How Options Work: A Basic Guide

Most people are relatively familiar with basic financial instruments like stocks and bonds. While these are the most accessible products, they are not the only option available to investors looking to make outsized returns.

There is a whole other class of investment products, called derivatives, that are available to you to grow your wealth.

Derivatives are financial products whose price is derived from the price of another underlying financial instrument, such as a stock or bond. Derivatives are usually considered as leveraged instruments.

This means you only need a small amount of capital to have a large exposure to the underlying asset. However, do note that if you incur a loss, it can be greater than the amount you put in for the trade. That’s because you’re borrowing money from the broker to temporarily make up the difference before you close your position.

On the other hand, the potential upside when trading derivatives is much greater than when trading stocks and bonds. That being said, investors who choose to invest via derivatives are advised to do so with caution as greater potential rewards also come with greater potential losses, as mentioned above.

Options are one type of derivative, and they’re also the most commonly traded derivative among retail investors. Below, we have prepared a simple explanation of the different types of options and how they can be used by savvy investors.

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Table of Contents

• Option Trading Basics
• Call Options
• Put Options 
• More on Buying Options
• Benefits of Trading Options
• Conclusion

Option Trading Basics

An options contract gives investors the option, but not the obligation, to buy or sell an asset at a predetermined price and date.

An option that gives an investor the right to buy an asset is known as a call option, whereas an option that gives an investor the right to sell an asset is known as a put option.

Options Investing Jargon

Here’s a list of terms that are crucial for you to know as you pick up options trading:

• Premium – The price that you must pay to acquire the option itself and is on a per-share basis
• Exercise/Strike Price – The price the option holder will pay or receive for the underlying asset if they decide to exercise their right to buy or sell it
• Expiration Date – The last day on which you can exercise your option to buy or sell the underlying asset
• In the money – Options are said to be in the money when they have a positive payout for the holder
• Out of the money – Conversely, options are out of the money when they have a negative payout for the holder. I.e., the trader loses money when they buy or sell the option.
• At the money – When an option has a $0 payout for the holder. I.e., they don’t gain or lose any money when they exercise their right to buy or sell it.
• Long – When you buy an option. In other words, you’re going long on it.
• Short – When you sell an option. In other words, you’re shorting it.
• American Options – This type of options allows the holder to exercise their right on or before the expiration date
• European Options – This type of options allows the holder to exercise their right only on the expiration date

One more thing to note is that you typically have to buy options in lots of 100 shares of the underlying asset. For simplicity’s sake, we’ll assume that we are trading an option for one share of the underlying stock in the examples below.

What Are Call Options?

As mentioned above, a call option gives its holder the right, but not the obligation, to buy a financial asset at a predetermined price by a predetermined date. Investors can both buy and sell (or “write”) an call option.

Buying a Call Option

Let’s say you buy a call option for Company A. Its strike price is $60, its premium is $10, and the expiration date is one month from today.

Soon after buying this option, Company A’s stock price rises to $75. You then decide to exercise your option. Since the call option you have is “in the money”, you can now pay $60 to buy a stock that is now worth $75. Therefore, you earn a profit of S$15.

After subtracting the $10 premium you had to pay when buying the option, your total profit comes out to $5.

Conversely, what if Company A’s stock price drops instead? If it drops to $50 for example, you can choose not to exercise the call option because it is “out of the money”. After all, you wouldn’t want to spend $60 to buy something that you can now get for $50. In this case, you would’ve lost the $10 premium you initially paid.

Also, do note that because the option’s expiry date is a month from now, you still have time to analyse Company A’s stock price and exercise your option at a better time. You don’t have to close your position at a loss.

Selling or Writing a Call Option

You can also sell (or write) a call option. In doing so, you are essentially selling someone the right to buy a stock at a certain price. For instance, you could write a call option for Company A, with an exercise price of $60, a premium of $10 and an expiration date one month from now.

On the expiration date, if Company A’s stock has declined to $45 per share, the buyer will not exercise the option since the option is out of the money. You, the seller, consequentially will make a profit of $10 from the premium you charged when selling the call option.

It is important to note that as a writer of a call option, you have an unlimited downside if the stock increases in value. Remember, your profit depends on the buyer of your option not exercising it.

For example, if Company A’s stock price rises to $80 from $60, the call option will now be in the money. If your buyer chooses to exercise the option, as the seller of the options contract, you are obligated to sell the stock to the buyer at the strike price. Do note the difference from buyers of options who have the right but not the obligation to buy the underlying asset.

This now means you will have to buy the stock for $80 and sell it for $60 to the buyer of your option, which nets you a S$10 loss, after accounting for the S$10 you make from the option’s premium.

This loss can increase infinitely if Company A’s stock price continues to rise. In the graph above, we can see that the call option writer turns a profit only when the stock price is below the exercise price plus the premium charged ($70 in this case).

What Are Put Options?

A put option gives its holder the right, but not the obligation, to sell an underlying asset at a predetermined price and date. Like a call option, an investor can either buy or sell (“write”) a put option.

Buying a Put Option

Let’s say you’re buying a put option for Company B’s stock. It has an exercise price of $45, a premium of $15, and an expiration date that’s one month away.

Company B’s stock price drops to S$25 the week after you buy the put option. In this case, exercising your option will yield a profit of $5 because you can buy a stock for $25 and use your option to sell it at $45 ($45 – $25 – $15 = $5).

If the price of Company B’s stock increased instead, then it wouldn’t make sense to exercise your option. For example, if its stock price increases to $55, you wouldn’t want to sell the stock for $45 as you’d be making a loss.

Selling or Writing a Put Option

Just like a call option, you can also sell (or write) a put option.

Let’s assume you sell a put option for Company B for a premium of $15, a strike price of $45 and an expiration that’s a month away. If Company B’s stock price increases to $50, you’ll turn a profit on the put option.

The buyer will not choose to exercise the option and sell the underlying asset since the option is out of the money. You then get to profit from the $15 premium.

If the price of the stock declines, however, your potential loss can be large. This is akin to selling a call option. Let’s say Company B’s stock price declines to S$30. Since this is $15 below the exercise price, you would lose a total of $0 ($15 minus the $15 premium).

However, if Company B’s stock price falls even further, you would be in the red as the premium would not be enough to offset the difference between the stock price and the exercise price.

Although they appear to be similar, one key difference between selling put options and selling call options is that the downside to selling a put option is not limitless, unlike selling a call option.

While the price of a stock could hypothetically increase infinitely, the price of a stock can at the very most drop to $0. Thus, as a seller of a put option, you are able to anticipate your maximum potential loss. That said, you do need to implement proper stop-loss and take-profit levels when you’re trading any asset, not just options contracts.

More on Buying Options

When buying an option, you need to consider a few factors apart from the exercise/strike price. These include:

1. The option’s duration
2. The option’s premium
3. How the underlying stock price will behave

As a rule of thumb, the longer the maturity of an option, the higher its premium. As the duration until the options expiration date lengthens, the uncertainty about how the price of the underlying asset can change increases.

This then translates to greater risk for the seller of the options contract. As such, the writer of option would demand a higher premium to take on that risk. For example, it’s much easier for a stock to rise from $100 to $500 over five years as compared to 10 days.

The price gap between the exercise/strike price and current stock price will also impact the premium you pay. For example, you want to buy a call option for a stock which currently costs $50. It will be more expensive to buy an option with an exercise/strike price of $51 than to buy an option with a strike price of $60. That’s because the chance of the stock hitting $51 is almost guaranteed because of how small the price difference is.

As a buyer of an options contract, you can calculate your profits, barring any broker’s fees, according to these formulas:

• Call Options Profit: Price of Underlying Asset – Exercise Price – Option Premium
• Put Options Profit: Exercise Price – Price of Underlying Asset – Option Premium

As an example of how the call options profit formula would work, let’s use the following figures. Company X’s stock price is $100, the price you can exercise your contract at is $50, and the option premium is $30. Your profit would therefore be $20 ($100 – $50 – $30).

What Are Some Benefits of Trading Options?

It’s crucial to have a clear understanding of how options can add value to your investment plan before you actually start trading them. With that said, here are two common benefits of trading options:

Risk Management

One of the main reasons investors trade options is to manage risk. Owning an option of a stock and owning the underlying stock itself comes with very different risks and returns. Buying a call option gives the buyer greater upside while simultaneously limiting the downside as compared to buying the underlying stock.

At the same time, if the stock price goes down, you will limit your loses to only the premium you paid to buy the options contract.

Lets illustrate this with an example: Assume a stock has a price of $40. You can buy a call option for the underlying stock with a strike price of $45 for a premium of $5. If the stock price drops to $20, the stockholder will lose $20 on a $40 investment (-50%). On the flip side, an option trader will only lose the $5 premium they initially paid for the call option (-100% of initial investment).

However, if the stock price rises to $60 instead, the stockholder would have made $20 on a $40 investment (+50%), while the call option holder would’ve earned $15 ($20 price increase – $5 premium) on their $5 investment (+300%).

Your loss when trading options is also defined unless the stock moves in your desired direction before the options expiration date. When you own the underlying stock, you have the luxury of waiting indefinitely for its price to recover.

Potentially Higher Returns

As alluded to in the example above, another benefit of trading options is that your returns can be higher than spot trading the underlying stock itself. Remember, with margin/leverage trading, your upfront capital is smaller. At the same time, you gain full price exposure to the underlying asset. Because your capital used for the trade is lower, your potential profits would naturally be greater.

This is especially impactful should the underlying stock move substantially before the expiration date. Your profits are magnified even further. However, the potential for losses can be higher too. That’s where you’ll need to rein in your fear and greed, and trust your fundamental and technical analysis.

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In Closing

Options is a useful tool for investors looking to diversify their portfolio and add a new tool to their trading arsenal. However, because of the leveraged nature of this financial derivative, it’s important to manage your risk carefully when trading it. You can always start with a demo account on a trading platform first, before moving onto live trading.

Additionally, because options will always have an expiry date, you don’t have the same luxury of time as holding the underlying asset. As an investor, you need to ensure the options you’re trading complements your portfolio, whether to magnify returns or to hedge against unrealised losses.

Investing and trading are never easy, but taking the time to do your research and carefully prepare can allow you to fully optimise the capital you deploy. Check out our investment archives today for all the tips you need to make wise investing decisions.

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