As we saw in the previous article, the main options advantage is that you can control a large security or a contract for a fraction of the share price. Before we get to the trading strategies and further options advantages, here is a brief review of basic terminology used in option trading
Option type: a call (right to buy) or a put (right to sell).
Underlying security: the security controlled by the option.
Current price: price of security — it determines when an option is in or out of the money.
Strike price: price point at which the holder of an option can exercise the right to buy or sell the underlying security — sometimes called the exercise price.
Expiration date: date the option expires and becomes worthless
Side of trade defines whether you are selling or buying the underlying asset if the option is exercised.
Price of the option: price to purchase the option. Options are generally purchased in lots of a hundred shares.
The price of an option includes four basic factors: time value, intrinsic value, option premium value, and the strange term “moneyness”.
I am assuming most readers here are familiar with option trading basics. Therefore, I will cover these terms in the most basic fashion.
Moneyness refers to whether the option is” in the money” (ITM), “at the money” (ATM), or “out of the money” (OTM).
The meaning of these terms can be confusing as the meaning changes depending on whether you purchase a call or a put option, here is a simple reference table.
Strike price is BELOW the price of the security
IN the money
OUT of the Money
Strike price is EQUAL to the price of the security
AT the money
AT the money
Strike price is ABOVE the price of the security
OUT of the Money
IN the money
The option premium is the value placed on the option for the risk taken by the party selling the option.
The intrinsic value of the option is the difference between the strike or exercise price and the underlying price of the security. In my previous example, if Alphabet, Inc. rises to $810 before the call option expires, the intrinsic value of the call option would be
$810 – $800 = $10.
Time value is one of the most important aspects of options. Unlike owning a stock, options have a limited time to be exercised. Time value of options decreases each day and can also include other aspects of options — such as moneyness. However, time value decreases generally as the exercise date for the option nears. Time decay is another term for the decrease in the value of options as the exercise date nears.
Advantages of options
Now that we have covered basic terminology, here is a list of five key advantages of options.
- Options give us leverage to control a larger security value than we otherwise would be able to with the same amount of money.
- Options allow us to limit our risk of exposure to the underlying security.
- Options allow us to execute trades that have a high probability of turning a profit and a very limited risk of loss.
- Options can protect our investments in the underlying security such as stocks, commodities, bonds, and mutual funds.
- Options allow us to invest and trade in a wider range of assets that we may otherwise not be able to afford. This diversification can lead to more stable returns in a portfolio.
While these are only five of many options trading advantages, there are few disadvantages as well. However, with proper knowledge and understanding you can minimize those disadvantages.
Disadvantages of option trading
Many investors are not comfortable using some of the option trading strategies that are a bit more complex or risky. Short side of investing — selling calls and buying puts – is one example. However, when it comes to options trading, everyone should be comfortable on the short side in order to be a successful options trader.
Complexity and variety of options trades can be considered a disadvantage. But, we only need a few option trading strategies to take advantage market conditions we are likely to encounter. My main goal is giving readers enough information to be confident with trading one of the safest forms of trading options: spread trading.
One major disadvantage of options is the potential to lose far more than you invest. This can only happen if you are in the position of selling an option. While option trading certainly has few disadvantages, advantages outnumber disadvantages by a large margin.
Options are available on almost any security. You can trade calls and puts on any of the following basic types of securities:
- Stocks – GOOGL, APPL, IBM, etc.
- Commodities – oil, gold, silver, cattle, corn, copper, etc.
- Indices – DJIA, SP500, etc.
- Mutual funds and ETFs – GLD, SLV, and many others.
Most options have a requirement that the underlying security has sufficient volume for there to be a market for the options. When I first entered the market for coppers futures, they were somewhat hard to find for the strike prices and expiration date I wanted. I had to buy options on the stock for mining company called Freeport-McMoran that served as a proxy for copper futures.
Options are available for most stocks on the New York Stock Exchange, on the S&P 500 and many of the Wilshire stocks. Options are available on most commodities, the major indexes — NASDAQ, the Dow Jones industrial average — and worldwide indexes.
Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.