Options trading explained
Options trading is the process of buying and selling shares of the same stock at the same time at different prices. You can also sell stock options to earn cash now or use them as insurance to protect your investments against market downturns.
Trading options is a popular investment tactic to generate income that has increased in popularity over recent years due to its flexibility and profitability potential.
Traders using this strategy enjoy an array of benefits including hedging against unexpected risks or losses, generating income from short-term fluctuations in share price, limiting exposure to fast-moving markets, taking advantage of arbitrage opportunities between two securities with different prices on both sides of the trade.
However, before you jump into this type of trading there are some things you need to know.
Types of options
There are two types of options contracts: The long call and the short put.
What is a call option in options trading?
When investors or traders expect the price of shares to rise, they purchase a call option giving them the right to buy shares at a predetermined price before the expiration day. The strike price is the amount you spend. The expiration date is the last day on which you may exercise a call option.
For example, if you bought a one-month call option with a strike price of $25 on ABC Corp. for $0.50 per share and the share value is above that number at expiration then you can exercise that contract to buy 100 shares at $25 each even though it’s now trading at $30.
What is a put option in options trading?
Alternatively, when share prices are expected to fall, investors can purchase a put option giving them the right to sell shares at a fixed price before the expiration day. This is known as shorting that particular option. Put options are also subject to expiration dates.
For example, if you bought a one-month put option with a strike price of $25 on ABC Corp. for $0.50 per share and the share value is below that number at expiration then you have the right to sell your 100 shares at $25 each even though it’s now trading at $20.
How options pricing is determined
An options price is determined by five factors.
1. Stock symbol: The underlying asset associated with an options transaction is identified by its stock symbol.
2. Option type: The two types of options contracts are calls and puts, with each giving you different rights over the underlying security.
3. Strike price: This is the amount you spend on the option contract.
4. Premium: The premium is the cost of a stock options contract, also known as its price. It’s a combination of money and time value. An options trader can buy or sell an option at any time before expiration, but it costs more the closer they get to the deadline.
5. Expiration date: Options contracts are limited in time, with expiration dates ranging from a month to two years.
Stock options are listed in the form of a quote on exchanges such as the New York Stock Exchange.
How the price of an option is determined will depend on whether it’s a call or put, with each giving you different rights over the underlying security.
A call gives you the right to buy shares at a fixed price before the expiration. A put gives you the right to sell shares at a fixed price before the expiration.
The premium of an option is made up of two elements: time value and intrinsic value.
What is intrinsic value?
Intrinsic value (IV) is the difference between an options strike price and its current underlying asset. The closer an option contract is to expiration, the less time value there will be and the more intrinsic value it will have because you are that much closer to exercising your right to buy or sell the underlying security.
For example, let’s say that ABC Corp.’s share price is currently priced at $30 per share in the market and you buy a one-month call option with a strike price of $25 per share for $0.50 and there is only one day left to expiration, then the IV will be $5 because it’s trading at $30 but the strike price is only $25.
You’re allowed to exercise your right to buy those shares at $25 so the difference between their current market price of $30 and your purchase price is $5.
What is time value?
Time value is the cost of an option above its intrinsic value. It’s determined by more than just time left until expiration, but also by how much you paid for that options contract relative to the amount it would cost to buy the stock itself.
If you paid $0.50 for that option based on an underlying security trading at $30 per share, then your time value is very low because it’s not highly unlikely that the price of shares will drop below the strike price before expiration (which is in one month).
The more likely it is that shares will drop below the strike price before expiration, the more you should expect to pay for an option based on its value.
The less likely it is that this will happen, the lower you can expect premium prices to be because there’s a higher chance of your option expiring worthless.
Shorting options contracts
You can sell options contracts to collect a payday based on their premium. The risk with this is that you’re obligated to purchase the underlying security at the strike price if it makes sense for your option, or accept its current market value in cash if it does not.
For example, let’s say that ABC Corp.’s share price is trading at $28 but you sell a $25 strike price call option for $0.50 with 14 days left to expiration and this line represents the current market value of that option.
You will be paid $0.50 because you sold an options contract based on a strike price of $25 while its worth is $28 in the market, but if ABC Corp.’s share price rises beyond $25 before expiration, then you’ll be obligated to pay $25 for each share when the contract expires.
That’s what “being short” means: you receive a payment upfront based on the premium and hope that it doesn’t rise above your strike price so that you can keep it.
If shares do rise above $25, then you’ll be obligated to pay $25 or accept cash for each share based on the current market value of shares at expiration.
The risks associated with the options trading strategy
You also need to understand that trading options involve risks that may not be suitable for all traders and investors.
Traders who are long on an options contract have the obligation of making good on the contract if it is assigned to them.
Whether an options trader makes or loses money will depend on the difference between the stock position at the initiation of the hedge and its assignment or exercise.
For example, assume you are long 100 shares of XYZ Company at $50 per share. Now assume that you bought one call contract with a strike price of $50 expiring in three months.
This gives you the right to purchase one call option at a price of 100 shares x $50 = $5,000.
When the option expires, XYZ company is currently trading at $55 per share. If you decide to exercise your options contract, then you will buy 100 shares of XYZ Company at $50 and immediately sell it at the current market price of $55. Your overall profit would be:
($55 – $50) x 100 shares = $500, net gain on the transaction without considering commissions.
On the other hand, if you decide to let your options contract expire, then you will not incur any loss or gain because you bought the contract at a price lower than its market value. In this case, your maximum loss will be limited to the premium paid for the option which is $5,000.
Second, while options trading might seem like a low-risk way of increasing your money in a short amount of time due to its short lifespan, there are some risks associated with this strategy.
Unlike trading in the traditional sense, options traders have the obligation of making good on their contracts if they are assigned to them. In other words, whether an options trader makes or loses money will depend on the difference between the stock prices at the initiation of a hedge and at its assignment or exercise.
For example, let’s say you bought a call option contract with a strike price of $50 for three months when the stock price was at $52 per share. Because there are only three months left before the expiration day, the expected value of the options contract would increase in accordance with its time value or premium deduction.
Therefore, as the expiration date gets closer you could sell your option contract at $5 per share and earn a profit of $7.50. On the other hand, if your stock’s price remained stagnant or refused to go higher than $52 per share after three months and dropped lower than the strike price of $50 by the time of expiration, you would not be able to sell it at $5 per share because the market value has now fallen below $50.
In this case, your maximum loss will be: (1 x 100 shares x the difference between the strike price and current share price) = ($50 – $52)x100=$1,000.
Please also note that the past performance of a security or financial product doesn’t ensure future results or returns.
How to trade options
Options trading is an investment tactic where you get to buy and sell shares of the same stock at the same time. You can also use options as insurance against market downturns.
You can buy options through brokerage accounts with online brokers. Once you’re approved to trade options, you’ll be able to see your available contracts, which are based on the number of shares in each contract.
You can open a brokerage account with the majority of online brokers with a low or no minimum deposit.
When buying and selling options, try to remember that owning puts (and calls) means you’re “long” on their respective options. You can also use them as insurance for your investments, so selling puts is called “buying to open,” and buying calls is called “writing an option .”
Conversely, selling a put or call means you’re “shorting” those respective options.
Puts and calls have specific strike prices that define whether they’re in-the-money, at-the-money, or out-of-the-money.
For example, if you buy a call with a price of $15 and the current market value is $16.50, then that’s considered “at-the-money.” If the value drops below $15, then it’ll be called “out-of-the-money.” If the value goes above $15, then it’ll be considered “in-the-money” and you can sell that option to someone else for a higher price.
Options trading strategies to know before
You might be interested in more sophisticated options trading methods once you’ve mastered the fundamentals of options trading.
As you gain experience with options trading, you may want to incorporate some of these regularly utilized strategies into your investment strategy.
Make sure to consider your investment objectives and risks carefully before trading options.
Options trading is popular with investors who believe a stock will make big moves, as opposed to those who want to own the underlying stock for the long term. With options trading come many strategies and not all of them are good for novice traders. However, there are some simple options trading strategies that may help you earn money.
The Put-Call parity relationship
One useful options trading strategy is related to the put-call parity rule. This rule is especially helpful when you believe that the price of an underlying stock will fall, but also has some utility value (which is common with many tech stocks).
With this approach, you buy a put option on the stock with a price that is equal to or just below the stock price. If the underlying stock falls, you will be protected by your put option and this strategy will start to look like buying the stock on margin (where you borrow money from your broker to invest in the stock).
However, if an investor doesn’t have enough cash available to purchase a particular stock or is not interested in borrowing money to buy the stock, one options trading strategy they might try is buying a put option with a higher strike price. This will give investors limited downside risk if the underlying stock falls, but no upside potential beyond this point.
Stocks that are volatile all the time or have high beta values are good for this options trading strategy.
One more options trading strategy investors can use is anticipating a dividend announcement about an underlying stock. You can buy a call with a strike price that is equal to the total value of the stock plus its expected dividend payout.
This gives you a guaranteed return on your investment if the stock rises and you get to collect the dividend while owning the stock because you have the call options.
A covered call is when you own the underlying security and sell call options on that security.
You might profit from a covered call if the stock does not move much in the short term, but you will lose your premium and possibly your stock if it goes in the opposite direction.
One advantage of this strategy is that it limits the risk in investment to any one company. This strategy is used often with stocks that are less volatile, which makes it easier to get out of the trade before the expiration date if the market situation changes.
If you are just beginning, it is recommended that you only use the covered call options strategy on stocks with less volatility.
That way if your stock price takes a hit, you have better chances to get out of the investment without losing too much money.
A Married Put
This options trading strategy is highly recommended for investors who are beginning their options trading careers. It is very safe, but the downside is that you are limiting your return on investment.
With this strategy, you buy a put option with the same expiration date as your stock. When you do this, it means that if the stock price goes down before the put expires, you will have to purchase the stock at the strike price.
To compensate for this, you get to keep the premium that you got when you bought the put option. This means that your initial investment will be returned even if your stock takes a hit in value while it is still under contract with the put.
Trading stocks near the expiration date can be risky because you don’t know how much it is going to change in value before the contract ends. It’s a good strategy to use for stocks that have no potential for growth, but if you want to trade with options on volatile stocks, make sure you are prepared for any outcome.
The long straddle is an options trading strategy that involves buying call options and put options with the same strike price and expiration date. When you do this, your profit zone will be the price of the underlying security plus the two premiums.
The downside to this strategy is that it will cost you more at the outset because you are investing in both premium positions.
However, if the price goes up, you have unlimited potential for profit because these positions are purchased at different prices so they can both increase in value without being capped out by each other.
Iron condors is one of the advanced strategies and is also known as a “reverse strangle.”
It’s an investment tactic that involves selling an out-of-the-money call option and buying another out-of-the-money call option with a higher strike price, so they are both at different points on each side of your original position.
You then purchase an out of the money put with a price that is lower than your original trade and sell another out of the money put with a price that is higher.
The risk of this strategy is very low because it uses four different points to limit any loss. However, you will lose more if your prediction about where the price of the stock is going turns out to be wrong.
As a beginner, this options trading strategy is not recommended because it will take a lot of time and effort in order to execute correctly, and if a novice trader makes a mistake in their calculations or predictions, they can lose money very quickly.
Options trading tips for beginners
A lot of beginners get overwhelmed when they trade options for the first time. There are a few things that you should do before you start trading to make your experience easier.
The first thing is to pick a strategy that fits your personality type and risk tolerance. Make sure you understand the risks before you start trading so if something goes wrong, you’ll know what went wrong and how to fix it.
You should also set a clear exit point or stop loss so if the market moves against your position, you’ll know when to stop trading and wait for a better time to enter again.
The second tip is to only trade with money that you can afford to lose because if your stocks go down, all of your money can be lost.
Trading options allow you to trade with a fraction of the amount of money that it would take to actually buy all the stock.
Once you’re ready, start trading! Choose a reliable online broker and open a trading account.
Here are some good rules to follow when opening an account:
- It should be simple but not too simple
- Easy-to-use and efficient, but not too basic
- Easy to deposit and withdraw money with low transaction fees.
There are also things you can do to protect yourself as an investor such as:
- only doing business with a broker that is known for honoring its contracts
- making sure that the company pays out on time
- verifying that they use reputable industry standards
- and having reliable cash flow so you can meet any margin calls
To cut costs, avoid dynamic stock replacement strategies such as spreads and combinations.
Look for high-volume contracts that offer lower time premiums because they can help you offset fees and commissions.
Options trading is a good strategy for investors looking to maximize their profit without having to put up as much money.
However, it should only be used by experienced traders once they have already mastered the basics of investing and understand all of the risks associated with options trading.