If you’ve been regularly trading and investing in Canadian stocks, you might be ready to try your hand at options. Make no mistake; options are not for the person who is a complete newbie here. But if you have some background, and subscribe to the adage of “nothing ventured, nothing gained,” step into to the world of options.

Here’s a roundup of the essentials of options trading. In this article, you’ll learn what options are, the types of options, option strategies, and how to get started in options trading.

First, a clarification. Options can be based on a vast array of ‘underlying’ instruments such as commodities, indices, currencies, ETFs, stocks, and more. This article, however, will focus on stock options.

What are options?

Options are a kind of financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset (a stock, for example) at an agreed-upon price and date.

A call option gives its buyer the right to buy the stock at a specific price (the ‘strike’ price) within an agreed time frame (the expiry period of the option).

However, a put option gives its buyer the right to sell the stock at a specific price (the ‘strike’ price) within an agreed time frame (the expiry period of the option).

Buyers of options are known as holders, whereas sellers of options are known as writers.

These option mechanisms usually cost little money to buy (typically referred to as the ‘premium’), but they allow the investor to control the profits on the underlying stocks as if they actually owned those stocks.

A call option is said to be in-the-money if the stock's current market price is higher than the option's strike price. A put option is said to be in-the-money if the option’s strike price is higher than the stock’s current market price.

And how do options differ from stocks?

Stock options are different from stocks. That’s because they are contracts to buy or sell the underlying stock within a specific time frame.

Secondly, while stocks may remain with you for years, your option contract will terminate on its expiry date. For the same reason, the amount you paid for the option (the premium) could also vanish into thin air if the price did not move as expected by the time of the option’s expiry.

Options are amenable to many different strategies that singly or in combination, achieve profit from the price movement of a stock in any direction – up, down or sideways.

It is tricky to short a stock if you expect it to move down. Shorting requires a margin deposit, and many brokers do not allow shorting. On the other hand, you can easily ride the stock’s slide downwards by simply buying a put option.

Lastly, options can be used to hedge one’s risks from holding stocks.

Why trade options?

The number one reason for trading stock options is the efficiency of capital. An options trader can effectively take on the same position as a stock investor by purchasing calls at a much lower outlay, freeing up capital for other purposes. However, because of the leverage that options provide, the risk is much higher. So, the options trader must know his stuff.

Also valuable is the inbuilt ‘maximum-loss’ feature of options. In the above example, the stock price could fall sharply and cause a substantial loss to investors if they had a position in the stocks. But if they held a call option, their loss would be limited to the premium paid on the option.

As mentioned above, options are useful vehicles for hedging stocks. By buying a put option, investors can shield their stockholding from a sudden collapse in prices due to unforeseen factors.

Imagine, a gap down open in a stock due to overnight developments. A stop order will kick in at the open price, exposing the investor to most of the overnight loss. However, a put option would be unaffected by the overnight closure of the market and will save the investor from that huge loss.

Apart from hedging, many players use options as a handy means of generating recurring income.

Options – the long and short of it

We discussed above the two kinds of options contracts known as a call and a put. Well, you can either buy or sell both of them, depending on your view of the trajectory of the underlying stock.

Here’s a table to understand the permutations: