Options Basics
What is Options Trading?
In the financial markets, options refer to contracts that offer the right — but not the obligation — to buy or sell an asset at a later date for a predetermined price. Options are binding contracts with a strict set of clearly defined terms, and they can be used by investors for a wide variety of reasons. At first, options might seem difficult to understand. But the reality of that options scenarios occur regularly in our daily lives.
Practical Example
Imagine, for example, that you are looking to buy a new home. You find a house that meets all of your requirements, but it is slightly out of your current price range. You arrange a deal with the homeowner to buy the house in six months once you have accumulated additional cash funding. The agreed upon contract allows you to purchase the home for $250,000, six months from now. For this contract, the homeowner asks for a payment of $5,000 in the event that you decide not to purchase the house in six months.
In a scenario like this, there are two potential outcomes that might be seen. First is that the value of the house increases during the six month waiting period. To illustrate this, let’s assume the value of the house rises to $300,000. This is a clear positive from the perspective of the home buyer, as the initial contract locked in a purchase price of $250,000. The home buyer would then benefit from actually purchasing the home, as there is an initial profit of $45,000 ($50,000 minus the $5,000 contract fee). The home buyer would then want to exercise the option to buy, and complete the purchase for $250,000.
In the alternate scenario, imagine that the house decreases in value to $200,000 in the six months after the contract is drafted. Here, it would not make sense for the buyer to spend the $250,000 required to buy the home because it is no longer worth the same amount of money. In this case, the potential home buyer could walk away from the deal and allow the contract to expire worthless. There would be a loss of the $5,000 needed to purchase the original contract — but that is much better than the $50,000 that would be lost if the potential home buyer would have acted on the option.
Options Planning
In this example, we can see that an option can work in multiple directions depending on how the financial environment changes. Buying an option does not mean that you will be required to buy the asset associated with the contract. You have the right to buy or sell the asset (depending on the type of option that you buy). But this is in no way a requirement to execute the transaction. If you choose to let the option expire worthless, you will simply lose the amount of money that was initially needed to buy the contract. In this way, an option is simply a contractual agreement — and not the asset itself. This is why options are also referred to as derivatives, as the option contract derives is worth from another asset. In the example above, the asset was a house. In other cases, the asset might be a stock, a commodity or a currency.
Key Terminology
When you are considering buying an options contract, it is important to have a firm understanding of the key terms involved. In the example above, the agreed price for the home is $250,000. In an options contract, this would be referred to as the strike price. This is the price at which the contract holder can buy or sell the asset at a later date. The date marking the end of the options contract is referred to as the expiration date. In this example, the cost of the contract was $5,000. When trading options, this would be referred to as the premium.
Premium prices are not the same for all options contracts. Prices will change based on the type of asset being traded, the level of volatility that is seen in the broader market, and the expiration time. There are many factors that go into the pricing of an option — and it would be impossible to address all of those issues in this article. But it is important to know exactly how much your option contract will cost before you buy it. This is essentially the amount of money you will forfeit if you choose not to exercise the contract before its expiration time.
Options Exchanges
Options are often traded through national exchanges. The largest options exchange is the Chicago Board Options Exchange (CBOE), but there are many other national exchanges that offer options trading. When options are traded through these exchanges, they are referred to as listed options. There are some advantages when this method is used, as listed options might have fixed strike prices and expiration dates for specific assets. But there are many brokerage choices available now for those looking to begin in options trading. So traders are not required to use these exchanges in order to gain exposure to the options market.
Calls Vs. Puts
Those with some familiarity in trading the financial markets probably understand that there are two broad ways of profiting from speculative positioning: buying and selling. If you buy a stock at one price and then sell it back at a higher price, a profit is made. If you sell a stock at a high price and then buy it back at a lower price, profits can also be made.
Options markets work a bit differently, but the same general idea applies. When trading options, the two most basic strategies are referred to as “calls” and “puts.” Here, we will discuss the differences between these two strategies and outline ways options traders can use each approach to capture profits in the financial markets.
Call Options
In options markets, those looking to express a positive (or bullish) view on an asset will consider using call options. A call option is a financial contract that gives an investor the right — but not the obligation — to buy an asset at a specific price at a predetermined date in the future. An investor that holds a call option is similar to an investor that holds a long position in the stock market. In order to profit from a call option, the value of the underlying asset will need to rise before the contract expires. If this does not occur, the investor will allow the contract to expire worthless. In this case, losses will be equal to the cost of the options contract itself.
Put Options
Those looking to express a negative (or bearish) view on an asset will consider using put options. A put option is a financial contract that gives an investor the right — but not the obligation — to sell an asset at a specific price at a predetermined date in the future. An investor that holds a call option is similar to an investor that holds a short position in the stock market. In order to profit from a put option, the value of the underlying asset will need to fall before the contract expires. If this does not occur, the investor will allow the contract to expire worthless and losses will be equal to the cost of the options contract.
Market Participants
Market participants in the options realm can be divided into four separate categories: buyers of calls, sellers of calls, buyers of puts, and sellers of puts. When you buy a call or put option, you are referred to as the holder of the option. When you sell a call or put option, you are referred to as the writer of the option.
Option buyers have established long positions, while option sellers have established short positions. When dealing with options, there are some key differences between buyers and sellers. Investors that buy calls or puts have no obligation to buy or sell any asset. Buying a call or put option only implies the purchase of the right to buy or sell at a later date. If the buyer chooses not to exercise that right, the options contract expires worthless. In contrast, option writers (sellers) do have an obligation to buy or sell an asset if the buyer chooses to exercise the option. It is important to understand that all options contracts have two different sides and that the obligations for both sides are not the same. Generally speaking, selling options contracts is associated with larger risk levels. So, it is often recommended that new options traders focus on buying options rather than selling them.
Options Profitability
When we look at profitability in the options market, there is some added terminology that must be understood. When an option is in-the-money, it means that profits have started to accumulate in the position. When an option is out-of-the-money, it means that losses have started to accumulate in the position. When an option is at-the-money, it means that market prices are currently trading at the strike price, and that no profits or losses are being seen.
If you are buying a call option, your trade is in-the-money when market prices have risen above your strike price. If you are buying a put option, your trade is in-the-money when market prices have fallen below your strike price. When buying a call option, your trade is out-of-the-money when market prices have fallen below your strike price. When buying a put option, your trade is out-of-the-money when market prices have risen above your strike price. The degree to which your trade is in-the-money (profit) or out-of-the-money (loss) is referred to as the intrinsic value of the trade.
With all of this in mind, it becomes clear that the options market is largely dual in nature. Do you have a positive stance on an asset, and do you believe its value will rise in the future? If so, call options are the best choice. Do you have a negative stance on an asset, and do you believe its value will fall in the future? If so, put options are the best choice. In this way, most of the attention in the options market is devoted to whether a trader should be dealing with calls or put when establishing a position.
Choosing a Broker
Nowadays, options traders have many choices available when selecting a brokerage company. But there are positives and negatives here that come with all of these choices. On the positive side, these brokers are competing for your business and this forces them to offer additional services that might not otherwise be available. On the negative side, options traders will have to assess the quality of many of these companies in order to decide which broker is most appropriate. Here, we will look at some of the most critical factors to consider when choosing a broker that will allow you to access the options market.
Competitive Trading Costs
The first factor to consider is the cost of trading that will be charged in each position. Your broker is offering you access to the options market, and this does create costs for the company that must be paid. But not all options brokers charge the same fees when you establish a position. Generally speaking, options brokers will charge a flat see for each trade and then a smaller added cost for each contract in the position.
For example, an options broker might charge a $7.95 flat rate for each trade and then charge $1.25 for each contract in the position. In this way, larger position sizes will incur larger trading costs. If is always important to find a broker that offers competitive pricing — but only if the cheaper broker offers all of the essential services you will need when you are trading. In some cases, lower trading costs are offered for a reason and those brokers will have deficiencies in other areas of the company. The expression “you get what you pay for” does apply here, so the cheapest broker will not always be the best choice.
Intuitive Trading Platform
The next factor to consider if the trading platform that is offered by the broker. The trading platform is the main tool you will be using when you are placing your trades. So, it is important to have a software package that is intuitive, efficient, and easy to use. This is especially true for traders that use short-term strategies or place trades after news events. In these cases, options traders will not have much time to execute positions. Mistakes can always occur (ie. clicking to buy a CALL option when you meant to buy a PUT option), and these can be costly if they occur on a regular basis.
When looking at a broker’s trading platform, pay special attention to the charting package that is being using and in whether or not the application is available for mobile devices. If you are looking to employ technical analysis strategies, access to a well-designed charting package is critically important. There can be a great deal of differences in the charting software offered by different brokers. So you should never deposit any money into an options trading account until you have tested the charting package and made sure that it includes the indicators and price features you will be using regularly.
Access to Updated Market Research
The financial markets move very quickly in the digital age — and it is always important to have access to relevant news sources and updated market research. Many of the biggest options brokers are very good in terms of the updated news and research that is made freely available. This information can be vital when you are looking to construct your market outlook for a specific asset. Without updated news and research options traders are essentially “driving at night with no headlights.” There is really no excuse for this in modern trading as any decent broker will have these features freely available for its traders.
Many options traders will focus their attention on specific markets (ie. stocks, commodities, or currencies). So when you are assessing the news and research facilities offered by a broker you will need to make sure that the information is relevant to the type of asset that you expect to be trading on a regular basis. Some brokers might offer analyst research that is better suited to trading some asset types rather than others. Always make sure that the information you are getting is going to actually help you gain an edge on the rest of the market.
Responsive Customer Service
Last, make sure your broker offers easy access to customer service. This is especially critical for traders that are still in the early phases of their careers. There is nothing worse than having a question about a real-money trade and not having access to customer service. In addition to phone and email, brokers should offer access live chat representatives that are able to fully answer your questions about how to execute and monitor your trades. Make sure to take advantage of these resources, as there is no such thing as a dumb question — especially when your hard-earned money is on the line in an options trade. Many of these chat services offer access to well-informed representatives that are able to offer help with a wide range of trading issues.
All of these factors are of high importance for options traders looking to find an options broker. This is a part of the trading process that cannot be overlooked, and there can be significant differences when comparing individual companies. So exercise patience and remember that if one broker does not fit all of your needs, there are always more choices available.
Is Options Trading Risky?
Anytime a trader is looking to tackle a new investment, there are a few questions that should be asked before any other decisions are made: Is this a risky investment? How much money do I stand to lose if things go wrong? Are there other markets that offer more better protection for my assets?
Of course, these questions are somewhat difficult to answer. But if you fail to take any assessments in these areas, the outcome is unlikely to turn out well. So, what are the risks for those trading in options? Is the options market riskier than other financial endeavors? Here, we will look at some of these issues so that new traders have a better understanding of the risks involved when trading in options.
Potential for Risk and Reward
In any investment, there are inherent risks involved. Any time there is the potential for profit, there is the potential for loss. These facts represent two sides of the same coin — and you cannot have one without the other. So if you are looking for a totally riskless activity, then options trading is not for you. But there are arguments that can be made with support the assertion that options trading is actually less risky than many other forms of investment. The reason for this stems from the fact that in certain types of options trading, your maximum losses for every trade are known right from the start. This is not something that can be said for investments like traditional stock investing or the buying and selling of physical commodities.
Options traders can capture some key advantages in this regard. When you buy an option, your maximum losses will be equal to the premium paid as the position was initially opened. This applies for both calls and puts, and your maximum losses will not increase even if markets become excessively volatile. So when you buy an option, you are able to plan out your potential for risk in a relatively easy fashion. This is one of the reasons many traders gravitate toward options in the first place, as it can be much more predictable when compared to other, more traditional, forms of investment. As an example, think about a stock investor that buys shares in a company that later goes bankrupt. That trader might lose all of the initial investment, as the asset eventually becomes worthless. When you are buying options, the worst thing that can happen is that the option expires worthless. Losses in this case would be equal to the initial premium, rather than in the equal to the differences in price that are seen at the beginning and end of the trade.
Option Selling
Options buyers have much less inherent risk when compared to options sellers. Option sellers are vulnerable to volatile price changes in the market if the option buyer chooses to exercise the option at the expiration date. Remember, options sellers are obligated to execute the trade if the option buyer makes that choice. The option buyer is under no obligation to do anything at the time of expiry. So, the two roles are very different — and this is why many expert traders argue that option selling should not be undertaken by traders with less experience. There are tactics that options traders can use in order to limit the potential for risk (ie. hedging the position). But this involved additional steps that might be too complicated for beginner traders.
Leveraged Trades
Additional risks can be seen when traders open positions using leverage. As retail trading becomes more and more popular, many options brokers have made it easier for traders to establish large positions with a relatively small cash outlay. This increases a trader’s potential for gains, but it also increases the trader’s potential for loss. For these reasons, it is generally a good idea to keep leverage levels to a minimum. Just because your broker allows you to place a large trade, it does not mean you need to take the bait and maximize the size of your position. When used conservatively, leveraged trades can be an incredible tool for generating profits. But when leverage is overused, traders become vulnerable in ways that are unnecessary and avoidable. This is especially true for options traders that are starting with small account sizes.
These are some of the factors involved when assessing the level of risk in the options markets. In some ways, options trading is actually much safer than many other forms of investment. For conservative traders that want to know exactly how much money is at risk in any given trade, buying options is an excellent strategy. More experienced traders looking to sell options encounter a higher level of risk — but even these risks can be mitigated through hedging strategies. No investment should ever be undertaken unless risk levels can be accurately assessed and (hopefully) limited. Without this, unexpected losses can quickly debilitate a trading account.
Fundamental Analysis in Options Trading
In order to start investing in any of the financial markets, you will need some way of assessing where market prices are likely to travel next. This can be done in a number of different ways, but the two most common methods used by options traders are technical analysis and fundamental analysis.
For beginning traders that are well-versed in news reports and economic data, fundamental analysis is generally the best approach as these are skills that will be needed in order to create accurate forecasts. Once this is accomplished, trading ideas can be constructed and active positions can be established. Here, we will look at some of the ways options traders use fundamental analysis to assess the market and create an outlook that can be used in trading.
Creating an Outlook
Options trading requires us to establish a positive or negative stance on an asset — and then to express that view through calls and puts. When fundamental analysts are determining which stance is most appropriate, they will assess the relevant economic factors that could change an asset’s price (positively or negatively) in the future.
These factors are going to be different, depending on which asset is being traded. For example, those trading stock options will want to watch for upcoming earnings reports or new product lines that could bring added attention to the company. If Apple, Inc. is ready to release its new iPhone or iPad, valuations in the stock are likely to be influenced. If sales for its new product are strong, this will help boost quarterly earnings for the company and send the stock price higher. This would be an excellent scenario for options traders to start buying call options in AAPL. If sales are weak, the outlook would turn negative, and this would be a good environment to start establishing put options in AAPL.
Separating Asset Classes
In other asset classes, different factors will be considered market-moving. For example, those trading currency options will want to watch macroeconomic data reports, inflation, and changes in financial policy or interest rates. All of these are factors that could inspire the market to start buying or selling a specific currency, and this is price volatility that can be used to generate profits if accurately anticipated. Financial events or data reports that show strength in the country’s economy will likely cause binary options traders to purchase call options in that currency. Evidence of economic weakness will make put options in that currency much more attractive.
The commodities market has its own set of relevant criteria. For example, those trading options in gold or oil will want to watch inventory reports that show the level of supply that is currently available in the market. Falling supply levels tend to be bullish (positive) for market prices because consumers will need to pay more for these commodities in order to outbid their competitors. In this type of environment, options traders would want to consider buying call options. When supply levels are increasing, it is usually bearish (negative) for asset prices. In this case, it would make more sense for binary options traders to consider put options.
When fundamental analysts are trading in currencies and commodities, it is critically important to watch for events that could impact market demand in the future. When an options trader is looking to establish a position in oil, this could mean paying greater attention to consumer sales numbers or geopolitical events that might change valuations for that commodity. There is no hard and fast rule for which events will be most important, or whether an event will cause prices to rise or fall in the future. For this reason, it is essential for options traders to have a broader understanding of the context dictating price direction for whichever asset is being traded. This takes some time to develop, but if you actively monitor market news on a regular basis it will become much easier to forecast how a news event might influence prices going forward.
Watching the Economic Calendar
Most of the information that is watched by fundamental analysts is made publicly available, and these traders are able to use economic calendars to find out when this data will be released to the market. There are many different sites that offer free economic calendars, and one example can be found here. Some of the most commonly watched market events by fundamental analysts include:
- Monetary policy meetings at central banks
- Weekly inventory reports
- Corporate earnings reports
- GDP
- Non Farm Payrolls
- CPI and PPI (inflation)
- PMI (manufacturing)
- Retail Sales
This is by no means an exhaustive list of all of the reports that are watched by fundamental analysts. But these are some of the most important events and all are critical for those looking to base trades in options using fundamental analysis strategies. It is also important to watch for geopolitical events that could influence market prices (ie. military conflicts in the Middle East tend to cause volatility in oil prices). Options traders that have at least some understanding of fundamental analysis tend to find it much easier to forecast price direction in market assets. This information can be a highly valuable when placing real-money trades.
Technical Analysis in Options Trading
Most experts in finance tend to agree that options trading truly deconstructs the market and brings it back to the basics. All options traders are trying to determine is whether the market will be rising or falling in the future. No publicly traded asset has a price that remains static — and when price changes are seen, options traders are able to profit from the volatility. But how exactly are options traders able to determine whether the price of an asset is going to rise or fall in the future?
For options traders, the two main approaches are called fundamental analysis and technical analysis. In fundamental analysis, traders mainly watch for economic data and news events that might influence prices. In technical analysis, options traders use price charts to determine the direction of the dominant trend and to identify situations where buyers and sellers are likely to enter the market. This information can be highly useful in generating new trade ideas, and so it is generally a good idea to have some understanding of how each approach works. This helps to avoid missed trading opportunities as they arise.
Here, we will look at the ways options traders use price charts to forecast where market trends might be headed in the future.
Trends, Indicators, and Chart Patterns
As a general rule, technical analysts tend to believe that price trends that occurred in the past are likely to happen again in the future. This assertion has been proven over time, as market backtesting continues to show patterns of repetition in trader sentiment and majority behavior. Three of the terms most commonly used in technical analysis are: trends, indicators, and chart patterns. These terms form the basis of the strategies that are employed by technical analysts.
A trend is simply an assessment of the dominant price momentum that is present in the market. If there are more active buyers than sellers, an uptrend in place and options traders should consider entering into call options for that specific asset. If there are more active sellers than buyers, a downtrend in place and options traders should consider entering into put options. A more detailed explanation of trend analysis can be found in the Options Intermediate section.
Indicators help technical analysts look at price activity in a more objective way. Indicators run price chart activity through a pre-determined formula in order to get a sense of where prices are now relative to their historical averages. When an asset has become too cheap relative to its average, it is much more likely that prices will start rising in the future. This is a good environment to start establishing call options in that asset. If the asset has become too expensive relative to its average, it is much more likely that prices will start falling in the future. This is a good environment to start establishing put options in that asset.
There are many different types of technical indicators, and all of these choices will display its readings in its own unique way. Some of the most common technical indicators for options traders include:
- Relative Strength Index (RSI)
- Moving Average Convergence Divergence (MACD)
- Stochastics
- The Momentum Indicator
- Average True Range
A chart pattern refers to a specific price formation that helps options traders forecast where prices are likely to travel in the future. This might sound like an impossibility. But each of these patterns are based on specific sets of logic that have been tested over time — and have been proven to be highly accurate as forecasting tools. There are many computer software programs that can help binary options traders to identify price patterns as they occur. But this can also be done manually, and this is the approach that is taken by most technical analyst traders.
Chart patterns can be highly useful in determining whether a new trend is likely to begin, or whether an old trend is likely to end. Some of the most common chart patterns include:
- Head and Shoulders / Reverse Head and Shoulders
- Flags
- Pennants
- Wedges
- Double Top / Double Bottom
- Triple Top / Triple Bottom
- Triangles (Ascending, Descending, Symmetrical)
Conclusion
Technical analysis is a very broad topic that could easily fill a textbook on its own. These lists are by no means exhaustive — and there are many technical indicators and chart patterns that could be added as part of the discussion. The main point for technical analysts to remember is that price activity occurring in the past gives clues into what might happen again in the future. This information is highly useful for options traders looking to generate new trading ideas, and it makes it much easier to view market activity in a more objective way.
Which Markets Can I Trade?
When you are starting to trade options, it is a good idea to have an understanding of the varied asset types that are available. The inclination for many beginning options traders is to focus on stocks alone — but there are other choices available that might be better suited to your financial goals and base of knowledge.
In addition to this, there will be circumstances where some asset types are going to be more appropriate than others when certain market conditions are present. When this occurs, it is a good idea to have an understanding of the range of markets that can be traded using options. This helps you keep more tools in your trading toolbox and it exposes more trading opportunities as they become apparent. Here, we will look at the range of commonly traded markets used by options traders.
The most commonly trade assets in the options market are related to stocks. Options traders that are interested in this section of the market can choose to buy contracts in individual companies, or as a collection of stocks listed in an index. Shares in individual companies are delineated according to the symbol used to list the stock on an options trading exchange. Popular examples here include stocks like Exxon Mobil (XOM), Apple, Inc. (AAPL), Johnson and Johnson (JNJ), and General Electric (GE). Of course, there are many more stock choices available and it is usually a good idea to select an options broker that offers many different stocks to trade.
If you have a clear outlook for a specific company, then single stock shares provide a good avenue for options investments. But if you have a broad outlook for the stock market as a whole, it is generally a better idea to consider trading stock indices. Common choices here can be found in the S&P 500, Dow Jones Industrials, FTSE 100, NASDAQ, Nikkei 225, the German DAX, and the French CAC 40. Since these indices separate stocks geographically, options trading with indices makes it easy for investors to establish a stance based on the outlook for a national economy. Is there evidence that the German economy is experiencing a bullish cycle with stable employment, low inflation, and strong consumer spending? If so, it might be wise to consider call options in the DAX. Is Japan experiencing economic stagnation, weak manufacturing productivity, and a slowdown in consumer spending? If so, it might be wise to consider put options in the Nikkei 225.
Commodities
The next most commonly traded asset class can be found in commodities. Options traders are able to express a market view in a wide variety of raw materials when dealing with the commodities space. In general, commodities are divided into two main types: hard commodities and soft commodities. Hard commodities are things like energy and metals, which to get the most market attention and the highest trading volumes. Popular examples here include commodities like oil, natural gas, gold, silver, copper, and steel. Soft commodities are things like grains and other agricultural products. Popular examples here include corn, wheat, cotton, orange juice, and livestock.
Soft commodities tend to trade with higher levels of volatility. This is because unexpected weather changes can have a significant impact on the level of supply that is available in the market. These are some of the factors that should be considered by those looking to trade commodities options. For example, an unexpected frost could damage the orange trees that are needed by orange juice companies. Fewer oranges mean less orange juice available in the market, and this is a bullish scenario for those trading in orange juice. A scenario like this would make it wise to consider call options in orange juice. Conversely, larger than expected production levels by silver miners would increase the amount of supply available in the market. This would be a good opportunity for traders to consider buying put options in silver.
Currencies
The last of the major asset classes used by options traders can be found in currencies. Currencies are somewhat different from the other asset classes in that one currency is always priced relative to another currency. For example, the EUR/USD shows the value of the Euro currency relative to the US Dollar. So, the value of the EUR/USD is going to be very different than the value of the EUR/GBP, which pits the value of the Euro against the British Pound. For these reasons, currencies are said to trade in “pairs,” rather than individually.
Rising values in a currency pair suggests that the value of the first currency (the base currency) is increasing. Falling values in a currency pair suggest that the second currency (the counter currency) is increasing. Some of the most commonly traded currencies include the US Dollar, Euro, British Pound, Japanese Yen, Australian Dollar, Canadian Dollar, New Zealand Dollar, and the Swiss Franc. Interest rates tend to be a critical factor when trading currency options. For example, if the Bank of England decides to raise interest rates, it would make sense to consider buying call options supporting the value of the British Pound. If the Bank of England decided to cut interest rates, it would make sense to consider buying put options.
Most of the trading in options markets is conducted using these three asset types: stocks, commodities, and currencies. Expert traders tend to focus on one asset type. But it is always a good idea to have some knowledge of the other asset classes, as this can help to increase the number of trading opportunities you encounter on a regular basis.
Types of Options
Most expert traders would likely agree that options trading is one of the most complicated investment approaches in all of the financial markets. This is largely because there are so many different types of options strategies that can be utilized for active trading. But this should not deter or intimidate new investors from trading options. Instead, the vast array of strategies should be viewed as a positive, because this is what makes options so versatile in opening up new opportunities to profit from the financial markets. Patience is required here, however, as there are many facets to options trading that must be understood. Here, we will look at various types of options available to market traders.
American, European, Asian Options
Many traders are familiar with the mechanics of call options and put options. If you believe the price of an asset will rise, you should buy a call option contract. If you believe the price of an asset will fall, you should buy a put option contract. But there are three different types of calls and puts: American, European, and Asian. Each have different implications for how profits and losses are determined when positioning.
American options can be exercised at any point during the contract period. Let’s say you buy a call option in Apple (AAPL) in January 2016, with an expiration at January 2016. You then notice that the stock shows a major rally six months after you purchase the contract. You decide to collect your profits, and close the position six months early. But if this was a European option, this would not be possible. European options can only be exercised at the time of maturity. If we use the Apple call option as the example, you would be forced to wait until January 2016. In this way, American options are more valuable to investors because they offer much greater flexibility in capturing profits.
Asian options are even more strict in nature. Asian options can only be exercised at maturity, and factor in the asset’s average price over the lifetime of the contract. When you buy Asian call options, you profit if the asset’s average price is above the strike price outline in your contract. When buying Asian put options, you profit when the average price is below the strike price.
One-Touch Options
The next options contract type to consider is the one-touch options contract, which has become more popular with commodities and currencies traders in recent years. When using a one-touch option, a trader profits if the market price hits the chosen strike price before the end of the contract period.
Consider the EUR/USD chart below:
Chart Source: Metatrader
In the chart above, we can see that the EUR/USD is caught in a downtrend. But let’s assume that economic data in the Eurozone has shown signs of improvement and we have a positive outlook for the Euro currency in the months ahead. We can see that prices have recently traded above the 1.25 mark, and then decide to buy a one-touch option in the EUR/USD with a strike price of 1.2520. The contract period is one year.
Chart Source: Metatrader
In the chart above, we can see that prices later meet our expectations and cross above the 1.2520 strike price. This put the one-touch option into positive territory and ensures profitability on the trade. If the market has not touched the 1.2520 strike price before the end of the contract period, the option would have expired worthless and the total losses would be equal to the initial cost of the contract.
Double One-Touch Options
A variation on this strategy is the double one-touch option, which essentially adds a second strike price to the contract. The same rules apply but there will be one strike level above the current price, and one set below.
Consider the price chart below the GBP/USD:
Chart Source: Metatrader
Here, we can see that price activity in the GBP/USD is trading in a sideways direction. But the Bank of England is expected to make changes in its interest rate policy and this will probably increase market volatility in the weeks ahead. But it is still unclear whether the central bank will raise rates, or lower them. This makes it difficult to know if prices will be rising or falling. In a case like this, it would make sense to buy a double one-touch option at the price levels that fall outside of the price range in the GBP/USD.
Chart Source: Metatrader
In the chart above, we can see that the Bank of England elected to raise interest rates, and this created a surge of buying activity in the GBP. This activity sent the market through the upper strike price, and this put the trade into profitability before the end of the contract period. If prices had held within the previous range (between the two strike price levels in the double one-touch contract), the option would have expired worthless. Losses would be equal to the initial cost of the option contract.
No-Touch Options
Last, we look at the no-touch option, which operates under the opposite premise. No-touch options are profitable when prices avoid touching the strike price before the end of the contract period. No-touch options also come in the “single” and “double” varieties. Options traders establish either one or two strike levels on the expectation that market participants will prevent prices from reaching those levels during the duration of the contract.
First, we look at a one-touch option using the USD/JPY:
Chart Source: Metatrader
Traders with a bearish bias in an asset might select a no-touch option with a strike price placed above recent price activity. In the USD/JPY chart above, we can see an example of this. As long as prices hold below the strike price for the duration of the contract, the options trade will close profitably. Traders with a bullish bias would place the strike level below recent price activity.
Double no-touch options work a bit differently. Here, options traders are expecting market volatility to contract with prices forming a tightened range. Consider the following example in the USD/CHF:
Chart Source: Metatrader
In this example, we can see that market valuations in the USD/CHF are holding relatively steady, and no major trending moves are taking place. If an options trader expects these conditions to persist, it might be a good idea to buy a double no-touch options with strike prices just outside of the recent price range. If neither strike price is hit during the contract period, the trade will close profitably. If one of the strike price levels is reached during the contract period, losses will equal the amount initially paid for the contract.
Support and Resistance in Options Trading
For options traders that are looking to basis trading decisions on technical analysis techniques, two of the most important concepts can be found in support and resistance. These terms refer to price areas that have shown historical importance, and can be used to generate entry points for options trades. Identifying support and resistance zones might seem difficult at first. But once we start to see the visual cues, it becomes much easier to spot support and resistance zones that can be used to structure active positions in the options market. Here, we will look some of the signs that a support or resistance zone has developed — and then discuss ways these price zones can be used in options trading.
Support Levels Defined
A support level is an area where a majority of the market has started to buy an asset. This change in market behavior will literally “support” the price of the asset, and create a new bullish trend. Support levels are confirmed when markets test those price levels multiple times, and fail to break below those levels. This ultimately suggests that the market has deemed the asset to be excessively cheap at that price. This is why options traders will often use support levels to take a bullish stance and buy call options.
Let’s take a look at a visual example of a support level. Consider the following price chart:
Chart Source: Metatrader
Here, we can see sideways trading activity, followed by a period of increased volatility near the middle of the chart. Prices jump quickly, and then start to fall until markets reach a level of support. This line is marked in black, and shows prices testing this level on three separate occasions. A support line does not need to be tested three time in order to be considered valued. But, as a general rule, the more a support level is tested (without breaking), the stronger it is considered to be. In the example above, we can see that market bears tried three times to push prices below this support level — but they failed. Those traders were then forced to exit their positions, and this activity creates the price rally that immediately follows. For these reasons, options traders will look to buy call options when a strong area of support can be identified.
Resistance Levels Defined
A resistance level is an area where a majority of the market has started to sell an asset. This change in market behavior will prevent prices from rising further — and this tends to create bearish trends. Resistance levels are also confirmed when markets test those price levels multiple times, and fail to break above those levels. This inability to rally suggests that the market has deemed the asset to be excessively expensive at that price. This is why options traders will often use resistance levels to take a bearish stance and buy put options.
Next, we will look at a visual example of a resistance level:
Chart Source: Metatrader
This example is similar in that we can see sideways trading activity, followed by a period of increased volatility near the middle of the chart. But, here, fall quickly, and then start to rise until markets reach a level of resistance. The resistance line is marked in black, and it prevents markets from rallying on three separate occasions. Market bulls tried three times to push prices above this resistance level — but these attempts also failed. When these bullish traders exited forceful price declines were then seen. For these reasons, options traders will look to buy put options when a strong area of resistance can be identified.
Implications For No-Touch Option Trades
It can be argued that support and resistance levels are most important for traders that are looking to buy no-touch options. This is because support and resistance levels are able to act as barriers for future price activity. If you have a clearly defined resistance level, this is something that could be used as a strike price above the current market valuation level. If you have a clearly defined support level, this is something that could be used as a strike price below the current market valuation level.
No-touch options can also be used when traders are able to identify a trading range. A trading range is essentially a period of sideways activity that is visible on a price chart. Sideways activity is an indication of market indecision. To the uninitiated, it might seem as though there is no way to profit from such an environment. But those that have experience trading in options understand that there are clear avenues to capture monetary gains when price activity is trading in a sideways fashion.
Advantages of Options Trading
Now that we have completed the basics of trading options, it is important to look at some of the benefits that can be captured by investors looking to enter into this financial arena. Essentially, options allow investors to maximize the efficiency of trading capital, reduce risk (relative to traditional stock investments), and create the potential for higher returns. Options trading gives investors access to a broader range of strategic alternatives to the traditional “buy and hold” strategies that characterize most other types of investment. Here, we will go over these advantages in greater depth so that options traders are truly able to play to the strengths of these markets.
More Efficient Use of Capital
When compared to traditional reforms of investment, options trading allows for much more leveraging power and efficient use of capital. For example, let’s compare two similar investments — one using a traditional stock strategy, and another using options. Let’s assume stock XYZ trades for $50 and you are looking to buy 200 shares. In order to accomplish this, you will need to spend $10,000 to open the trade (200 shares x $50). But if, instead, this investor purchase two call options at $25 each (each contract equal to 100 shares in XYZ stock), the initial cost would be only $5,000 (2 contracts @ 100 shares each x $25). This is a significant different in terms of initial cash outlay, and the remaining $5,000 could then be used for other investments.
Increased Returns
Next, we look at the potential for increased returns, as it is clear that many investors are solely interested in the amount of money that can be made on a given trade. In percentage terms, options offer the potential for much higher returns. This is because options trading requires much less capital when compared to traditional forms of investment. As shown in the example above, a bullish investment in XYZ stock carries with it the same potential for profit, but with a much smaller cash outlay. In percentage terms, this results in potential returns that are doubled (since the initial cash outlay was cut in half when using options). This can make a significant difference when trades are closed in positive territory. This is also highly advantageous for newer traders that are starting with a smaller trading account size.
Reduced Risk
Another factor to consider is that some reforms of options trading will allow you to drastically reduce your level of risk in any market environment. This is a factor that is often overlooked by newer investors that are mostly focused on the potential for profits. But it must be remembered that your true profits will be the difference between your winning trades and your losing trades. So it is always important to understand how much money is put at risk in any given trade.
When buying options, you are always fully aware of the exact amount of money you stand to lose in your trades. This is something that cannot be said for all other reforms of traditional investment. Let’s say for example that after you buy shares in XYZ stock, there is a breaking news story suggesting that the company is ready to file for bankruptcy. When the market opens the following morning, the stock price falls to $2 per share. This would create losses of $9,600 (-$48 * 200 shares). But if we chose instead to buy call options in the stock, losses would be only $5,000 as we would allow the options contract to expire worthless on the expiration date. This is a massive difference, and one that can keep your trading account healthy even when there is catastrophic news affecting your investment.
Wider Range of Trading Strategies
Last, we should consider the wider range of trading strategies that are made available for options investors. Call and put options allow traders to profit when market prices are rising and falling. This is a strategy that can be highly valuable when markets are trending. But what happens when there is no strong trend present in the market? In these scenarios, traditional investment strategies have a very difficult time producing gains.
For options investors, this is entirely untrue. When markets are trading sideways, and there is no strong momentum present, options traders can enter into no-touch options that stand to profit if these market conditions persist. This is an example of the ways options trading truly does give investors more “options” when attempting to profit from the financial markets. This is also an example of why all investors should at least familiarize themselves with options trading so that they are aware of the broad array of strategies that are made available in these areas.
In all of these ways, options contracts offer key advantages for traders. Many new traders are intimidated when the topic of options markets is brought into the discussion. But before you can reasonably expect to generate consistent gains in any of the financial markets, you should have some understanding of the way options work so that they can be utilized at the right time.