How to Use Stock Options to Your Advantage
6 of 10 in Series: The Essentials of Futures and Options Trading
The options market goes hand in hand with the futures markets. When used properly, options give you an opportunity to diversify your holdings beyond traditional investments and to hedge your portfolio against risk. The key is discovering how to use options the right way.
Here’s some basic information about options:
Option buyers are also known as holders, and option sellers are known as writers. Call options give the owner the right, not the obligation, to buy an underlying asset at a specified price within a specified time frame. Put options give the owner the right, not the obligation, to sell an underlying asset at a specified price with a specified time frame. Call and put holders can exercise these rights at the strike price, the predetermined price at which an option will be delivered when it is exercised.
Call option writers (sellers) have the potential obligation to sell. Put option writers (sellers) have the potential obligation to buy the underlying asset.
Options, like futures contracts, have expiration dates. All stock options expire on the third Friday of the month. Options on futures expire on different days depending on the contract. Sometimes different classes of options expire on the same day. These days are known as double-, triple-, and quadruple-witching days:
Double-witching days: When any two of the different classes of options (stock, stock index options, and stock index futures options) expire.
Triple-witching days: When all three classes expire simultaneously, which happens on the third Friday at the end of a quarter.
Quadruple-witching days: When all three classes of options expire along with single stock futures options.
Options trade during the trading hours of the underlying asset.
Owning an option doesn’t give the holder any share of the underlying security. The right to buy or sell that security is what options are all about.
Options are a (slightly less than) zero-sum game. For every dollar someone makes, someone loses a dollar. Options, like futures, have both a seller and a buyer. When you make a losing trade, someone else gets an amount equal to your losses transferred to his or her account, and you get charged commission. The exchanges also get a fee.
If you win, you’ll probably owe taxes. The treatment of options in the tax code is complex, and much of it deals with whether you have short-term or long-term gains. The details are provided in the option disclosure statement, which is required reading before you ever trade options. The statement is part of the packet of information your broker gives you along with the account application. Be sure to read that document carefully and discuss the tax-related details with your accountant before trading.