Options Mechanics

Options are investment vehicles that have their own unique payout profile, which allow investors to customize their desired payout to the risk they are willing to assume.

Although investors can create a synthetic long or short stock position using options, there are numerous risks associate with options that go well beyond vanilla securities.  Options have an embedded leverage structure that an investor should be aware of prior to initiating options positions.

Option Positions

A long options position is one where an investor either purchases a call or put.  Recall, a call option is the right but not the obligation to purchase an asset on a specific date at a certain time.  A put is the right but not the obligation to sell a security at a specific price on or before a certain date.  The risk associated with a long position is limited to the premium paid for the option.  The option buyer cannot lose more than the premium paid for the option.

A short option position is one where an investor either sells a call or a put.  When selling an option, the investor is receiving premium, but giving up the right to purchase or sell a security based on the criteria of the option contract.

The risk on a short option position can be substantial.  A naked option position is one where the investor is not hedging the option risk exposure.  A naked call option position can have unlimited risks, as the price of a security can move to infinity, which exposes the option seller to large outsized market moves.

A naked put option position can also contain substantial risks but in theory it is bounded by zero for most assets.  For example, although a move from $500 to zero for Apple stock would be a painful trade for an investor that is short a put option, the risk is bounded at zero.  With a short naked call option, Apple stock could move to infinity which is not bounded.

Types of Orders

Options transactions are similar to other securities and each option broker will facilitate the process in a similar manner.  Trading at the market is an instruction to a broker where the investor buys or sells an option at the current price.    The buyer of an option purchases at the offer price, where the seller of an option sells at the bid price.  Market orders are advantageous because you are likely guaranteed an expedited fill of your trade where the disadvantage is that you will likely pay are higher price for your option as there is no specific price to stop buying (or selling).

A limit order specifies a specific price where you would like to transact an option trade. The advantage of limit orders is paying exactly the price that you specify. The disadvantage is that filling the order will could be time consuming and an investor risks the chance that they will miss the trade.

A Stop loss order is and order that only gets executed when the market price of the underlying stock reaches a specified price.

Leverage

Leverage is the use of borrow capital such as margin, to increase the potential return of an investment.  Options have an imbedded leverage component as it allows an investor to control a larger notional amount of capital than feasible with a vanilla security.

For example, each regulated stock option controls 100 shares of a given security.  One call contract of Exxon Mobil, allows an investor to purchase 100 shares of Exxon Mobile.  While 100 shares of XOM at a price of $90 per share would cost an investor $9,000 dollars, a one month $90 call option only costs $2 dollars and a total value of $200 ($2 * 100).

While the payout to an investor for holding an option relative to the underlying asset is not the same, the ability to lever the returns can be a benefit.

Leverage for option is valued by using margin.  Margin is the amount of capital that a broker needs to hold to allow an option trade to transact (read more about margin requirements here). Each options broker can have a slightly different calculation for margin.  Margin for long call and put option usually equals the premium, given that an investors risk is limited to the premium.

Margin requirements for option sellers are complicated and not the same for each type of underlying security. Margin for options writers will be different for stocks than futures.  Options margin for sellers can be subject to change and can vary from brokerage firm to brokerage firm. As they have significant impact to the risk/reward profiles of each trade, writers of options should determine the appropriate level of capital needed to trade structures that require an option sale.  Not all short options positions require margin, there are hedging capabilities that will eliminate the margin requirement on an option.

For example, a covered call options strategy only requires margin for the stock that is held.  A covered call strategy is a strategy were the investor purchases a stock and simultaneously sells a call at a strike that is equate to or above the current underlying price. The sold call risk will only be in effect if the price of the stock climbs above the strike price of the option.  If the price of the underlying stock is above the strike at expiration, the stock which is held by the investor will be delivered to the call option buyer.

Availability

Not every stock or futures contract has options that trade activity as a derivative to that underlying asset. There are some criteria’s that a public company will need to meet before their stock options can be listed by an exchange for trading. The simplest way to find out if an option exists on a stock or security is to enter the security into your brokers system and search for an option chain. The availability of an options chain will mean that there are options being traded for that stock. An option chain show the available puts and calls for each strike price for a given expiration date.

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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