INVESTING BASICS

Quick Overview

Options are financial contracts that create rights or obligations to buy or sell an underlying asset at a set price by a specific date. Whether a contract creates a right or an obligation depends on whether the option is bought (long) or sold (short), and whether it is a call or a put.

The rights and obligations differ by position type:

• A long call provides the right to buy the underlying at the strike price.
• A short call creates the obligation to sell the underlying if the option is exercised.
• A long put provides the right to sell the underlying at the strike price.
• A short put creates the obligation to buy the underlying if the option is exercised.

Key Contract Details

• Underlying security: The stock, ETF, or index on which the option contract is based.
• Strike price: The fixed price at which the underlying is bought or sold.
• Expiration date: The last date on which the option holder can exercise their right. After this date, the option expires worthless if not exercised.
• Premium: The price paid by the buyer (long call/put) of the option and received by the seller (short call/put) for taking on the contract's obligations.
• Contract multiplier: The number of units of the underlying represented by one option contract (commonly 100 shares for equity options in Canada).

An options chain shows all available contracts, including pricing, volume, and expiration dates. On Questrade, investors view the options chain directly in the trading platform.

What Are Options (Core Definitions)

Options are standardized contracts traded on regulated exchanges. Depending on whether an option is bought (long) or sold (short), it creates either a right or an obligation to buy or sell an underlying asset at a predetermined price before a specified expiration date.

• A long call gives the holder the right to buy the underlying security at the strike price.
• A short call creates the obligation to sell the underlying security if the option is exercised.
• A long put gives the holder the right to sell the underlying security at the strike price.
• A short put creates the obligation to buy the underlying security if the option is exercised.

Standardization means contracts for the same security share identical terms, which supports consistent trading. Exchanges and clearinghouses handle trade matching and settlement, reducing counterparty risk for both buyers and sellers.

Options Pricing Components

• Intrinsic value: The portion of the option's price that reflects any favourable difference between the underlying price and the strike price.
• Time value: The portion of the premium related to the remaining time until expiration and the potential for price movement.

Together, these components explain how options are priced and traded. Clear rules, standardized contracts, and exchange oversight make options a widely used tool in Canadian markets.

Calls vs. Puts

Options are generally categorized as calls or puts, with each contract creating different rights or obligations depending on whether the option is bought (long) or sold (short).

A long call gives the holder the right—but not the obligation—to buy the underlying security at a predetermined price, known as the strike price, before the option expires. A short call creates the obligation to sell the underlying security at the strike price if the option is exercised by the holder.

A long put gives the holder the right—but not the obligation—to sell the underlying security at the strike price before expiration. A short put creates the obligation to buy the underlying security at the strike price if the option is exercised.

Exercise and Assignment

• Exercise: When the holder of a long option chooses to use the rights in the contract, either to buy (long call) or sell (long put) the underlying security.
• Assignment: When the seller of an option (short call/put) is notified that the option has been exercised and must fulfill the contractual obligation.

Comparison: Call vs. Put Options

Calls and puts represent complementary rights and obligations within options trading. They could be combined in various ways in the market, but the core distinction lies in whether the contract grants a right or obligation to buy or sell the underlying security.

Options Pricing Basics

The price of an option, commonly called the premium, is influenced by several factors. One of the main drivers is the current price of the underlying security. For call options, premiums generally increase as the underlying price moves above the strike price. For put options, premiums tend to increase as the underlying price moves below the strike price. These relationships apply regardless of whether the option is held long or sold short.

Key Pricing Factors

• Time remaining until expiration: Options with more time before they expire usually carry higher premiums, reflecting the greater possibility of favourable price movement. This increases the value of long options and, correspondingly, increases the obligation and potential risk for short options.
• Volatility: Higher volatility raises the likelihood of larger price swings, which increases option premiums for both calls and puts. Higher premiums benefit option sellers (short positions) through greater premiums received, while increasing the cost for option buyers (long positions).
• Interest rates and expected dividends: These could also influence option pricing in more subtle ways, reflecting broader market conditions and the relative cost or benefit of holding the underlying security over time.

While mathematical models, such as Black-Scholes or binomial models, are commonly used to estimate option prices, they are beyond the scope of this discussion. At a conceptual level, understanding how underlying price, time, volatility, and market conditions interact helps explain why option premiums fluctuate for both long and short call and put positions.

Examples to Understand Option Outcomes

This section provides two simple, at-a-glance examples showing how options could behave at expiration. These illustrations are conceptual and do not include actual fees or premiums, which are noted separately.

Example A: Long Call at Expiration

A long call gives the right to buy the underlying security at the strike price. The table below shows potential outcomes at expiration for a single call contract with a strike of $50.

Note: Premiums and trading fees exist and affect actual profit or loss; amounts above illustrate intrinsic value only.

Example B: Long Put at Expiration

A long put gives the right to sell the underlying security at the strike price. The table below shows potential outcomes at expiration for a single put contract with a strike of $50.

Note: Premiums and trading fees exist and affect actual profit or loss; amounts above illustrate intrinsic value only.

These tables provide a quick, conceptual view of how calls and puts behave at expiration, highlighting in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM) scenarios for understanding potential outcomes.

Options Chains: What's Displayed

An options chain is a structured listing of all available contracts for a particular underlying security. It provides key information for both call and put options, often presented in separate panels for clarity.

Common Columns in an Options Chain

• Strike price: The set price of the underlying security.
• Bid/ask: The highest buying and selling price.
• Last: The most recent trading price for the option contract.
• Volume: The number of contracts traded during the session.
• Open interest: The total number of outstanding contracts that have not been exercised or closed.

An expiry selector allows viewing contracts for different expiration dates. Options chains are typically grouped by strike price and expiration, which helps organize information when reviewing multiple contracts at once.

Reading an Options Chain

Reading an options chain involves recognizing which columns reflect market activity (volume, bid/ask, last) and which represent contract specifications (strike, expiry, open interest). Strikes are generally listed from lowest to highest, and expiration dates are often presented in chronological order.

Some trading platforms allow the creation of single-leg tickets, where one contract is traded at a time, or multi-leg tickets, which combine two or more options in one transaction. These options are available for display within the chain.

Overall, an options chain provides a structured view of the available contracts and their market data. Understanding how to navigate columns, groupings, and panels could support efficient analysis and comparison of multiple call and put contracts.

Placing an Options Trade

Placing an options trade typically follows a consistent sequence across most trading platforms. The steps below describe the process at a high level.

Typical Order Flow

• Locate the options chain for the selected underlying security.
• Select an expiration date from the available listings.
• Choose a strike price and option type (call or put).
• Enter the quantity, reflecting the number of options contracts.
• Select the order type, such as market or limit.
• Review the order details, including contract specifications and estimated cost.
• Submit the order to the market.

After submission, orders might be filled, partially filled, delayed, or cancelled, depending on factors such as liquidity, pricing, and market activity. Execution status and trade details are typically displayed in an order blotter or activity log, where updates are monitored.

Most trading platforms also provide tutorials and help resources that explain how to navigate option chains, enter trades, and review order status. These resources are usually accessible through internal navigation links and are intended to support understanding of platform-specific features and workflows.

Understanding Expiration, Exercise, and Assignment

Expiration is the date when an options contract ends. At that point, the option will either have value or it will not.

• An option is ITM (in the money) if the underlying price is favourable compared to the strike price at expiration. ITM options have intrinsic value.
• An option is OTM (out of the money) if the underlying price is not favourable at expiration. OTM options have no intrinsic value and typically expire without value.

What Happens Based on Position Type

• Long options (buyers): Holders might choose to exercise the option anytime before the date of expiry. Exercising a call allows the holder to buy the underlying at the strike price; exercising a put allows the holder to sell the underlying at the strike price.
• Short options (sellers/writers): Sellers will be assigned if the option is exercised. They must fulfill the contract by delivering (for calls) or purchasing (for puts) the underlying security.

Settlement is coordinated through the clearing system, which ensures the exchange of securities or cash between parties.

Operational details, such as exercise cut-off times, automatic exercise rules, and notification methods, vary by platform and broker. These are typically communicated through platform messages, trade confirmations, or account activity records.

Important Risks and Practical Considerations

Options involve both market-related risks and operational factors that might affect how contracts behave over time. These considerations apply to all positions, whether held long (bought) or short (sold). Long positions carry rights that might be exercised, while short positions carry obligations that will be assigned if the option is exercised.

Market-Related Factors

• Time decay: An option's time value decreases as expiration approaches, which could reduce its price even if the underlying security does not move. This affects the value of long positions and the potential risk of short positions.
• Price gaps: Sharp moves in the underlying security, especially after news or scheduled events, could quickly change option values.
• Liquidity and bid/ask spreads: Options that trade less frequently might have wider spreads, impacting pricing and execution for all positions.
• Early assignment: American-style options could be exercised before expiration, potentially resulting in assignment for short positions.
• Events and volatility: Earnings releases, economic data, and other events could increase volatility, influencing option premiums independently of the underlying price.

Operational Considerations

• Expiration handling: Options have fixed expiration dates, after which contracts no longer exist. Exercise cut-off times and automatic processing vary by platform and broker.
• Corporate actions: Stock splits, mergers, dividends, and other events might result in contract adjustments, including changes to strike prices, contract size, or deliverables. These are handled according to standardized clearing rules.

Understanding these factors helps clarify potential risks and obligations for both long and short calls and puts.

Key Terms and Mini-Glossary

• Premium: The price paid by the buyer (long call/put) of the option and received by the seller (short call/put) for taking on the contract's obligations.
• Bid/ask: The bid is the highest price a buyer is willing to pay for an option; the ask is the lowest price a seller is willing to accept.
• Spread: The difference between the bid and ask prices of an option, reflecting market liquidity and trading costs.
• Open interest: The total number of outstanding options contracts for a particular strike price and expiration date that have not been exercised or closed.
• Volume: The number of options contracts traded during a specific period, typically reported daily.
• Implied volatility: A measure of the market's expectation of how much the underlying security might fluctuate in the future, derived from the option's price.
• Greeks: Metrics used to describe an option's sensitivity to various factors:
  • Delta: Sensitivity to changes in the underlying security's price.
  • Gamma: Rate of change of delta as the underlying price changes.
  • Theta: Sensitivity to the passage of time (time decay).
  • Vega: Sensitivity to changes in implied volatility.
• Assignment: The process by which the seller of an option is notified that the option holder has exercised the contract, creating an obligation to deliver or purchase the underlying.
• Exercise: When the holder of an option chooses to use the rights in the contract, either to buy or sell the underlying security.
• American vs. European style: American-style options could be exercised any time before expiration; European-style options could only be exercised on the expiration date.
• Contract multiplier: The number of underlying shares represented by a single options contract, often 100 in Canadian markets.
• Expiration cycle: The schedule of standard expiration dates for options, typically monthly or weekly.
• Options chain: A listing of available options contracts for a security, including strike prices, expiration dates, and pricing information, used to review market activity and potential trades.
• Time value: The portion of an option's premium above intrinsic value, related to time remaining and market expectations.

These definitions provide a reference point for understanding options terminology, supporting clarity when reviewing contracts and market information.