07 August 2015

Trading Stock Options: How does option trading work?

Learn the basics of options trading with Saxo Capital Markets UK.

​​​​​​​​​​​​​​​​​​Options Defined

An option is a contract to buy or sell a specific financial product officially known as the option’s underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange-traded fund (ETF), or similar product. Options come in two varieties, calls and puts, and you can buy or sell either type. You make those choices — whether to buy or sell and whether to choose a call or a put—based on what you want to achieve as an options investor.

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​The value of Options Contracts

What a particular options contract is worth to a buyer or seller is measured by how likely it is to meet their expectations. In the language of options, that’s determined by whether or not the option is, or is likely to be, in-the-money or out-of-the-money at expiration. A call option is in-the-money if the current market value of the underlying stock is above the exercise price of the option, and out-of-the-money if the stock is below the exercise price. A put option is in-the-money if the current market value of the underlying stock is below the exercise price and out-of-the-money if it is above it. If an option is not in-the-money at expiration, the option is assumed to be worthless. An option’s premium has two parts: an intrinsic value and a time value. Intrinsic value is the amount by which the option is in-the-money. Time value is the differenc​e between whatever the intrinsic value is and what the premium is.​The longer you wait for market conditions to work to your benefit, the greater the time value.

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Other Options

While the most popular options are those offered on individual stocks, ETFs, and stock indices, contracts are also available on limited partnership interests, American Depository Receipts (ADRs), American Depository Shares (ADSs), government debt securities, and foreign currencies. Many debt security and currency options transactions are initiated by institutional investors. More recently, retail investors have begun to trade cash-settled foreign currency options.

On which securities are Options offered?

Options aren’t listed on every stock, and each exchange doesn’t list every available option. The US Securities and Exchange Commission (SEC) regulates the standards for the options selection process, and beyond that, exchanges can make independent decisions. There are some rules, though. On every options exchange, a stock on which options are offered must:

 

  • Be listed and traded on the National Market System for at least three months. 
  • Have a specified minimum number of shareholders and shares outstanding. 
  • Have a specified minimum average trading price during an established period of time. 

 

In addition to those minimum qualifications, stocks are chosen based on the stock’s volatility and volume of trading, the company’s history and management, and perceived demand for options.

How does option trading work?​

Every option contract is defined by certain terms, or characteristics. Most listed options’ terms are standardized, so that options that are listed on one or more exchanges are fungible, or interchangeable. The standardized terms include:

 

  • Contract size:For equity options, the amount of underlying interest is generally set at 100 shares of stock.
  • Expiration month: Every option has a predetermined expiration and last trading date.
  • Exercise price: This is the price per share at which 100 shares of the underlying security can be bought or sold at the time.
  • Style: Options that can be exercised at any point before expiration are American style. Options that can be exercised only on the day of expiration are European style.
  • Type of delivery: Most equity options are physical delivery contracts, which means that shares of stock must change hands at the time of exercise. Most index options are cash settled, which means the in-the-money holder receives a certain amount of cash upon exercise.

 

​Buying and selling

If you buy a call, you have the right to buy the underlying instrument at the strike price on or before the expiration date. If you buy a put, you have the right to sell the underlying instrument on or before expiration. In either case, as the option holder, you also have the right to sell the option to another buyer during its term or to let it expire worthless. The situation is different if you write, or sell, an option, since selling obligates you to fulfil your side of the contract if the holder wishes to exercise. If you sell a call, you’re obligated to sell the underlying interest at the strike price, if you’re assigned. If you sell a put, you’re obligated to buy the underlying interest, if assigned. As a writer, you have no control over whether or not a contract is exercised, and you need to recognise that exercise is always possible at any time until the expiration date. But just as the buyer can sell an option back into the market rather than exercising it, as a writer you can purchase an offsetting contract and end your obligation to meet the terms of the contract.

Buying Options at the premium

When you buy an option, the purchase price is called the premium. If you sell, the premium is the amount you receive. The premium isn’t fixed and changes constantly—so the premium you pay today is likely to be higher or lower than the premium yesterday or tomorrow. What those changing prices reflect is the give and take between what buyers are willing to pay and what sellers are willing to accept for the option. The point at which there’s agreement becomes the price for that transaction, and then the process begins again. If you buy options, you start out with what’s known as a net debit. That means you’ve spent money you might never recover if you don’t sell your option at a profit or exercise it. And if you do make money on a transaction, you must subtract the cost of the premium from any income you realise to find your net profit. As a seller, on the other hand, you begin with a net credit because you collect the premium, if the option is never exercised, you keep the money. If the option is exercised, you still get to keep the premium, but are obligated to buy or sell the underlying stock if you’re assigned.

LEAPS®

Long-term Equity AnticiPation SecuritiesSM, or LEAPS, are an important part of the options market. Standard options have expiration dates up to one year away. LEAPS, however, have longer expiration dates, which may be up to three years away. LEAPS are traded just like regular options, and each exchange decides the securities on which to list LEAPS, depending on the amount of market interest. In the US about 17% of all listed options are LEAPS. 

LEAPS allow investors more flexibility, since there is much more time for the option to move in-the-money. At any given time, you can buy LEAPS that expire in the January that is two years away or the January that is three years away.

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Exercise and assignment

Most options that expire in a given month usually expire on the Saturday after the third Friday of the month. That means the last day to trade expiring equity options is the third Friday of the month. If you plan on exercising your options, be sure to check with your broker about its cut-off times. Brokers may establish early deadlines to allow themselves enough time to process exercise orders. When you notify your broker that you’d like to exercise your option:

 

  1. Your broker ensures the exercise notice is sent to The Options Clearing Corporation (OCC), the guarantor of all listed options contracts.
  2. OCC assigns fulfilment of your contract to one of its member firms that has a writer of the series of option you hold.
  3. If the broker has more than one eligible writer, the broker allocates the assignment using an exchange-approved method.
  4. The writer who is assigned must deliver or receive shares of the underlying instrument—or cash, if it is a cash-settled option.​

The above applies for US listed Stock Options only.

NOTE: Exercising options​ - OCC employs administrative procedures that provide for the exercise of certain options that are in-the-money by specified amounts at expiration on behalf of the holder of the options unless OCC is instructed otherwise. Individual brokers often have their own policies, too, and might automatically submit exercise instructions to OCC for any options that are in-the-money by a certain amount. You should check with your broker to learn whether these procedures apply to any of your long positions. This process is also referred to as “exercise by exception.”

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The value of your investments can go down as well as up.
Losses can exceed deposits on margin products. Please ensure you understand the risks.