A sage gives you two pills; take pill A and you can make $100 or lose $100, or take pill B and you can make $99 or lose $1. Which of these would you choose? 

It seems self-evident that pill B is the better option. This is especially so if we consider one of Warren Buffett’s most famous quotes, which goes that “Rule No. 1 is never lose money. Rule No. 2 is never forget Rule No. 1.” In other words, only the money you can keep can grow. 

Stock options are the closest thing to pill B. They can help you limit your losses on the downside and even magnify your returns on the upside with the leverage they provide. 

But what is options trading in the stock market and if it sounds so good why is everyone not trading them?

In what follows, we will seek to answer both of these questions in a simple yet comprehensive manner. We’ll consider: 

1. What is options trading in the stock market? A brief introduction
2. Types of stock options and stock options traders
3. Options pricing
4. Stocks and options difference: Why do investors trade options
5. Pros and cons of options trading
6. Should you trade stock options?

[Do you want information that will make you a better trader delivered right into your inbox every week? Subscribe now to Sarwa’s Fully Invested Weekly Newsletter and improve your trading results.]

1. What is options trading in the stock market? A brief introduction

Options trading in the stock market is the buying and selling of stock options. 

So, what are stock options?

A stock option is a financial derivative that confers on its buyer a right (but not an obligation, discussed here and here) to buy or sell a stock (the underlying asset) at a predetermined price on (or on or before) a specific date.

There are many things to unpack in this definition but let’s start by identifying and commenting on the basic features of options: 

• Exercise: When the option contract favours the buyer, they will buy or sell the underlying asset at the agreed price within the agreed period. In such cases, they are said to have exercised the right conferred by the contract. 

• Expiration: If, on the other hand, the deal does not favour the buyer, they may choose not to exercise the option and allow it to expire instead. An option expires once it has not been exercised after the due date. 

• Underlying asset: The underlying asset is the asset whose price movements the parties to an options contract are speculating on. For our purpose, the underlying assets are stocks. But there are options for other assets like ETFs (exchange-traded funds), mutual funds, index funds, commodities and cryptocurrencies.

• Strike price (or exercise price): The strike price is the set price at which the option buyer can exercise their right to buy or sell the underlying security.   

• Premium: The premium is the price option buyers pay for the right the seller confers on them.  

• Options contract: One option contract represents 100 shares of stock.

Parties to a stock option contract 

In addition to knowing the basic terms and structure of an options trade, understanding options trading requires a grasp of the parties to a stock option contract. 

Just as in every other market where you have participated, there are two key parties to an option contract: 

• Buyer (also called the option holder): The buyer of the option contract is the one who has the right to buy or sell an underlying security. To get this right, the buyer pays a premium to the seller of the option contract. 

• Seller: The option seller is the counterparty (the other party) to the option buyer. Sellers are also said to be writing the contract and they are the ones who receive the premium from the option buyer. 

Unlike the option holder who has a right to buy or sell, the seller has an obligation to buy or sell once the buyer has exercised their right to buy or sell. 

For example, if the buyer decides to exercise a right to buy a stock at $150, then the seller must act as a counterparty by selling to the buyer at that price. On the other hand, if the buyer decides to exercise a right to sell a stock at $150, then the seller must buy at that strike price. 

The seller is compensated for taking on this obligation through the premium paid by the buyer. 

Note, however, that where the buyer decides not to exercise a right, the seller is not obligated to do anything. Instead, they keep the premium they have received. 

Source: finance cracker

So, what is options trading in the stock market? Put simply, it is the buying and selling of the right to buy and sell a stock at a given strike price on (or on or before) a given expiration date. 

With the basics covered, let’s move on to understanding the different types of stock options. 

2. Types of stock options and stock options traders

We can go about the differentiation between stock options in two ways: by the type of right it confers on the buyer and by the nature of the expiration date. 

Types of stock options by nature of rights

As we have previously mentioned, a stock option can confer the right to buy or sell. There is a name for these different types of options: 

• Call option or calls: A call option gives the option holder the right to buy an underlying security at a given strike price. Given what we have discussed about parties to the contract, this then means that the seller has an obligation to sell at the strike price if the buyer exercises their right. 

Call options are appropriate when you believe that the underlying asset’s price will increase. For example, if the current share price of AMZN is $200 and you believe it will rise to $250, you can buy a call option with a $200 strike price. 

If you are right (the price rises to $250), you can buy the stock at $200 (the strike price) and then sell it at $250 (the current market price in the stock market) for a gross profit of $50 per share. 

• Put option or puts: Puts, on the other hand, confer on the buyer the right to sell a stock at a given strike price. The seller must act as a counterparty by buying at the strike price once the buyer exercises their right to sell. 

Put options are appropriate when you believe that the underlying asset’s price will decrease. Suppose you believe that the price of AMZN will fall to $150, you can buy a put option with a strike price of $200.

If you are right, you can sell the stock for $200 (the strike price) while everyone else is selling for $150 in the stock market.  

Source: Royal Bank

Types of stock options by the nature of expiry date

Here, we also have two types of options: 

• American options: These are options that can be exercised by the buyer on or before the expiration date. For example, if you purchase an American call option on July 10 with an expiry date of August 10, then you can exercise the option any future date before August 10 or on August 10. 

Types of stock option traders

Like stock traders, we can also differentiate between stock options traders based on their time horizon: 

• Day traders: Day traders focus on options that expire within a day. Since intraday price movements are typically small, day traders will tend to enter and exit many trades every day. 

• Swing traders: Swing traders also focus on the short-term – trading stock options that expire in days or weeks. Price movements are more significant over days and weeks so swing traders don’t typically trade as much as day traders. 

• Position traders: They tend to have the longest time frame of stock option traders. Some of their option contracts can have expiration dates that last for months (which is still short-term when compared to long-term investors). 

• Market makers: These traders act as counterparties to both buyers and sellers, depending on what is needed in the market. They exist to provide liquidity in the options market.     

3. Options pricing

Understanding options trading also requires a grasp of options pricing. The premium you pay for an option will affect your net profit, so knowing what the option premium is all about is crucial. 

The components of the option premium

The option premium (or the price of the option), as we have seen, is the price options buyers pay for the right the option confers on them. 

This price has two components: 

The intrinsic value

An option’s intrinsic value is the difference between its strike price and the current market price. The current price can be higher or lower than the strike price depending on the type of stock option. 

Related to this is the concept of the moneyness of an option. There are three options here: 

• In-the-money (ITM) options: A call option contract is in the money if its current price is greater than the strike price. This is in tandem with what we mentioned about call options: traders use them when they believe that the market price will increase. 

On the other hand, a put option contract is in the money if its current price is less than the strike price. This is also in tandem with the fact that traders use call options when they believe that the market price will decrease. 

When an option is in the money, it has intrinsic value. 

• At-the-money (ATM) options: With these options, the current market price is equal to the strike price. 

• Out-of-the-money (OTM) options: A call option contract is out of the money when its current market price is less than the strike price. 

On the other hand, a put option contract is out of the money if the current market price is greater than the strike price. 

When an option is out of the money, it has zero intrinsic value. 

Time value

This is the portion of the option premium that is not due to the intrinsic value. In essence, the excess of the option premium over the intrinsic value. 

Time value represents the hope that the current market price can still change to turn an out-of-the-money option into an in-the-money option. 

Since the possibility of changes in market prices declines as we get closer to expiration, the time value of an option reduces as the option nears expiration. 

In fact, at expiration, the time value is exactly zero and the intrinsic value alone represents the value of an option. 

Consequently, the price of an option can change as the market price of the underlying asset changes and the expiration date gets closer. The more in-the-money the option, the higher the option premium, and vice versa. 

One more point needs to be made: the volatility of an option’s underlying asset will affect its premium. If the stock is very volatile, then the possibility of market price adjusting to turn an out-of-the-money option into an in-the-money option is higher. This results in a higher premium. 

On the other hand, if the stock is less volatile, then the option premium will be lower when compared to the more volatile option (ceteris paribus). 

Closing your position

There are many ways to close your position in an options contract: 

• Early exercise: If it is an American option, then you can exercise it before the expiration date. Early expiration makes sense when the option is in-the-money. 

For example, if you purchased a put option and the market price is already below the strike price, you can choose to exercise the contract (especially if you believe the price will start increasing). 

1. Buying or selling the option: You can sell your long positions and buy your short positions to realize the profits and losses on them. This can be a way to gain early access to your profits and also cut short your losses.  
2. Rolling your position: You can move from one call or put option with a given expiration date to another one with a longer expiration date (or a different strike price).  Rolling your position can help enhance your returns or defend your position that is currently losing money. 
3. Holding it until expiration: Alternatively, you can hold the option until expiration if you believe it will be in the money on that day. 
4. Sell to close your position: Before its expiration, you can try to sell your long put. In doing so, you’ll realise any profits or losses associated with the trade.
5. Roll your position: Rolling a long put involves selling your existing position (realising any gains or losses) and simultaneously purchasing a new put option with a further expiration date and/or a different strike price. This allows you to establish a similar position while managing your risk prior to expiration.
6. Exercise early: When you own a put option, you can exercise your contract before expiry if you want to sell the underlying asset at the strike price. You should only consider exercising your option contract if it is in the money. However, if you decide to exercise early, you’ll forfeit any extrinsic value (time value) remaining in the option, so it rarely makes sense to exercise early.
7. Hold through expiration:

• When holding your contract until expiry, the following three scenarios can occur:
• It can either expire worthless out of the money, and you lose the premium you paid for it.
• It can get auto-exercised at expiry if you have the selling power to sell the underlying shares of the options contracts.
• It can auto-liquidate. If you don’t have the selling power to exercise the contract, your broker will attempt to sell your option contract for its intrinsic value prior to its expiry.

4. Stocks and options difference: Why do investors trade options

Now that we understand what stock options are all about, two questions remain: how do they differ from stocks and why should you bother with them?

Let’s start with the second question.

Stock options are used for three main reasons: from the buyer side, to limit potential losses on the downside and magnify returns on the upside; from the seller side, to earn an income.  

Magnifying returns

Options can magnify returns due to the leverage they provide. 

How so?

To buy 100 shares of AMZN, you need $20,000. However, to enter an option position for AMZN, you only need to pay $100 (the option premium for the 100 shares in the contract). 

If this is a call option and the price increases from $200 to $250, then the intrinsic value of the entire contract is $5,000. An option contract you purchased for $100 is now worth $5,000 (and that is with the assumption that the time value is zero), a 4,900% return. 

What if you had just gone long on the underlying stock? You would have bought for $20,000 and sold for $25,000, for a 25% return. 

Limiting potential losses

We can show how this works by highlighting one of the popular stock option trading strategies: the married put strategy. 

With this strategy, the trader buys a put option contract and also goes long (that is, owning the stock for a long period) on the underlying security. Traders use this when they believe prices will increase but want to hedge their risk. 

If the price of the underlying security reduces, the trader loses money on the underlying security.   

However, the trader makes money on the put option since a put option is in the money when the market price is less than the option’s strike price. When others are selling at the market price, this trader can sell at the strike price, thus making money on the difference between the strike price and the market price. 

Let’s clarify this with an example. Suppose trader B buys AMZN at $200 and also purchases a put option with a strike price of $200. 

If the price falls to $150, he loses $50 per share on the long position. However, he also makes $50 on the put option by buying in the stock market at $150 and selling in the option market for $200. 

In essence, the loss on going long on the underlying security has been canceled by the profit on the put option. 

The only money this trader loses is the $1 premium per share (our assumption) he paid for the put option. Without the put option, he would have lost $50 per share. 

Earning income

For sellers, the major appeal of options is the possibility of earning income through the premium received while the option expires worthless. 

If a trader sells a put option, they receive a premium from the buyer. Suppose the price of the underlying rises above the strike price, the buyer will not exercise that put option. Thus, the seller can keep the premium received without doing anything. 

In the same way, if the trader sells a call option and the price falls below the strike price, the buyer will not exercise the contract. Again, the seller can keep the premium already received. 

Differences between stocks and options

Now, we can highlight the differences between stocks and stock options: 

• Ownership: Buying stocks confers ownership while buying options only confers a right to buy or sell a stock. 

• Time: Options only exist for a given period while stocks don’t have expiration dates. 

• Capital requirement: As we have seen, options trading allows you to access more significant leverage than stocks can offer.

• Trading strategies: With stocks, you can only go long or short. You have more alternatives with options – covered calls, short call, married puts, bear-put spread, long straddle, long call, long put, etc.

• Commissions: Commissions on options trading are higher.     

5. Pros and cons of options trading

Before considering whether you should trade options, let’s go over the pros and cons. Some of them will be evident already but it is better to identify them clearly.

Pros of options trading

• Risk hedging: You can use stock options to limit potential losses on the downside risk, thus protecting your capital. 

For example, in a married put strategy, you can go long on a stock and purchase a put option to hedge against the risk of the stock’s price falling instead of rising. No matter how much the price falls, your loss is limited to the premium you paid for the put option.  

• Low capital requirement: If you don’t have the capital to take a position on a stock, you can enter into an options contract with just a fraction of what you would have needed. 

• Cost efficiency:  A call option can help you buy an underlying stock cheaper than the current market price. 

• Leverage: As we saw above, options can help you magnify your returns through the leverage they provide. 

Cons of options trading

• High risk: Just as leverage can magnify your returns, it can also magnify your losses if you attempt certain call options strategies.  

An uncovered call option (also called a short call strategy) is an example. If the market goes against you, your losses are unlimited. 

For example, if the strike price is $50 but the stock has risen to $150, you have to buy at $150 in the market and sell for $50 to the option buyer. However, stock prices can increase indefinitely within the lifetime of the contract, which makes potential losses unlimited.  

• High market volatility: If you think stock prices are volatile, then consider that options prices are even more volatile. 

• Complexity: Options are complex financial instruments. Some options strategies can be very complex for non-professionals to understand, talk less of implementation. With some of these strategies, losses can become very significant if things go south. 

• Time value decay: We have seen that the time value of an options contract decays as it nears expiration. 

• High commission: Commissions charged by brokerages can be very expensive. 

6. Should you trade stock options?

The opportunity to magnify returns and hedge against risk may make stock options seem to be a no brainer. But what about the higher risk, higher volatility, and added complexity?

If you are a beginner with little experience in the market, it might be better for you to stick with learning how to buy stocks in the UAE only. On the other hand, if you are an experienced trader, you should also consider trading stock options. 

Your risk tolerance also matters. Since the risk that options provide can magnify losses, you might be better off sticking with stock trading only if you are risk-averse. But if you are risk-seeking (and experienced in the market), you can trade both. 

If stock options help to hedge risk, does it not make sense that those who are risk averse should use them more? In one sense, this is correct. Yet options trading in itself requires a certain level of expertise and risk tolerance. 

Overall, you should read the pros and cons section over again before deciding if options trading is right for you. 

How to get started trading options in the UAE 

If you have decided to start trading stock options, you can do so in the UAE through the Sarwa Trade app. 

The Sarwa Trade app provides you access to US securities including stocks, ETFs, and stock options. 

With Sarwa Trade, your data and money are protected with bank-level SSL security. Furthermore, Sarwa is regulated by the Financial Services Regulatory Authority (FRSA) in Abu Dhabi Global Markets (ADGM), so you don’t have to worry about the government. 

Transfers from your local bank account to and from your Sarwa trading account are free and the commissions on your trades are lower than the industry average. 

If you are a low-capital trader, you don’t need to be discouraged. Our low capital requirement and provision of fractional trading will make it easy for you to get started. 

[Do you want to magnify your returns and limit your losses on the downside? Sign up for Sarwa Trade to securely and cost-effectively trade stock options in the UAE.]

Takeaways

• A stock option gives the buyer the right to buy or sell an underlying security for a specified price on (or on or before) a future date (the expiration date). 
• Call options give the right to buy while put options give the right to sell. American options can be exercised at any point prior to expiration while European options can only be exercised on the expiration date. 
• The options price (premium) consists of the intrinsic value and the time value. The former depends on the difference between the strike price and the current market price while the latter reduces as the contract gets close to the expiry date.  
• While stock options can magnify returns and limit losses, they are complex, volatile, and risky.

Disclaimer

Options trading carries significant risks, including the potential for substantial or total loss of your capital. Level 1 strategies, such as covered calls and cash-secured puts, involve risks like assignment and price volatility. Level 2 strategies, including buying calls and puts, add further risks due to leverage, time decay, and the chance of losing the entire premium if options expire out of the money. No financial advice is provided; you must exercise your own discretion. Ensure you understand these risks and are financially prepared. Examples are for illustrative purposes only. Past performance is not indicative of future results, and market conditions can lead to unforeseen losses.