Options Trading: What Is It And How To Do It?

When it comes to speculation or hedging, options are capital-efficient tools that provide leveraged exposure in the markets, allowing traders to capitalize on their market opinions at a low cost.

What Are Options?

An option contract is a derivative of an underlying asset; it is an insurance contract that represents the right to buy or sell an asset, at a later date and agreed upon price.

An option, though it can be used to speculate, is a hedging instrument.

Option buyers purchase an option to insure against losses on an underlying they are long or short in. In other words, if an individual was short stock, they would buy a call to hedge risk to the upside (i.e., as the stock rises, the call rises in value). Or, if an individual was long stock, they would buy a put to hedge risk to the downside (i.e., as the stock falls, the put rises in value). 

Option sellers write options in exchange for premiums derived from pricing formulas that take into account the following:

• Spot Price: Current price of an underlying security
• Strike Price: Level at which an option will begin to accrue intrinsic value at expiration
• Time to Maturity: The time left before an option expires
• Volatility: The magnitude of potential price change
• Rate of Interest: The annualized rate of interest

As most people have realized, nothing in the world is free. When it comes to insurance, money is made through the calculation of expected probabilities and writing of overpriced policies.

Actuaries assess the information provided by prospects and derive expected values.

For example, assume that it is determined that there is a 0.25% chance an insurance company will have to pay out $10,000. At the same time, there is a 99.75% chance a payout will not be made. Based on this information, the company derives a fair expected policy value of -$25. For the insurance company to make any money, it will have to charge a premium that is greater than $25.

The previous example highlights -- at a very basic level -- how options work. The option buyer pays a seller to take on the obligation of covering losses past a certain level and time. If the seller is mechanical in his or her approach of managing positions, then a positive expectancy is possible.

Option Pricing Basics

When purchasing options, one must be correct in their assumption on direction, time, and volatility. When selling options, one must manage aggressively positions, hedging against delta, gamma and vega risk.

As stated earlier, options pricing is derived from models that take into account the market environment (the price of security and demand for protection, among other things). Resulting model outputs are the following:

• Delta: Probability an option realizes intrinsic value at expiration, or the hedge ratio required to establish a neutral hedge. Delta tells a trader how many shares are needed to neutralize directional risk present in a position. A proper hedge is equivalent to dividing 100 by the option delta.
  • Example: If the delta is 0.5, then 100 divided by 0.5 is 2. This means that the directional risk of 100 shares of stock can be neutralized with two option contracts.
• Gamma: Rate of change experienced by an option’s delta as the underlying security changes price.
  • Example: If the gamma is 0.02, for every point rise or decline in the underlying asset, the option delta change in value by 0.02.
• Theta: Rate at which an option decays in value as expiration nears.
  • Example: A theta of 0.05 indicates that the contract will lose $0.05 in value for every day that passes.
• Vega: Sensitivity of an option’s value due to volatility changes.
  • Example: If a contract has a vega of 0.10 and the premium is $2.00 at 10% volatility, then absent any other changes, if volatility rises to 11%, the price of the option will be worth $2.10.

It’s important to note that options sellers have an embedded edge: volatility. Volatility is derived from demand; when demand for an option rises, volatility and option premiums spike.

However, demand for an option -- alone -- does not necessarily mean an underlying security will actually move, it just means that fear has compelled market participants to increase their buying of what inherently is insurance. As is true for most other aspects in life, fear is blown out of proportion and hence this is what happens in the derivatives market: fear is overstated and volatility pumps premium in options, most of which expire worthless.

Executing Option Trades

When finding and executing on opportunities in the options market, it is important to have access to two major things: liquidity and quality, low-cost broker.

Here’s an overview of some of the top option-trading platforms based on experience, trading style, and cost.

Top Platform For The Professional: Interactive Brokers

Interactive Brokers Group, Inc. IBKR, a former options market-making firm, is a deep-discount electronic access broker for online equity, options, futures, and forex trading.

Two choices are available when customers open accounts: Pro and Lite.

With Pro, users pay commissions but receive smart routing and best execution.

In an interview late last year, Steve Sanders, the company’s executive vice president of marketing and product development said “According to IHS Markit, our clients save 43 cents per 100 shares by using our smart router. If you take the average trade size, that works out to about $6 or $7 per trade.”

The Lite service offers no minimum balance and maintenance fees, interest on idle cash, free market data, mobile and desktop platforms, and access to over 120 global market centers.

Top Platform For The Active Trader: tastyworks

Tastyworks, developed by former Cboe Global Markets, Inc. CBOE floor traders, the experts behind thinkorswim Group Inc., and the famous tastytrade media network, is a discount broker for equity, options, and futures trading.

The firm’s mobile and desktop platforms offer users professional analysis and order management tools. Core features include an intuitive curve analysis feature that allows for visual management of trades, quick-roll which allows traders to quickly add duration to positions, and a trade ideas section.

Top Platform For Anyone: TD Ameritrade

TD Ameritrade Holding Corp. AMTD is for everyone; whether a novice or seasoned professional, TD Ameritrade is a holistic research, trading, and education solution for the equity, options, futures, and forex asset classes.

A core offering is the thinkorswim desktop trading software that came into TD’s ownership after the acquisition of thinkorswim Group Inc., a brokerage firm that placed heavy emphasis on investor education and active trading.

In October, prior to being acquired by Charles Schwab SCHW, TD Ameritrade introduced free trading on online stock, ETF, and options trades making it easier to trade small and often.

Top Platform For The Beginner: Robinhood

As the saying goes, you must give credit where credit is due.

Robinhood has truly democratized investing with its retail trading platform that offers investors no-fee stock, ETF, option, and cryptocurrency trading. The firm was popularized after it became one of the first brokers to disrupt the industry through its no-commission trade offering.

Through Robinhood, basic strategies like covered calls, credit spreads, debit spreads, cash secured puts, and basic long options can be executed.

Additionally, the firm introduced fractional share trading, allowing investors to buy stocks like Amazon Inc. AMZN, Apple Inc. AAPL, Walt Disney Co. DIS, and thousands of others with as little as $1, according to Robinhood.

Photo by Markus Spiske from Pexels.