Warrior Trading Blog

Option Definition: Day Trading Terminology

Option

Options are a financial derivative that trade based on the price action of the underlying asset and are bought and sold in units called contracts, which usually represent 100 shares per contract of the underlying. Options come in two different types: calls and puts. Traders can choose to buy (option holder) a call/put long or sell them (option writer) to the buyers depending on their trading strategy and goals.

Option

Unlike stocks, options have an expiration date, meaning they are a time sensitive asset. The time to expiration is an important part of how the option is priced.

When you buy/sell an option you have to specify the expiration date, and the further you go out in time the more expensive the option will be. The other part of buying/selling options that you have to specify is the strike price, which is the price for the shares if you decide to exercise your options.

Options are a leveraged product which means you can buy one option contract that represents a 100 shares of the underlying for much cheaper than if you were to go out and buy the actually shares themselves.

This makes them a great product for scalping for day/swing traders and for portfolio managers who wish to hedge positions without tying up a bunch of capital. However, selling naked options is inherently more risky than buying them and is why brokers generally have higher equity requirements to be an option writer.

Options are a very versatile financial product with a lot of different strategies you can trade depending on what you think the market is going to do.  You can choose to buy calls or puts, or you can put on a spread position.

Spreads are a bit more complicated than just buying a call or put. Depending on what type of strategy you are putting on you will be buying and selling the same amount of options on the same underlying but they will have different strike prices and sometimes expiration too.

Simply buying and selling vanilla options is simple enough, but holders must be prepared to actually exercise options by their expiration date if they cannot find a buyer at an adequate price. Writing options, on the other hand, is far more complicated, and can open the writer to nominally unlimited exposure, particularly as many options are written with only fractional collateral deposits.

Traders are encouraged to study the nature of the options they are trading and the exchanges that they are trading on to fully understand the rules and regulations involved. Options traders are expected to be a sophisticated class of investors, and very little in the way of guidance is offered in the writing, trading and exercising of options.

Call Options

Buying calls means you want the price of the underlying to go higher than the strike price that you have chosen (a bullish position), while selling calls means you want prices to stay below the strike price (a neutral/bearish position). Probably the most popular way of using calls is to just buy them in hopes that the underlying will go up and profiting from that move.

Another popular strategy for calls is something called a “covered call,” where if you own 100 shares of a company you can sell a call against them and collect the premium, but if the share price expires over the strike price then your shares will be called away and sold to the person who exercised his right to buy the shares.

If the option stays below your strike price then you will get to keep the premium you collected when you sold it and your shares will stay in your account. This strategy works great if you own the shares but think they may be due for a pullback and want some protection.

Put Options

Buying puts is the opposite of buying calls and means that you want the price of the underlying to go below your strike price and is considered a bearish position, while sellers will want the prices to stay above the strike price and is a bullish/neutral position.

Other than just buying puts straight up in hopes of prices of the underlying will go down, some traders will do what’s called a “cash-secured put” where they’ll sell puts against the cash in  your account which would require you to buy the shares if assigned. This is a good strategy for collecting premiums especially if you wouldn’t mind owning the underlying.

Final Thoughts

Options have transformed the modern financial landscape. Many traders who develop the mathematical skill to trade in options become fully immersed in this area of finance, and rarely trade in other areas again. The ability to create highly sophisticated trading positions that can pay off enormously when correct is a powerful draw to the world’s most talented traders.

However, the sophistication and complexity involved in options trading means that it is not an area for amateurs, and very little in the way of help and guidance is offered to the unprepared.