How Options are Traded

Wi-fi business
John Lamb/ Digital Vision/ Getty Images

Many day traders who trade futures, also trade options, either on the same markets or on different markets. Options are similar to futures, in that they are often based upon the same underlying instruments, and have similar contract specifications, but options are traded quite differently. Options are available on futures markets, on stock indexes, and on individual stocks, and can be traded on their own using various strategies, or they can be combined with futures contracts or stocks and used as a form of trade insurance.

Options Contracts

Options markets trade options contracts, with the smallest trading unit being one contract. Options contracts specify the trading parameters of the market, such as the type of option, the expiration or exercise date, the tick size, and the tick value. For example, the contract specifications for the ZG (Gold 100 Troy Ounce) options market are as follows:

  • Symbol (IB / Sierra Chart format): ZG (OZG / OZP)
  • Expiration date (as of February 2007): March 27 2007 (April 2007 contract)
  • Exchange: ECBOT
  • Currency: USD
  • Multiplier / Contract value: $100
  • Tick size / Minimum price change: 0.1
  • Tick value / Minimum price value: $10
  • Strike or exercise price intervals: $5, $10, and $25
  • Exercise style: US
  • Delivery: Futures contract

The contract specifications are specified for one contract, so the tick value shown above is the tick value per contract. If a trade is made with more than one contract, then the tick value is increased accordingly.

For example, a trade made on the ZG options market with three contracts would have an equivalent tick value of 3 X $10 = $30, which would mean that for every 0.1 change in price, the trade's profit or loss would change by $30.

Call and Put

Options are available as either a Call or a Put, depending on whether they give the right to buy, or the right to sell.

Call options give the holder the right to buy the underlying commodity, and Put options give the right to sell the underlying commodity. The buying or selling right only takes effect when the option is exercised, which can happen on the expiration date (European options), or at any time up until the expiration date (US options).

Like futures markets, options markets can be traded in both directions (up or down). If a trader thinks that the market will go up, they will buy a Call option, and if they think that the market will go down, they will buy a Put option. There are also options strategies that involve buying both a Call and a Put, and in this case, the trader does not care which direction the market moves.

Long and Short

With options markets, as with futures markets, long and short refer to the buying and selling of one or more contracts, but unlike futures markets, they do not refer to the direction of the trade. For example, if a futures trade is entered by buying a contract, the trade is a long trade, and the trader wants the price to go up, but with options, a trade can be entered by buying a Put contract, and is still a long trade, even though the trader wants the price to go down.

The following chart may help explain this further:

Futures

  • Entry type: Buy
  • Direction: Up
  • Trade type: Long
  • Entry type: Sell
  • Direction: Down
  • Trade type: Short

Options

  • Entry type: Call
  • Direction: Up
  • Trade type: Long
  • Entry type: Put
  • Direction: Down
  • Trade type: Long

Limited Risk or Limitless Risk

Basic options trades can be either long or short and can have two different risk to reward ratios. The risk to reward ratios for long and short options trades are as follows:

Long Trade

  • Entry type: Buy a Call or a Put
  • Profit potential: Unlimited
  • Risk potential: Limited to the options premium

Short Trade

  • Entry type: Sell a Call or a Put
  • Profit potential: Limited to the options premium
  • Risk potential: Unlimited

As shown above, a long options trade has unlimited profit potential, and limited risk, but a short options trade has limited profit potential and unlimited risk.

However, this is not a complete risk analysis, and in reality, short options trades have no more risk than individual stock trades (and actually have less risk than buy and hold stock trades).

Options Premium

When a trader buys an options contract (either a Call or a Put), they have the rights given by the contract, and for these rights, they pay an up front fee to the trader selling the options contract. This fee is called the options premium, which varies from one options market to another, and also within the same options market depending upon when the premium is calculated. The options premium is calculated using three main criteria, which are as follows:

  • In, At, or Out of the Money - If an option is in the money, its premium will have additional value because the option is already in profit, and the profit will be immediately available to the buyer of the option. If an option is at the money, or out of the money, its premium will not have any additional value because the options is not yet in profit. Therefore, options that are at the money, or out of the money, always have lower premiums (i.e. cost less) than options that are already in the money.
  • Time Value - All options contracts have an expiration date, after which they become worthless. The more time that an option has before its expiration date, the more time there is available for the option to come into profit, so its premium will have additional time value. The less time that an option has until its expiration date, the less time there is available for the option to come into profit, so its premium will have either lower additional time value or no additional time value.
  • Volatility - If an options market is highly volatile (i.e. if its daily price range is large), the premium will be higher, because the option has the potential to make more profit for the buyer. Conversely, if an options market is not volatile (i.e. if its daily price range is small), the premium will be lower. An options market's volatility is calculated using its long term price range, its recent price range, and its expected price range before its expiration date, using various volatility pricing models.

Entering and Exiting a Trade

A long options trade is entered by buying an options contract and paying the premium to the options seller. If the market then moves in the desired direction, the options contract will come into profit (in the money). There are two different ways that an in the money option can be turned into realized profit. The first is to sell the contract (as with futures contracts) and keep the difference between the buying and selling prices as the profit. Selling an options contract to exit a long trade is safe because the sale is of an already owned contract. The second way to exit a trade is to exercise the option, and take delivery of the underlying futures contract, which can then be sold to realize the profit. The preferred way to exit a trade is to sell the contract, as this is the easier than exercising, and in theory is more profitable, because the option may still have some remaining time value.