1. Money

How Options are Traded

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Many day traders who trade futures, also trade options, either on the same markets or on different markets. Options are similar to futures, in that they are often based upon the same underlying instruments, and have similar contract specifications, but options are traded quite differently. Options are available on futures markets, on stock indexes, and on individual stocks, and can be traded on their own using various strategies, or they can be combined with futures contracts or stocks and used as a form of trade insurance.

Options Contracts

Options markets trade options contracts, with the smallest trading unit being one contract. Options contracts specify the trading parameters of the market, such as the type of option, the expiration or exercise date, the tick size, and the tick value. For example, the contract specifications for the ZG (Gold 100 Troy Ounce) options market are as follows:

  • Symbol (IB / Sierra Chart format): ZG (OZG / OZP)
  • Expiration date (as of February 2007): March 27 2007 (April 2007 contract)
  • Exchange: ECBOT
  • Currency: USD
  • Multiplier / Contract value: $100
  • Tick size / Minimum price change: 0.1
  • Tick value / Minimum price value: $10
  • Strike or exercise price intervals: $5, $10, and $25
  • Exercise style: US
  • Delivery: Futures contract

Note that options contracts have three more entries than futures contracts because of the three additional parameters that are needed to trade options, which are the strike price, the exercise style, and the delivery method.

The contract specifications are specified for one contract, so the tick value shown above is the tick value per contract. If a trade is made with more than one contract, then the tick value is increased accordingly. For example, a trade made on the ZG options market with three contracts would have an equivalent tick value of 3 X $10 = $30, which would mean that for every 0.1 change in price, the trade's profit or loss would change by $30.

Call and Put

Options are available as either a Call or a Put, depending upon whether they give the right to buy, or the right to sell. Call options give the holder the right to buy the underlying commodity, and Put options give the right to sell the underlying commodity. The buying or selling right only takes effect when the option is exercised, which can happen on the expiration date (European options), or at any time up until the expiration date (US options).

Like futures markets, options markets can be traded in both directions (up or down). If a trader thinks that the market will go up, they will buy a Call option, and if they think that the market will go down, they will buy a Put option. There are also options strategies that involve buying both a Call and a Put, and in this case the trader does not care which direction the market moves.

Long and Short

With options markets, as with futures markets, long and short refer to the buying and selling of one or more contracts, but unlike futures markets, they do not refer to the direction of the trade. For example, if a futures trade is entered by buying a contract, the trade is a long trade, and the trader wants the price to go up, but with options, a trade can be entered by buying a Put contract, and is still a long trade, even though the trader wants the price to go down. The following chart may help explain this further:

Futures

  • Entry type: Buy
  • Direction: Up
  • Trade type: Long
  • Entry type: Sell
  • Direction: Down
  • Trade type: Short

Options

  • Entry type: Call
  • Direction: Up
  • Trade type: Long
  • Entry type: Put
  • Direction: Down
  • Trade type: Long

The important point is that an options trade that is entered by buying either a Call or a Put, is a long trade, regardless of which direction the trader wants the price to move (up for a Call, and down for a Put).

Limited Risk or Limitless Risk

Basic options trades can be either long or short, and can have two different risk to reward ratios. The risk to reward ratios for long and short options trades are as follows:

Long Trade

  • Entry type: Buy a Call or a Put
  • Profit potential: Unlimited
  • Risk potential: Limited to the options premium

Short Trade

  • Entry type: Sell a Call or a Put
  • Profit potential: Limited to the options premium
  • Risk potential: Unlimited

As shown above, a long options trade has unlimited profit potential, and limited risk, but a short options trade has limited profit potential and unlimited risk. However, this is not a complete risk analysis, and in reality short options trades have no more risk than individual stock trades (and actually have less risk than buy and hold stock trades).

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