Lesson 3: Which basic option strategies might make sense for beginners?

Now that you understand some options basics, let’s start to think about making an option trade.

While it’s possible to create very sophisticated and complex option trades — something you might want to consider in the future — new options traders will likely start with more basic strategies. In this lesson, we’ll describe some simpler option trades.

Some financial transactions are quite straightforward — you hope to buy an asset at a low price and sell it later at a higher price. People often trade stocks like this, and you can also trade options this way.

Beginner options traders will often start by buying call or put options, hoping to sell the option contract at a higher price in the future.

This is generally a straightforward trade for these reasons:

The idea is simple

A trade is successful when you buy at a low price and sell at a higher price.

Although most aspects of call and put buying are straightforward, there are special circumstances that can arise if you hold an option position that’s in-the-money at expiration — you may need to take action, depending on your trading objectives. We suggest you build a good understanding of exercising in-the-money options at expiration, discussed later in this lesson. You should do this  before you begin trading options, especially if you plan on holding your option position until expiry.

At expiration, the call option has value if the stock closes above the strike price. The trade becomes profitable when that value exceeds the initial price paid for the call. While profit is unlimited – the stock can rise to any price - the maximum loss is limited to the call purchase price, plus commission.

Buying a call option might offer theoretically unlimited potential profit while the risk of the trade is generally limited to the premium paid plus commission. Buying a put option might also offer a large, but not unlimited potential profit, with the risk also generally limited to the premium paid plus commission.

In addition, options buying provides leverage, as they give you exposure to a stock position with less capital than buying (or shorting) the stock directly.

One of the main challenges when buying calls or puts is time erosion. This is especially true if an option is close to its expiry date.

• Options continuously lose time value over their lifetime.
• Options that are close to their expiry date, also called short-dated options, can lose time value quickly.

Consider this scenario: you purchase an XYZ call option on March 1. XYZ stock is trading at $40 and you purchase a call with a strike price of $42 and an expiry date of March 12. The option premium is $2, so the call option costs ($2 x 100) or $200 per contract, plus commission.

You want to sell your call option for more than the option premium of $2 you originally paid for it in order to make a profit. You can:

• sell it any time on or before expiry for the market price at that time,
• wait until expiry and exercise the option,
• or exercise American-style options before expiry. Note that you’ll lose the time value of the option if you exercise before expiry.

In this example, you’ve chosen a strike price that’s out-of-the-money (the intrinsic value is zero), so the $2 premium represents only time value at the time of purchase.

Next, we move to March 5, a few days later. XYZ stock price has increased to $41 but the price of XYZ 42 call option has declined to $1.10. Why? Because time erosion has reduced the value of the call to a greater extent than the increase in XYZ’s price has contributed to its rise. In addition, the call is still out-of-the-money and has no intrinsic value. The option is close to its expiry date, so time erosion is happening at an accelerated pace.

Moving now to March 10. XYZ stock price has increased to $43 and the option is now in-the-money. However, with just 2 days left to its March 12 expiry, almost all of the call’s time value has eroded and the call is trading at $1.25. Since the call is in-the-money, it now has intrinsic value, which you can calculate: the intrinsic value of XYZ call option on March 10 is $1 which is the $43 stock price minus $42 option strike price. The call’s time value is $0.25.

Between March 1 and March 10, XYZ stock increased from $40 to $43. However, the March 12 XYZ $42 call option premium declined from $2 to $1.25.

In this example, the time erosion was greater than the increase in the value due to the stock’s price appreciation and the call option price declined.

Note that it was possible to do a successful trade in this period by buying the call on March 5 and selling on March 10. However, timing trades that precisely is a very challenging goal.

When you hold a call or put option that is in-the-money and about to expire, there are some decisions you’ll need to make. You can sell the option at any time before market close on expiry day. However, if you continue to own the option after market close on expiry day, one of the following things will happen, depending on your circumstances.

1. If you hold a call option that’s in-the-money at expiry, the option might be exercised and you might own that stock position on the following business day — you’ll need sufficient margin or buying power in your account to cover the exercise. Please refer to the Execution of Orders section of the Derivatives Trading Agreement or contact us for details. You may need to take action based on your specific situation and strategy.
2. If you hold a put option that’s in-the-money at expiry, and your account holds the underlying stock, the option may be exercised and your stock may be sold. Please refer to the Execution of Orders section of the Derivatives Trading Agreement or contact us for details. You may need to take action based on your specific situation and strategy.
3. If you hold a put option that’s in-the-money at expiry, and your account does not hold the underlying stock, the option might still be exercised. In this case, you would receive a short position in the stock at the option’s strike price and you would be short that stock on the following business day — you’ll need sufficient margin or buying power in your account to cover the exercise. Please refer to the Execution of Orders section of the Derivatives Trading Agreement or contact us for details. You may need to take action based on your specific situation and strategy.

The takeaway: Make sure you understand your choices if you don’t sell an in-the-money option before market close on expiry day. For more information, consult the AA&D Derivatives Trading Agreement Execution of Orders (PDF, 1.3 MB) Opens a new window.. If you have any questions, contact us Opens a new window..