Options trading can seem complicated, but it’s actually a powerful tool for experienced investors. With options, investors can protect investments, take advantage of market movement or enter into financial investment contracts with less money upfront. Let’s start with the basics to help you understand how options work and why they’re worth exploring.
An option is a financial contract giving the holder the right (not obligation) to buy or sell a stock at a set price within a defined time frame. Options allow investors to increase leverage, hedge positions, or gain exposure to companies with a limited upfront payment, known as the option premium.
Types of options and their classifications
There are two types of options: puts and calls. And there are also two categories: European or American options.
Call Option: A call option gives the buyer the right, but not the obligation, to purchase a stock or ETF at a predetermined price (the strike price) within a set timeframe. Call options gain value when the price of the underlying asset increases.
Put Option: A put option gives the buyer the right, but not the obligation, to sell a stock or ETF at the strike price within a set timeframe. Put options become more valuable when the price of the underlying asset decreases.
Both call and put options provide flexibility for traders, offering potential opportunities to profit in rising or falling markets. However, these instruments involve risk and should be used with a clear strategy.
While understanding the basics of puts and calls is essential, it’s also important to know that not all options are created equal. Options can be classified into two main classifications based on their exercise rules: American and European options.
European Options: These options can only be exercised on their expiration date. This means the holder cannot act on the option before it matures.
American (US) Options: These options offer greater flexibility, allowing the holder to exercise the option at any time before its expiration date.
Note: Only US options trading is currently available on Tiger Trade.
Key terms of options trading
To navigate the world of options trading effectively, it's important to understand the foundational terms that define how options work.
Strike Price:The strike price, also called the exercise price, is the fixed price at which the owner of an option can buy (for a call option) or sell (for a put option) the underlying asset.
For example, if a call option has a strike price of $70, the buyer can purchase the asset at $70 per share, regardless of its market value at the time of exercise. The strike price is a key factor in determining an option's value and whether it is profitable ("in the money") or not.
Expiration Date: The expiration date is the final day an options contract is valid. After this date, the option can no longer be exercised, and it either expires worthless (if it’s out of the money) or is automatically exercised by the Clearing House (if it's in the money).
For example, if an option’s expiration date is January 19, the holder must decide to exercise or let it expire by the close of trading on that day.
Premium: The premium is the price an options buyer pays to the seller for the rights granted by the option. It’s essentially the cost of the contract and reflects factors like the option's strike price, expiration date, and the volatility of the underlying asset.
Underlying Asset: The underlying asset is the financial instrument that an options contract is based on. It can be a stock, ETF, index, or commodity. When you buy or sell an option, you’re speculating on the price movement of the underlying asset without directly owning it.
For example, in a call option for a stock, the underlying asset is the stock you have the right to buy at the strike price.
Intrinsic Value:The intrinsic value of an option refers to the actual value an option has if it were exercised right now. Essentially, intrinsic value shows how much an option is worth based on its immediate profitability, disregarding external factors like time or market volatility. This value represents the "real" worth of the option, independent of any external influences. It is the difference between the underlying and the strike price, and how much the option is in-the-money
Time Value: Time value, also known as extrinsic value, is the portion of an option’s price above its intrinsic value, reflecting the potential for the option to become profitable before expiration. It depends on factors like time remaining and the volatility of the underlying asset. The more time left until expiration, the higher the time value, as there’s more opportunity for the asset's price to move in the option holder’s favour.
Implied Volatility (IV): Implied Volatility (IV) reflects the market’s expectations of how much an asset's price could move over the next year. Higher IV indicates the market expects larger price swings, leading to higher option premiums. Lower IV suggests more stability and lower premiums. IV is a crucial factor in option pricing models, helping traders assess potential risk and market sentiment.
In-the-Money (ITM): An option is considered In-the-Money (ITM) when it has intrinsic value, meaning the option holder can potentially exercise the option profitably. For call options, this happens when the strike price is lower than the current market price of the underlying asset. For put options, it happens when the strike price is higher than the market price of the underlying asset. Example:
ITM Call: A stock is trading at $100, and the strike price of the call option is $90. The holder can buy at $90, making a profit.
ITM Put: A stock is trading at $100, and the strike price of the put option is $110. The holder can sell at $110, making a profit.
At-the-Money (ATM): An option is At-the-Money (ATM) when the strike price is nearly equal to the current market price of the underlying asset. These options have no intrinsic value, only time value, as they are at the threshold of becoming profitable. Example:
ATM Call: A stock is trading at $100, and the strike price of the call option is also $100. There is no immediate profit or loss, but the option still holds time value.
ATM Put: A stock is trading at $100, and the strike price of the put option is also $100. Again, there’s no intrinsic value, only time value.
Out-of-the-Money (OTM): An option is considered Out-of-the-Money (OTM) when it has no intrinsic value. For call options, this occurs when the strike price is higher than the market price of the underlying asset. For put options, it happens when the strike price is lower than the underlying asset's market price. These options consist solely of time value. The holder would not exercise as they would be better off buying the underlying asset at a price lower than the strike price (in the case of a call) or sell the underlying asset at a higher price than the strike price (in the case of a put). Example:
OTM Call: A stock is trading at $100, and the strike price of the call option is $110. The option has no immediate profit potential and consists only of time value.
OTM Put: A stock is trading at $100, and the strike price of the put option is $90. The option has no immediate profit potential and consists only of time value.
How options differ from stocks and futures
Note: Tiger Brokers Australia does not currently support futures trading.
Ownership vs. Rights:
Buying a stock means owning a piece of a company, giving you shareholder rights like voting and dividends.
Options grant the right to buy or sell an asset on or before the expiry date without owning it outright.
Obligations vs. Flexibility:
Futures contracts obligate both buyer and seller to transact the underlying asset at a set price on a specific date.
Options give the holder the right, not the obligation, to buy or sell. Sellers, however, may have an obligation if the option is exercised.
Leverage and Risk:
Options and futures both offer leverage, meaning you can control a large position with a smaller upfront cost. However, options limit your potential loss to the premium paid, whereas futures can expose you to unlimited losses.
Expiry:
Stocks have no expiration date, but options and futures contracts do.
You can easily access the options interface in the Tiger Trade app, as shown in the image below, and start your options trading journey.
Advantages and disadvantages of options
Advantages
Options trading offers several advantages, including limited downside for buyers, as the maximum loss is restricted to the premium paid. With options, investors can gain exposure to price movements without owning the underlying asset, making them a cost-effective way to leverage potential returns. Options also provide flexibility in strategy, allowing for risk management, income generation, or speculative plays. They can serve as hedges against market volatility, offer defined risk for buyers, and enhance portfolio diversification.
Disadvantages
While offering numerous benefits, Options trading also presents several risks and challenges. The complexity of options, including pricing and strategies, can be challenging for beginners, requiring advanced knowledge. Options also have a limited lifespan, creating urgency to act before expiration. Market volatility further increases risks, requiring constant monitoring of positions to mitigate potential losses.
Visit our Options Trading page on the website to explore more opportunities. Join Tiger Trade and practice options trading with no real capital risk by using the Tiger Trade demo account. Plus, if you open an account, you'll get four $0 brokerage monthly trades on ASX US stocks or US options.*
*New clients & unfunded existing clients only. Only min. brokerage waived for 4 ASX, US stocks or options trades. Third-party fees and other fees still apply. See T&Cs for details.
Disclaimer:
Capital at risk. Options trading carries high level of risk and may not be suitable for all investors. You should only trade with money you can afford to lose. See FSG, PDS, TMD and T&Cs via our website before trading. Information provided may contain general advice without taking into account your objectives, financial situations or needs. Past performance is no guarantee of future results. Graphics and charts are for illustrative purpose only. Tiger Brokers (AU) Pty Limited. ABN 12 007 268 386 AFSL 300767
