Options Trading 101
If you’re used to trading stocks, you should have a pretty good understanding of the mechanics of buying and selling securities. Getting started with options trading is fairly simple. Here are a few things to know before taking the plunge.
Step 1: Holding the right type of account for the option strategies you intend to use
Options can be traded in all types of accounts (cash, margin and registered) and you will need to submit a request to your broker accordingly. Please note that the type of account held determines which option strategies are available. For example, the following strategies are allowed in cash and registered accounts:
- Buying options (puts and calls)
- Selling covered calls
Canada Revenue Agency rules do not permit the use of other option strategies.
In a margin account, however, all option strategies can be employed and you will therefore be able to place spread or combination orders, as well as carry out uncovered writing.
Step 2: Pulling up an option chain is like getting a stock quote.
An option chain displays the list of all the strike prices available for a given expiry date. You will find below a sample option chain (figure 1). Options can feature weekly, monthly or long-term expiry dates. Options are divided into two groups: call options and put options. Call options give the holder the right to buy 100 shares at the strike price. Put options give the holder the right to sell 100 shares at the strike price. The strike price is simply the guaranteed price at which the option holder can buy (for a call) or sell (for a put) the underlying shares.
Fig.1 Source: m-x.ca
Step 3: Learning the option terminology
Here are some of the terms used:
- Buy to open means that you are buying an option to create a new position. In the stock world, it corresponds to a buy order.
- Sell to close means that you are selling the option to close your existing position. In the stock world, it corresponds to a sell order.
- Sell to open means that you are writing (or selling) an option that you do not possess. In the stock world, it corresponds to a short sell order.
- Buy to close means that you are buying back the option that you had sold to close your position. In the stock world, it corresponds to a buy to cover order.
Step 4: How to distinguish between “covered options” and “uncovered options”
When you sell to open (also known as writing) options, you receive a premium. In exchange, you take on an obligation. If you are assigned, you must sell the underlying shares at the strike price (in the case of a call option). If you hold the shares in your account, then you are “covered”. If you don’t hold the shares, you are “uncovered”.
Conversely, if you sell a put, you are taking on the obligation to buy the shares. In order to be covered in this case, you simply need to have sufficient funds (or buying power) to purchase the shares that will be sold to you at the strike price (if you are assigned).
Step 5: Be cognizant of the size of option contracts
In most cases, one option contract gives you exposure to 100 underlying shares of a stock or Exchange-Traded Fund. This means that if you trade 100 call options, they do not correspond to 100 shares, but rather to 10,000.
Moreover, fractions are not permitted when entering an option order. An order to trade 1.5 option contracts, for instance, would be declined.
Step 6: Keep in mind that options expire
When you trade options, you need to realize that they will expire in the foreseeable future. What this means is that you will only have the right to exercise the option up to the expiry date. After that date, the option will cease to exist and you will no longer see it in your account. Options expire on the third Friday of the expiry month (except for weekly options which expire every Friday). For example, a September option will be valid until the third Friday of that month.
Step 7: Exercising an option
Only the option buyer can exercise an option. When call option holders exercise an option, they are using their right to buy the underlying shares at the strike price. When put option holders exercise an option, they are using their right to sell the underlying shares at the strike price. It is necessary to call your broker to exercise an option. Once the option holder exercises the option, the counterpart (i.e. the option writer) receives an assignment notice. When this occurs, option writers are required to fulfill their obligations. Remember, you don’t need to exercise an option in order to realize a profit, because you can sell it on the market just as you would a stock.
The list of benefits and strategies associated with options is long. In that sense, one can say that the sky’s the limit. If you wish to learn more about options and the many possibilities they offer, please visit the Montréal Exchange website where you will find an abundance of educational material.
Until next time, maybe the best trades be with you.
By Richard Ho, CAIA, DMS, FCSI
This article is from Bourse de Montréal Inc. and is being posted with its permission. Opinions expressed in this document do not necessarily represent the views of Bourse de Montréal Inc.
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Edited on 22 August 2018