You may have heard about the concept of trading options before. If you have no idea what it means and how to trade options, you aren’t alone.
Without a doubt:
Options are more complex than stocks.
To trade options, you must fully understand what you’re getting into. If you don’t, you could put yourself in a risky position unintentionally.
Learn some of the basics of options trading so you can get an idea if it’s something you want to look into further.
What Are Options?
When you buy an option, you aren’t buying a stock, bond, commodity or any other underlying investment.
Instead, you’re acquiring the right to buy or sell a stock or other underlying investment up until a certain point in the future at a specific price.
It’s important to note:
You don’t have to exercise the option and actually buy or sell the investment. You just have the option to do so.
Options are called derivative investments. The reason for this is their value is derived based on the underlying investment.
When you buy an option, you don’t own an investment.
You only own the ability to buy or sell it based on the type of option you hold.
Components of an Option
Understanding the components of an option trade are extremely important when learning how to trade options.
Typically, options are traded based on 100 share increments of the underlying investment.
That means buying an options contract usually allows you to purchase or sell 100 shares of that underlying investment if you exercise your options.
To buy an options contract, you must pay the price of the contract. This price is usually called a premium.
The premium is the price you pay to have the option to buy or sell, but not the obligation to buy or sell, the underlying security. It provides you no other benefits.
If you don’t exercise your option before it expires, you end up with nothing.
Exercise or strike price
The exercise or strike price is the price you pay to buy the stock or other underlying investment or the price you’ll receive by selling the underlying investment, depending on the type of option you hold.
However, this only happens if you exercise your option.
Finally, options have an expiration date.
If you hold an option and do not take action before it expires, nothing happens. The options contract expires and you neither buy or sell the underlying investment.
In this case, you end up with nothing and the premium you paid to acquire the contract becomes a loss.
The two main types of options:
- call options
- put options
Here are the basics you should know about each.
A call option allows the option holder to purchase the underlying investment at the strike price before the contract expiration date.
Call options are useful when you believe the underlying investment price will increase beyond the strike price.
The call option costs you money when you paid the premium to purchase it.
That means you won’t technically be “in the money” until the underlying investment share price exceeds the strike price plus the premium you paid.
How you make money
If your option is in the money, you can exercise your option contract to buy the underlying investment at a discount to its current price.
Then, you could sell it at the current price to lock in your profit.
A put option is essentially the opposite of a call option.
Instead of allowing you to purchase an underlying investment, it allows you to sell it.
The strike price of a put option is the price at which you can sell the underlying investment up until your options contract expires.
How you make money
Put options are useful when you believe a stock will decline more than the strike price plus the associated premium.
If this happens, you could purchase the underlying investment then sell it at the higher strike price and make a profit.
Alternatively, you can use them as a hedge to avoid being stuck with a security that declines more than the strike price.
You can sell your investment at the strike price and lock in a smaller loss if your underlying security declines more than anticipated.
What Is Upside Potential vs. Downside Potential
When talking about investments, two common types of potential may be mentioned. These are upside potential and downside potential.
Upside potential is the amount you potentially stand to gain from a trade. You can have upside potential with a call option and a put option.
Technically, upside potential could be unlimited if an investment’s price goes through the stratosphere.
Upside potential usually refers to a more likely increase in an investment’s price over a shorter period of time.
Downside potential, sometimes called downside risk, is the amount you could possibly lose on a trade during a specific time frame.
Like upside potential, downside risk could be unlimited.
If an investment goes bankrupt, you could lose everything. At the same time, downside risk usually focuses on the more predictable moves in the shorter term.
Some investors use put options to limit their downside potential on trades.
This is called hedging.
If you own a put option at a certain price, you can sell the underlying investment at that price no matter how much it decreases before the contract expires.
What You Need to Trade Options
In order to trade options, you need access to a brokerage account that allows you to do so.
Since trading options is more complex than trading stocks, you may have to jump through some hoops to gain access to trade options.
Most brokerages offer the ability to trade options within their system. However, you may have to apply to unlock the ability.
Brokerages want to make sure you understand the risks.
They also want to make sure your finances can handle options trading.
Check with the brokerage firms you’re considering to see if trading options is an option and, if so, what you have to do to be able to unlock the ability to do so.
Don’t forget to compare fees for trading options, as well.
Examples of options trading
Trading options can be simple or complex.
On the simplest levels, you purchase a call or put option and either hold the option until expiration or exercise the option before it expires.
A call-option scenario
Let’s say you buy a call options contract to purchase 100 shares of Company A at a strike price of $10 per share.
The premium for this contract is $1 per share or $100 total.
The price of Company A’s stock rises to $12 per share and you decide to exercise your options. To do this, you’d pay $1,000 to purchase the 100 shares at the $10 option contract price.
You end up with $1,200 worth of Company A’s stock after you exercise your options. Due to the $100 premium you paid to purchase the option contract, you end up with a $100 profit if you then sell the shares immediately.
A put-option scenario
You may decide to buy a put options contract to sell 50 shares of Company B’s stock.
The strike price for the put option is $25 per share and the premium is $2.50 per share. The total premium paid for the put option contract is $125.
During the period of the contract, Company B’s stock price never drops below $25 per share.
Therefore, it likely makes the most sense to simply let the put options contract expire without exercising your option to sell the stock.
Otherwise, you’d be selling the stock below the market price and would realize an even larger loss.
Trading options contracts
On a more complex level, you can trade the options contracts you own prior to their expiration.
If your option has not yet expired, you could sell it to other options traders.
The amount you can sell your options contract for will depend on the type of option and the performance of the underlying security.
You can do this without exercising your option to buy or sell the underlying investment.
Reasons You May Consider Using Options
You may consider trading options for a number of reasons.
You could use them to hedge your risk against a certain event from happening.
For instance, you could purchase an option that limits your losses to 10% should a stock decline more than that during the option period.
You can also use options as a way to earn money by speculating about price movement on the stock market.
You could purchase an option that allows you to buy a stock at a future price that is lower than what you expect it to be.
- If you’re right, you could exercise the option and make money on the price difference less the premium you paid for the option.
- If you’re wrong, you only lost the premium you paid for the contract.
Carefully examine your current situation and your financial objectives before you consider trading options.
If you’re not comfortable learning how to trade options yourself, consult a financial advisor that may be able to help you do so.
Your financial advisor can explain the risks as they pertain to your specific situation. They can help you determine if trading options is a suitable strategy for you.
If it is, they may even be able to provide help with specific option-trading strategies.
Trading options is complex and you shouldn’t get involved until you completely understand all aspects of options trading.
That said, those that understand options completely might find them useful in obtaining their investment goals.