If you want to protect your funds and trade options effectively, it’s best to ensure you have full access to trade all types of options.

How Do I Determine the Best Option Price?

So now that you have done your research on options contracts and are ready to trade them, how do you determine the option’s price? You have to take a lot of factors into account when trading options, not the least of which are:

  • The strike price
  • The date the option expires
  • The past and present price of the underlying security
  • Current interest rates if you are trading with leverage on margin

I’m not going to tell you what the best way to determine options pricing is as it is up to your personal risk tolerance and investing goals. You might think a set strike price is too expensive, while I might think it is perfect for the trade. Your goal for trading options might be to just earn income on premiums while I might be looking to sell shares of the underlying security after I exercise when the option expires.

I will tell you that the more knowledge you have the better. Learning things like technical analysis and reading stock charts can help predict patterns in a stock’s behavior. You should also be aware of other catalysts that might affect your options contracts. These include but are not limited to the following:

  • Company earnings reports
  • Options Expiry weeks
  • Quad-witching dates
  • Reports on the economy from the Federal Reserve or other agency
  • Upcoming company-specific events like reports on a clinical study

Conclusion: Options Contracts

Options sometimes get a bad rep around the financial industry. In my opinion, they are just misunderstood. Personally, I love trading options contracts when I use the correct strategies that might cap my upside, but more importantly, limits the downside. Rather than spending the entire day staring at charts and screeners, trading options contracts can be a passive way to trade and only requires a few minutes every day. This makes options trading one of the most efficient and stress-free ways to trade on the stock market!

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