How Options Trading Works
Options trading may seem complicated, but it's not as bad as you imagine - once you get familiar with the terminology you use and the process you follow. That doesn't mean it's for everyone, though - before you jump in, become familiar with this required reading: Characteristics and Risks of Standardized Options.
More Than Just Buy and Sell
When you talk about options contracts, you can't just describe the transaction as a buy or a sell. Instead, when you enter into a position, you open it, and when you get out, you close it. With options you can either be long a position, meaning you bought the contract to open, or short the position, meaning you sold the contract to open.
Let's break this down a little more:
- If you buy a contract to open, you are long the option, and you are the holder of that contract. When it's time to close your position, you will sell it.
- If you sell a contract to open, you are short the option, and you will buy to close your position.
It helps to be familiar with these options terms:
- An buyer purchases a contract to open or close a position
- An holder purchases a contract to open a long position
- An seller sells a contract to open or to close a position
- An writer sells a contract to open a short position
You initiate all options trades through your brokerage firm, whether you're opening or closing a position. There are commissions on the transactions, typically a base plus a per-contract charge. It's important to include these charges as you calculate the potential for profit or loss in opening or closing a position.
All listed options contracts are standardized, as are most contract terms, or characteristics. This means that options listed on one or more exchanges are fungible, or interchangeable, and can be traded easily. In that sense they resemble shares of stock or dollar bills. The standardized terms include:
Adjustment provisions: Adjustments may be made to the details of options contracts on a particular underlying stock if there has been a stock split, merger, or other corporate action affecting the stock.
Contract size: The quantity of the underlying interest covered by a contract varies by category of option. For example, an equity options contract is generally based on 100 shares of the underlying stock.
Exercise price: The increments between the strike prices that are available on an equity options contract depend on the current market price of the underlying stock. Those increments may be one, two and a half, five, or ten points above or below that price.
Exercise style: American style options can be exercised any time before expiration. European style options can be exercised only on the expiration date. Most equity options are American style.
Expiration month: Every options contract expires on a predetermined day in a predetermined month.
Options class: All the calls or all the puts on an underlying security make up an options class. Within a class, contracts share some of the same terms, such as contract size and exercise style, but not others, such as expiration date.
Options series: All contracts on an underlying security that have identical terms, including expiration month and strike price, make up the option series.
Type of delivery: Contracts specify either physical delivery or cash settlement. Most equity options are the former, which means shares of stock must change hands at exercise. Most index options are the latter, which means cash would change hands if the option was exercised.
Take a Leap
Long-Term Equity AnticiPation Securities®, or LEAPS® are a type of equity options contract that have expiration dates of up to three years. At any given time, you can buy LEAPS that expire in the January that is two years away or the January that is three years away. Once expiration is a year away, LEAPS are converted to standard options, which have expiration dates of up to one year.
Each exchange where options are traded chooses the securities on which it will list LEAPS. The decision is based on investor interest. LEAPS, which make up about 10% of all listed options, may be attractive because they provide much more time for the option to move in-the-money.
Exercise and Assignment
Options typically expire on the Saturday after the third Friday of its expiration month. In most cases, that Friday is the last day to trade expiring equity options. But you should confirm your brokerage firm's cut-off times. Firms may set an early trading deadline to give themselves enough time to process exercise orders.
When you notify your brokerage firm that you'd like to exercise your option, you initiate a multi-step process:
- Your brokerage firm sends an exercise notice to The Options Clearing Corporation (OCC), the official guarantor of all listed options contracts.
- OCC assigns your contract to one of its member firms. At least one of that firm's clients has written an option in the series you hold.
- If there is more than one eligible writer among the clients of the firm, the firm assigns the exercise obligation to one of those investors, using an exchange-approved method.
- The writer who is assigned must deliver or receive shares of the underlying instrument - or cash, if it is a cash-settled option.
Some options are subject to automatic exercise. This means that OCC will exercise an option on behalf of the holder if the option is in-the-money by the specified amount at expiration. Individual brokerage firms often have their own automatic exercise policies as well. You should check with your brokerage firm to learn whether automatic exercise applies to any of your long positions.