Your guide to options trading
Long Options are contracts that give you the right but not the obligation to buy or sell a security, such as stocks, for a fixed price within a specific period of time. Learn about options.
Why trade options?
For call holders, you can benefit from an increase in the market value of the underlying security over the lifetime of the option at a cost which is far less than the cost of buying the stock outright.
If the price of the underlying security falls instead of rises, a call holder's maximum loss will be limited to the premium he or she paid for the option, plus any transaction or commission costs.
To fix a future price
For call holders, options allow you to fix the future price (at the strike price of the option) of the underlying interest if you decide to take delivery of the underlying security. However, should the long call option expire out of the money, the premium paid would be lost, as it would not be economical to exercise the option. For put writers, locking-in a cost that is below market value can give you the opportunity to acquire the underlying interest at a fixed cost if the option is assigned otherwise the premium collected by writing the put options will be your profit. The maximum risk for a short put is that the stock drops to 0 value, in which case you would take a loss equal to the strike price less the premium collected per the # of shares exposure.
Insurance against market drops
An investor who expects short term declines in a specific interest or market can buy a put option on the underlying and should the underlying drop in price, potentially sell the put at a profit or exercise it and sell the underlying (if sufficient margin is available) at the put’s strike price. The risk of the long put is limited to the premium paid.
Writers of puts and calls benefit from income received as a premium, which becomes pure profit if the option is never assigned. Naked call and put writing are extremely risky strategies and should be used only by sophisticated investors with clear understanding of potentially unlimited losses and limited rewards.
Strategies to help you invest better
For Margin Requirements related to the Investment Strategies described below, please go to the Margin Requirements page
- The most popular bullish strategy
- Holder of a Long Call has the right to take delivery of the underlying security at the exercise price within a set period of time prior to expiration
- Used when the investor anticipates that the underlying security will increase in price
- Risk to this strategy is limited to the price paid for the contract
- Just as Long Calls are the most popular bullish strategy, Long Puts are the most popular bearish option strategy.
- For a long put holder to profit, the market price of the underlying interest must decline sufficiently to recoup the put premium and commission.
- A long put is used to profit from a decline in the market price of the underlying or to hedge a long position in an underlying interest.
- The risk to this strategy is limited to the price paid for the contract.
- Potential profit is limited to the premium received when writing the call.
- If being assigned the Naked Call writer will have to buy the underlying at the higher market price and deliver it for the lower strike price.
- Risk is unlimited as the market price can potentially rise indefinitely above the strike.
- Potential profit is limited to the premium received when writing the put.
- Risk is limited to the strike price minus the premium received.
- Income strategy
- Covered Call writer buys the underlying stock and writes calls against the holding
- The maximum risk occurs if the market price of the underlying falls to zero
- Covered call writer gives up the potential gain above the strike price
- Long higher strike call and short lower strike call at same expiration
- The bigger the difference between the strikes, the bigger the potential profit and greater the risk
- Your maximum loss and profit are limited
- Long higher strike put and short lower strike put at same expiration.
- The bigger the difference between the strikes, the bigger the potential profit. And also the bigger the cost.
- Your maximum loss and profit are limited
- Long lower strike call and short higher strike call at same expiration.
- The bigger the difference between the strikes, the bigger the potential profit, but also the bigger the cost.
- Your maximum loss and profit are limited.
- Long lower strike put and short higher strike put at same expiration
- The bigger the difference between the strikes, the bigger the potential profit and the greater the risk
- Your maximum loss and profit are limited
- Long call and long put at same strike (straddle) or different strikes (combination) at same expiration
- You can profit if the underlying interest moves significantly in either direction
- Loss limited to the cost of the straddle or combination
- Short call and short put at same strike (straddle) or different strikes (combination) at same expiration
- Unlimited risk
- Profit potential limited to the premium collected for writing the straddle or combination
Characteristics and risks of options
- Option trading can carry substantial risk of loss.
- Risk of losing your entire investment in a short period of time for long options
- Writers of Naked Calls are faced with unlimited losses if the underlying stock rises
- Writers of Naked Puts are faced with losses limited to strike – premium collected if the underlying stock drops to 0
- Writers of naked positions are faced with margin risks if the position moves against the intended direction
- No privileges of ownership
- Standardized units of trading and expiration cycles
Because of their flexibility, options can provide investors with a chance to realize almost any strategic goal, from managing risk to enhancing leverage. Option trading can also carry a substantial risk of loss. Before investing in options, it's important to understand the strategies you can use to limit this risk.
Holders should also realize that options pay no interest or dividends, have no voting rights, and no privileges of ownership. They are available from TD Direct Investing on a wide variety of investment vehicles, including stocks, and market indices.
While many factors have contributed to the success of exchange-traded options in North America, standardization of key option features (including exercise prices, trading cycles, and expiration dates) is one of the most important as it has contributed to the viability of a secondary options market.
For equity options, a 100 share (board lot) contract size generally applies to all markets except in the event of a stock split or corporate reorganization (in which case the contracts are altered to adjust for the split).
For index options, which are cash-settled, the contract size is determined by multiplying the premium by an index multiplier, which is usually $100.
As for standard expirations, it's important to understand that each option class (which are options listed on the same underlying interest) has several different option series, which are identified as calls or puts by their symbol, expiration date, and strike price.
- Indices ~ European vs. American Style
The basic differences between equity and non-equity options are that some non-equity options are cash settled, while all equity options allow physical delivery settlement of the underlying shares. Similarly, some non-equity options have a European exercise style, which means they can only be exercised on their expiration date. Most equity options, on the other hand, are American style, which means they can be exercised on any trading day prior to their expiration date. Finally, the minimum margin requirements for equity and non-equity options are generally different.
Index Options are the most popular non-equity options, as they allow investors a very broad market exposure. Despite that, investors should be aware of certain index option characteristics. First, the component stocks of an underlying index are an important strategic consideration. For investors looking to participate in the overall market, you should choose an index with well-balanced underlying equities, not one heavily weighted in only one or two industries. Second, investors who are looking for a hedging strategy should find an index that has equities closely resembling their portfolio holdings.
Although TD Direct Investing can facilitate options trading in Canadian and U.S. stocks and most market indices, we do not arrange option trading on futures contracts.
- Risk of Loss
- Special Risks of Index Options
- Factors Influencing Option Prices
- Strategies for Reducing Risk
Many investors steer clear of options trading because they are unfamiliar with the mechanics involved or are concerned about risk. Indeed, a high degree of risk may be involved in the purchase and sale of options, depending on how and why options are used.
It is for this reason that you should understand the different options trading strategies available, as well as the different types of risk you may be exposed to.
Options have only a limited life. Because of that, option holders run the risk of losing their entire investment in a relatively short period of time.
For option writers, the risks are even greater. Many people who write calls are uncovered, which means they don't own the underlying interest. Call writers can incur large losses if the price of the underlying interest rises above the exercise price, forcing them to buy the interest at a high market price but sell it for much lower.
Similarly, uncovered put writers who don't protect themselves by selling a short position in the underlying interest may suffer a loss if the price of the underlying interest falls below the option's exercise price. In such a situation, the put writer will have to buy the underlying interest at a price above current market value, thereby incurring a loss.
When trading in U.S. options, the transaction is carried out in U.S. dollars which would expose you to risks from fluctuations in the foreign exchange market. Furthermore, transactions that involve holding and writing multiple options in combination, or holding and writing options in combination with buying or selling short on the underlying interests present additional risks.
- Timing Risks
- Imperfect Hedge
- If Trading is Interrupted
In addition to the risks just described which apply generally to the holding and writing of options, there are additional risks unique to trading in index options.
Investors with spread positions and certain other multiple option strategies are also exposed to a timing risk with index options. That's because there is generally a one-day time lag between the time that a holder exercises the option and a writer gets notice of an exercise assignment. Index option writers are required to pay cash based on the closing index value on the exercise date, not on the assignment date. Admittedly, this risk is somewhat alleviated by the use of European-style options.
As discussed earlier, investors intending to use index options to hedge against the market risk associated with investing in one or more individual stocks should recognize that this results in a very imperfect hedge. Unless the underlying index closely matches an investor's portfolio, it may not serve to protect against market declines at all.
Finally, if trading is interrupted in stocks that account for a substantial portion of the value of an index, the trading of options on that index could be halted. If this happens, index option investors may be unable to close out their positions and could face substantial losses if the underlying index moves adversely before trading resumes.
- Intrinsic Value
- Time Value
By making yourself familiar with the factors influencing option prices, you will be able to make informed decisions about which option investment strategies will work for you.
The relationship between the market price of the underlying interest and the exercise price of the option is a major determinant of the option price. For example, assume ABCD shares were trading at $30, ABCD Apr. 25 calls would have an Intrinsic Value of $5 per share (which is equal to their in-the-money amount). Conversely, if ABCD stock was trading at $20, ABCD Apr. 25 puts would have an intrinsic value of $5 per share. All else being equal, options that have an intrinsic value are clearly worth more than options that are at-the-money or out-of-the-money.
An option's Time Value is equal to its current premium minus the in-the-money amount. As an example, let's assume ABCD stock was trading at $30 and you buy one ABCD Apr. 25 call for $6. As we just saw, your call would have an intrinsic value of $5, and its time value would be $1 (premium - intrinsic value). Time value relates solely to the call holder's belief that the market price of the underlying interest will rise, or to the put holder's belief that the market price of the underlying interest will decline, before the option expires. Normally, option holders will pay a higher time value when the expiration date is a long time away. However, as the expiration date approaches the time value is constantly being eroded and eventually declines to zero on the expiration date.
The Volatility of the underlying interest's market price also affects the price of the option. Options on an underlying interest whose market price fluctuates widely over the short term command higher premiums to compensate for the volatility. Options on less volatile underlying interests will command lower premiums because of lower volatility.