A primer on Exchange Listed Options

Exchange-listed Options

Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specified date. Exchange-listed options in the United States are standardized option contracts that trade on regulated exchanges like the Cboe Global Markets ("Chicago Board Options Exchange" or CBOE).

I write this since there are so many BAD descriptions of options and strategies, that make even simple strategies sound horrible complex.

The main parameters of exchange-listed options are:

• Underlying asset - This is the security or asset that the option gives the holder the right to buy or sell. Common underlying assets include stocks[1], stock indexes, ETFs, and commodities.
• Strike price - The fixed price at which the holder can buy or sell the underlying asset if they exercise the option.
• Expiration date - The last date the option can be exercised. Options expire on the third Friday of the contract month.
• Contract size - The amount of the underlying asset controlled per contract. For stock options this is usually 100 shares.

There are two main types of options:

• Calls - Give the holder the right to buy the underlying asset at the strike price.
• Puts - Give the holder the right to sell the underlying asset at the strike price.

Options are also categorized based on when they can be exercised:

• American style - Can be exercised any time prior to expiration. These are the standard options traded on CBOE.
• European style[2] - Can only be exercised on the expiration date.

Call Option Strategies

The most basic call strategy is simply buying a call option to speculate on an upside move in the underlying asset. This limits risk to the premium paid while providing upside exposure. More conservative call strategies include:

• Covered call - Selling call options against stock owned to generate income. Caps upside on the stock.
• Call spread - Buying a lower strike call and selling a higher strike call to limit cost and risk. Caps upside on profit.

More exotic call strategies include:

• Call backspread - Selling lower strike calls and buying more higher strike calls. Risky but profits from large upside moves.
• Call condor - Combination of a call spread and put spread to define risk. Complex multi-leg strategy.
• Call calendar spread - Buying a longer-term call and selling a shorter-term call at the same strike. Attempts to profit from time decay.

Covered Calls

A covered call is an options strategy where an investor holds a long position in an asset, such as shares of a stock, and sells call options on that same asset. The investor receives a premium for selling the calls, which potentially generates income. The call options give the buyer the right to purchase the underlying shares from the investor at the strike price on or before the expiration date.

Reasons for using a covered call strategy include:

• Generating income from the call premium to offset part of the cost basis of the underlying shares. This lowers the breakeven point.
• Capping upside if the share price rises above the strike price since the shares may be called away. This defines the maximum return.
• Providing some downside protection through the call premium collected if the share price drops.
• Repeatedly writing covered calls to steadily earn income on stock positions.

Example:

An investor buys 100 shares of ABC stock at $50 per share, for a total cost of $5,000. The investor then sells a one-month call option with a strike price of $55 and collects a premium of $1 per share, or $100 total ($1 x 100 shares).        

There are then two main scenarios:

1. ABC stock stays below $55. The calls expire worthless, but the investor keeps the full $100 premium. Their net cost basis is lowered to $4,900.
2. ABC stock rises above $55. The calls are exercised, and the shares called away at $55. The investor sells at the higher $55 price and keeps the $100 premium. Total profit is $600 from stock gain plus premium.

The main risk is missing additional upside if ABC rose significantly above $55. The defined maximum return is the $55 strike price plus the $1 call premium initially collected.

Put Option Strategies

The most basic put strategy is buying puts to speculate on a downside move or for downside protection. Limits risk to premium paid. More conservative put strategies:

• Protective put - Buying puts on a stock you own to limit downside risk.
• Put spread - Sell higher strike puts and buy lower strike puts to reduce cost. Caps profit potential.

More exotic put strategies:

• Put backspread - Sell lower strike puts and buy more higher strike puts. Profits from large down moves.
• Put condor - Combination of a put spread and call spread. Defines maximum risk.
• Put calendar spread - Selling short-term puts and buying longer-term puts at the same strike. Benefits from time decay.

As we move from basic to more exotic strategies, they require more complex combinations of options and greater risks but allow for defined risk-reward profiles.

Using Protective Puts

A protective put is a risk management strategy used when an investor has a long stock position and purchases put options on that same stock to protect against potential downside. This limits the maximum loss an investor can incur if the stock price declines.

Reasons for using protective puts include:

• Hedging against a decrease in the stock price to define maximum loss.
• Maintaining upside exposure if the stock rises.
• Reducing portfolio volatility and drawdown risk.
• Retaining stock exposure to receive dividends.

Example:

An investor buys 100 shares of XYZ stock at $50, for a total cost of $5,000. To protect this investment, the investor also buys one put option contract with a strike price of $45 expiring in one month for a premium of $200 ($2 per share).        

Here are the potential outcomes before option expiration:

1. XYZ stock stays above $45. The put options expire worthless, so the investor loses the $200 premium paid but retains the stock position and any dividends.
2. XYZ stock drops below $45. The investor exercises the puts to sell their 100 shares at $45 each, for $4,500 total. Including the $200 spent on put premiums, the total loss is $700, much less than if unprotected.
3. XYZ stock rises above $50. The puts expire worthless but the investor benefits from the stock appreciation and dividends, while capping downside risk at the $45 strike price.

The main risk is that the stock doesn't decline enough for the puts to pay off, resulting in losing the premium cost. The benefit is retaining upside exposure and dividends while defining maximum loss on the downside.

Summary

Exchange-listed options provide a wide range of strategic opportunities for investors and traders. These flexible instruments can be used conservatively to generate income or reduce risk, or more aggressively for speculative leverage.

• The key parameters defining exchange-listed options are the underlying asset, strike price, expiration date, and contract size.
• Buying calls provides exposure to upside moves. Covered calls generate income by selling calls against owned assets.
• Buying puts hedge against declines. Protective puts limit downside on owned stocks. Put spreads define maximum loss amounts.
• Options strategies range from basic buying/selling to advanced multi-leg approaches. Increasing complexity allows more defined risk profiles.

Used prudently, options can provide income, protection, and strategic opportunities beyond merely owning the underlying assets outright.

Education Resources

The Options Clearing Corporation (OCC) provides free, unbiased information about the benefits and risks of exchange-listed options through the Options Industry Council (OIC). OIC offers a premium digital learning experience at OptionsEducation.org which is tailored towards many different learning styles and investing skill levels. The OCC Learning website is a self-guided eLearning destination that provides practical options education for a variety of learning styles and experience levels. You can learn at your own pace with self-guided courses that include basic concepts and terminology, getting to know the Greeks, options volatility, option strategies and more. The website also offers education from industry professionals, podcasts & videos, knowledge checks and course quizzes, polls & surveys and the ability to track your progress.

[1] Over-The-Counter stocks normally do not have options, except for employee stock options which are not traded.

[2] Even though the styles reference locales (American vs. European), both are employed throughout the world.

About Robert C. Rhodes

Robert C. Rhodes is an experienced sales and business development professional with a background in finance, operations, and?#strategicplanning. His proven track record of success in driving sales, leading teams, and managing customer relationships is visible as a former CEO of publicly traded companies with a history of successful?#fundraising,?#mergersandacquisitions, and revenue growth. He is skilled in managing financial and operational challenges in high-tech and?#cybersecurity?industries.

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DISCLOSURE - I made frequent usage of Claude from Anthropic and 微软 Bing's chat functionality to write this.