Aside from stocks, bonds, and mutual funds, options is one of the most common positions that can be held in a portfolio. Options are often used by day and swing traders to leverage positions.
Stocks rarely double in value in a short amount of time. On the other hand, options normally can double or triple in value in a month or less.
At the same time, a 50% loss is pretty common when holding an option. Understanding options can potentially have a big payout when used correctly at the right time.
This article will have five main parts.
- How Options Work
- Stocks vs Options (Risks and Upside)
- How to Trade Options in Canada
- Purpose/Use of Options
- Option Strategies
How Options Work
The two main kinds of options are call and put options. Option strategies are basically a combination of two or more call or put options with different strike prices and expiration dates.
Options give a right to buy or sell a stock at a particular strike price until the expiration date.
Options are a derivative, that is, the value of an option depends on the price of an asset. Options are available for most stocks and ETFs in US and Canada. Unlike stocks, options cannot be traded on premarket or after hours. Options trading can only be done during market hours (9 am – 4 pm).
Call Option – Option to buy a stock at a strike price
Put Option – Option to sell a stock at a strike price
In general, 1 option contract is equivalent to buying or selling 100 shares. The value displayed on any investing platform in US and Canada is a price of an option per share.
Let us say an option is valued at $2. One contract will be valued at $200. The minimum trade for any option is one contract (option to 100 shares).
Strike Prices
Options can be classified by their strike prices as either:
- OTM (out of the money) options
- ITM (in the money) options
Example: Apple 120 call
Apple 120 call option would be ITM if the price of Apple stock is greater than $120. Let us say Apple stock is trading at $125 per share. Using the option to buy at $120 and immediately selling on the market at $125 would result in a value of $5.
OTM options happen when the stock price is less than the strike price of an option. Assume that Apple stock is valued at $115 per share. Apple 120 call would be OTM since buying at the market ($115) is cheaper than exercising this call option to buy at $120.
In general, ITM options are more expensive and offer less upside than OTM options. Options can switch from being OTM to ITM, or from ITM to OTM at any time.
OTM option is used to have a bigger potential upside. A 500% return can be achieved with an OTM option while an ITM option will have a hard time giving 500% returns.
Exercising an option means using an option to buy or sell a stock at the strike price. Exercising an option is usually done at the expiration date as long as the option is ITM.
Exercising an Apple 120 call option means buying Apple stock at $120. This will only make sense if the price of Apple stock is above $120 on the expiration date.
Value of an Option
Selling a call/put option is usually better than exercising the option. Depending on how much time before expiration, selling an option may have some premium rather than exercising an option that will only give the intrinsic value.
Let us say Apple stock is trading at $125. An Apple 120 call expiring in 5 days may have a value of around $7 if sold on the market since other traders may pay a premium for it. Selling for $7 is better than exercising which will only yield $5 (Using the call option to buy at $120, selling on the market at $125).
Option Price = Value if exercised today (Intrinsic value) + Premium (Extrinsic value)
Intrinsic and extrinsic value is always positive or zero. Option prices cannot go negative. The worst-case scenario for a call/put option is $0 (expire worthless). This will be discussed later.
In general, the value of an option depends on how much the buyer and the seller of an option agree to make a trade. Intrinsic value is fixed while the amount of premium depends on the buyer and the seller.
Intrinsic Value
Intrinsic value may sound complicated, but it is basically the difference between the current price of a stock and the strike price of an ITM option. It is the value of an option if exercised immediately.
Only ITM options have intrinsic value, OTM options do not have intrinsic value.
Example: Apple 100 call
Assuming Apple stock is valued at $105, this call option will have an intrinsic value of $5 (Using the option to buy at $100, selling on the market at $105).
This call option will have a value of at least $5 since it may have some extrinsic value. If the value is less than $5, exercising this call option will give more value, but this rarely happens.
Extrinsic Value
OTM options are purely extrinsic value. OTM options that are closer to the current price of stock have higher extrinsic value while farther OTM options are cheaper since they are less likely to be ITM.
The extrinsic value of an option depends on two things:
- How long before an option expires (ex. 5 days)
- Demand (IV – Implied Volatility)
People are willing to pay higher prices for an option that expires in a year compared to an option that expires in a week. An Apple 120 call expiring in a year will be a lot more expensive compared to the same option that expires in a week.
Implied Volatility (IV) may sound complicated, but it is basically an expression of how motivated the buyers are compared to the sellers of options.
Low IV – few buyers, more sellers – Low option price
High IV – more buyers, few sellers – High option price
An option that moved 50% in a week will have a high IV and its option prices will be more expensive compared to an option that has stayed relatively flat.
Options expiring worthless
The worst-case scenario when buying a call or a put option is for it to expire worthless. An option expires worthless if it is OTM on the expiration date. The value of an option will be $0, a 100% loss on a position.
An Apple 120 call would expire worthless when Apple stock is less than $120 on the expiration date. An Apple 120 put would expire worthless if Apple stock is more than $120 on the expiration date.
Let us say Apple stock is valued at $119 on the expiration. Buying Apple stock for $119 is cheaper than using an option to buy Apple stock at $120 by using the 120 call option. Hence, this call option will expire worthless.
An option that expired worthless would automatically disappear on the investing platform the next trading day.
Stocks vs Options Risks and Upsides
On June 24, 2021, Apple stock is valued at $134.41. At this time, Apple 135 call with July 30, 2021 expiration is valued at $2.10.
Before buying any option, considering the potential price scenarios on the expiration date is helpful to evaluate the risks and upsides.
Potential Returns (Profit/Loss)
| AAPL on July 30 scenarios | AAPL Stock @ $134.41 | AAPL 135c (@$2.10) |
| $ 110.00 | -18% | -100% |
| $ 120.00 | -11% | -100% |
| $ 125.00 | -7% | -100% |
| $ 130.00 | -3% | -100% |
| $ 135.00 | 0% | -100% |
| $ 140.00 | 4% | 166% |
| $ 145.00 | 8% | 404% |
| $ 150.00 | 12% | 642% |
Potential returns on stocks are pretty straightforward. A $100 stock that crashed to $50 will result in a 50% loss. In the same way, an Apple stock bought at $134.41 and sold at $120 would be a loss of $14.41 per share (11%).
Options expire worthless when it becomes OTM at the expiration date. After all, buying at the market at less than $135 is cheaper than using a call option to buy at $135. For this reason, the value of an option is $0 if Apple stock is $135 or less at the expiration date.
Apple 135 call would be valued at $5 if Apple stock is $140 at the expiration date. Buying this option at $2.10 would result in a profit of $2.90, a 166% return. If Apple stock reached $140 earlier, let us say 2 weeks before expiration, it will have some extrinsic value and can be sold for more than $5.
One contract of Apple 135 call can be bought at $210 (100 X $2.10). Provided Apple stock reaches $150, it can be sold for at least $1,500 per contract (100 X $15), a return of 642%.
Hence, options provide a much higher risk/reward compared to stocks. After all, this option would expire worthless if the stock is below $135 on the day of expiration.
Traders can sell an option anytime before expiration to collect some premium on top of intrinsic value.
Buying a call or put options are often used to maximize returns to leverage for a big movement on a stock. Far OTM options offer the highest upside but have a higher risk of expiring worthless.
Expiration Dates
Here are the three main types of options based on expiration dates.
- Weeklies (expires in 1-3 weeks)
- Monthlies (expires in 1-6 months)
- Leaps (expires in 9 months or more)
The prices below are the prices of Apple 140 calls with different expiration dates. Prices are taken as of June 24, 2021. Apple stock is priced at $134.41 on June 24 market close (4 pm Eastern Time).
| Expiration | Value (AAPL 140c) | Value per contract (x100) |
| 2 weeks (7/9) | $ 0.27 | $ 27.00 |
| 3 months (9/17) | $ 3.40 | $ 340.00 |
| 1 year (6/22) | $ 11.70 | $ 1,170.00 |
Generally, options that have a shorter amount of time before expiration has a higher risk to expire worthless. After all, longer-dated options have more time to become ITM while weeklies have a shorter amount of time to become ITM.
On the other hand, shorter-dated options have more upside. For the first option above to multiply by 10 in value (900% profit), Apple stock would only need to be $142.70 (at least $2.70 in value) within 2 weeks.
The second example would need 140c to become $33.40 ITM by expiration to get the same 900% returns. Apple stock would need to be $173.30 for the option expiring in 3 months to multiply by 10 in value.
Weeklies offer the most potential upside but are more likely to expire worthless. If Apple stock is below $140 in 2 weeks, the first call option would be worth $0 on expiration.
Leaps can be used as an alternative to shares, requiring less capital and can capture the potential upside of shares. Buying 100 shares of Apple stock costs around $13,400 ($134.41 each), while 1 contract of a leap costs $1,170.
An Apple 140 call gives a right to buy Apple stock at $140 by paying a premium of $11.70 ($1,170 per contract). In case Apple stock reaches $190, this option would be worth at least $50, with a profit of $38.30 after subtracting the capital.
Buying Apple stock at $134 and selling at $190 would result in a profit of $56 per share. Two leap contracts would give a profit of $76.60 ($38.30 X 2) if Apple stock reaches $190 in a year.
Two Apple leaps would only require a capital of $2,340 while 100 shares of Apple would require a capital of $13,400. These two would give a similar return if Apple reach $190 in a year while requiring $10,000 less capital.
The maximum downside for two Apple leaps is $2,340 if Apple is below $140 in a year. A 50% crash in Apple stock would result in a loss of $6,700.
In summary, leaps can function as a leveraged version of shares that requires less capital than buying a stock outright, but at the same time, capital invested on a leap can expire worthless.
How to Trade Options in Canada
Here in Canada, options are available for most US and CAD stocks listed on the NYSE, TSE, and NASDAQ. In order for an option to be available, there should be enough people willing to sell an option.
Stocks that have a market capitalization of more than $1 billion typically have call and put options available. Popular stocks like Apple have more strike prices and expiration dates available.
To start trading options in Canada, a person needs to open an account with an Investment Dealer that is an IIROC (Investment Industry Regulatory Organization of Canada) member to comply with federal regulations and tax law requirements. Most platforms in Canada require at least $1,000 of capital.
From the members list page on iiroc.ca, an example of IIROC-regulated dealers are TD Securities Inc., RBC Direct Investing Inc., and Questrade, Inc.
Here is a tutorial video on how to buy and sell an option using Questrade. The process is similar to trading stocks.
One contract is always equal to 100 shares. Multiply by 100 to get the price of one option contract.
Option Trading Fees
Commission fees for option trades are different for every platform. Unlike in the United States where some platforms charge commission-free trades, platforms in Canada charge commission fees for option trades.
Trades in US dollars are charged fees in US dollars while CAD trades will be charged on CAD.
RBC Direct Investing
Regular Pricing: $9.95 + $1.25 per contract
Special Pricing for Active Traders: $6.95 + $1.25 per contract
How to Access Special Pricing: A person has to trade 150 or more times in a 3-month period.
TD Direct Investing
Regular Pricing: $9.99 + $1.25 per contract
Special Pricing for Active Traders: $7.00 + $1.25 per contract
How to Access Special Pricing: A person has to trade 150 or more times in a 3-month period.
Questrade
Regular Pricing: $9.95 + $1.00 per contract
Special Pricing for Active Traders: $4.95 + $0.75 per contract
How to Access Special Pricing: Subscription fee of $89.95 a month. This includes Level 2 market data. The plan can be canceled anytime. A subscription is worth the price for people trading 20 times in a month.
The free plan is cheaper for trades fewer than 20 times in a month.
Minimum Requirement: $1,000 to open an account, $250 to keep an account active.
Purpose of Options
- Leverage
- Insurance
- Alternative to shorting (Put option)
Leverage
The most common use of the call/put option is for leverage. A 10% move in a stock can potentially make a short-dated option double or triple in value. Also, a 50% move on a stock can give 1,000% returns or more by using a call or a put option.
At the same time, it is pretty common for the value of an option to be $0. This happens when an option is OTM on the expiration date. On the other hand, a stock has to go bankrupt to be $0.
Insurance
A put option is an option to sell a stock at a strike price. Let us say a put option with a strike price of $100 that expires in a year is available at $10 ($1,000 per contract).
At the same time, let us say I bought 100 shares at $100 each. If this stock crashed by 50% to $50, I would have lost $5,000 ($50 per share).
By purchasing a put option, the stock can be sold at $100 even if the price is $50. There would only be $1,000 ($10 X 100) loss on the position (purchasing the option) instead of a $5,000 loss.
Alternative to Shorting
Potential returns by shorting a stock are limited to 100% when a stock goes to $0. At the same time, losses from shorting a stock can technically go to infinity. A stock shorted at $10 can result in 2,000% losses if the stock has become $210.
Buying a put option can be a better alternative. The maximum downside to a put option is for it to expire worthless, that is, a 100% loss. Put options can return 500% profit or more.
For instance, consider a put option with a strike price of $100 purchased at $5 ($500 per contract). In case the stock crash to $80, the put option would be worth at least $20 ($2,000 per contract), a 300% profit.
Losses are maxed at 100% ($5) if the stock price is above $100 on the day of expiration.
*Options trading is considered risky. It is common for options to expire worthless ($0).
Most Common Option Strategies
1. Long Call/Put Option
A long call is basically buying a call option. The opposite of this is a short call, where a person is selling a call option.
All other option strategies are built by having a different call or put options with different strike prices or expiration dates.
Maximum Downside: -100%
The worst case scenario for any call or put option is for it to expire OTM, that is, $0.
Maximum Upside: No limit (almost)
Technically, there is a limit for put options. After all, a stock can only go to zero. But for call options, there is no limit.
For example, a call option and a put option are bought at $5 each ($500 per contract). Let us say both options have a strike price of $100.
The best case scenario for a put option is for this stock to become $0, in which the put option will be $100 ITM, a $95 ($9,500) maximum profit from the $5 purchase. This is a return of 19x or 1,900%, but this will only happen if the stock goes bankrupt.
For the call option, there is no limit since any stock can technically go as high as possible. If this stock became $500, the call option would be $400 ITM, around 80x return. In real life, stocks rarely more than triple in value, and a $5 premium usually lasts a couple of weeks.
Realistically, most short-dated options either triple in value or expire worthless. A return of 10,000% or more rarely happens and requires some luck.
2. Spreads (Vertical Call/Put)
Spreads are done by buying a call option and selling another call option with a different strike price and usually the same expiration dates. Spreads can either be debit or credit spreads.
Vertical Call Example: Buy AAPL 120c (expiring in 2 weeks) – $5
Sell AAPL 125c (expiring in 2 weeks) – $3
These prices are examples only. This trade would cost $2 (buying for $5, get $3 premium for selling the other option).
This is an example of a debit spread since it requires a capital of $2 to purchase this spread.
The maximum upside for this spread (vertical call) is $5 if Apple stock is $125 or more in 2 weeks.
Spread Scenarios for every Apple stock price on Expiration Date
| $120 or less | $ 123.00 | $ 125.00 | $ 127.00 | $ 130.00 | |
| $120 call value | $ – | $ 3.00 | $ 5.00 | $ 7.00 | $ 10.00 |
| $125 call value | $ – | $ – | $ – | $ 2.00 | $ 5.00 |
| Spread value | $ – | $ 3.00 | $ 5.00 | $ 5.00 | $ 5.00 |
Maximum Downside: $2 (spread both expire OTM)
Maximum Upside: $5 (Apple stock is $125 or more)
If Apple stock is between $120 and $125 on the expiration date, the $125 would expire worthless and the value of the spreads depends on the 120 call. The breakeven point is $122 where the 120c is $2 ITM, recouping the $2 capital for the spread.
Also, you can inverse the maximum downside and upsides through a credit spread by selling the 120c and buying the 125c, an inverse of the example. In this case, the maximum downside will be $5 while the maximum upside is $2.
The same thing applies to put option spreads. When doing this, make sure to review the strike prices of what option you are buying and selling. Starting with debit spreads is a better way to start trying out trading spreads.
Lastly, you can close a spread anytime before the expiration. To close a 120c buy and 125c sell, you need to sell the 120c and buy the 125c. The example above is a debit spread, which requires a credit spread to close.
The inverse (125c buy and 120c sell) is a credit spread. A credit spread can be closed with a debit spread. For the most part, closing any spread position can be done by inversing the original position.
Debit Spread – capital outflow (similar to buying a stock)
Credit Spread – capital inflow (similar to selling a stock)
Spreads are an alternative to a call or a put option since spreads aim to profit on a smaller move on stock while a long call/put option is used to maximize returns on big price movement on a stock.
3. Covered Calls
Covered calls are arguably the most popular options strategy after the long call/put options. Covered calls require shares, and collecting premiums by selling call options on those shares.
Requirements:
To sell a covered call, a person needs to own at least 100 shares to be able to sell 1 call option contract. A person collects the premium from selling a call option. If the option expires ITM, the shares are called away.
Example: Owning 100 Apple shares at $134 each ($13,400 total)
Selling an AAPL 135c (expiring in 2 weeks) at $1.20 would lead to collecting a premium of $120 (1 contract = 100 shares). Any strike price or expiration date can work when selling covered calls. Most people sell OTM-covered calls.
At the expiration date, there are two scenarios:
Scenario 1:
For this example, assume Apple stock is less than $135 after 2 weeks on expiration. AAPL 135c would expire worthless. Thus, keep the $120 premium and the 100 Apple shares.
After the call option expires, we can sell another call option and collect the premium again. Another covered call can be sold since the 100 Apple share collateral is kept.
Scenario 2:
This second scenario happens if the sold call option became ITM and higher than the strike price. Let us say Apple stock became $137 on the expiration.
In this case, the 100 Apple shares will be sold at $135 each (strike price) since the owner of the option will exercise it. Thus, $13,500 will be credited to the portfolio in exchange for 100 Apple shares. The $120 premium is also kept.
Since the Apple shares are bought at $13,400, the profit is $220.
To rerun another covered call in this second scenario, 100 Apple shares need to be bought.
Maximum Downside / Upside
Covered calls will expose the same risk as holding shares, but at the same time, limiting the upside at the call premium received plus any difference on the strike and purchase price.
For instance, Apple crashing to $80 will result in big losses since shares are purchased at $134. The premium of $1.20 may be collected, but is not enough to offset the losses on shares.
In the example above, the upside is limited to the premium collected ($1.20) plus the difference in strike prices if the option is OTM ($1).
Selling OTM calls is preferable to keep enough upside but not so far OTM to collect decent premiums.
4. Strangles
Strangles are done by buying both a call and a put option with the same expiration dates and different strike prices. Strangles is helpful when a trader is anticipating a big move on a stock but is not sure whether a big downward or upward move will happen.
Strangles can save commission fees in Canada compared to buying a call option and another trade to buy a put option. Strangle is considered as one trade on most platforms.
Buying a strangle with a single call and put option contract will result in around $11.95 commission fee ($9.95 + 2 x $1.00) on most platforms. Buying a single call option and another put option contract separately will result in a commission fee of $21.90 ($10.95 x 2).
Example: Buy AAPL 130c (2 months), Buy AAPL 120p (2 months)
Maximum Downside: -100% (Purchase price)
In this example, the strangle will expire worthless if the price of Apple stock on the expiration date is between $120 and $130. This is when both the call and put option is OTM.
Maximum Upside: No limit
Strangles is often used when anticipating a big potential price movement. Should Apple stock be either $100 or $150 on the expiration date, the strangle will have a value of $20.
How much money do you need for options trading?
Options trading is highly speculative and starting with small capital may be better to limit potential losses. A $2,000 capital can afford 10 option trades of $200 each, which is enough to start and gain experience along the way. To make enough profits, $10,000 to $15,000 is best after having at least 3 months of experience.
In general, most people have a rule of having a 20% maximum position in any trade.