If you hadn’t noticed by now, there are a lot of choices when it comes to investing in securities.
Whether you prefer to play the stock market or invest in an Exchange Traded Fund (ETF) or two, you probably know the basics of a variety of securities. But what exactly are options, and what is options trading?
What Are Options?
An option is a contract that allows (but doesn’t require) an investor to buy or sell an underlying instrument like a security, ETF or even index at a predetermined price over a certain period of time. Buying and selling options is done on the options market, which trades contracts based on securities. Buying an option that allows you to buy shares at a later time is called a “call option,” whereas buying an option that allows you to sell shares at a later time is called a “put option.”
However, options are not the same thing as stocks because they do not represent ownership in a company. And, although futures use contracts just like options do, options are considered lower risk due to the fact that you can withdraw (or walk away from) an options contract at any point. The price of the option (its premium) is thus a percentage of the underlying asset or security.
When buying or selling options, the investor or trader has the right to exercise that option at any point up until the expiration date – so simply buying or selling an option doesn’t mean you actually have to exercise it at the buy/sell point. Because of this system, options are considered derivative securities – which means their price is derived from something else (in this case, from the value of assets like the market, securities or other underlying instruments). For this reason, options are often considered less risky than stocks (if used correctly).
But why would an investor use options? Well, buying options is basically betting on stocks to go up, down or to hedge a trading position in the market.
The price at which you agree to buy the underlying security via the option is called the “strike price,” and the fee you pay for buying that option contract is called the “premium.” When determining the strike price, you are betting that the asset (typically a stock) will go up or down in price. The price you are paying for that bet is the premium, which is a percentage of the value of that asset.
There are two different kinds of options – call and put options – which give the investor the right (but not obligation) to sell or buy securities.
A call option is a contract that gives the investor the right to buy a certain amount of shares (typically 100 per contract) of a certain security or commodity at a specified price over a certain amount of time. For example, a call option would allow a trader to buy a certain amount of shares of either stocks, bonds, or even other instruments like ETFs or indexes at a future time (by the expiration of the contract).
If you’re buying a call option, it means you want the stock (or other security) to go up in price so that you can make a profit off of your contract by exercising your right to buy those stocks (and usually immediately sell them to cash in on the profit).
The fee you are paying to buy the call option is called the premium (it’s essentially the cost of buying the contract which will allow you to eventually buy the stock or security). In this sense, the premium of the call option is sort of like a down-payment like you would place on a house or car. When purchasing a call option, you agree with the seller on a strike price and are given the option to buy the security at a predetermined price (which doesn’t change until the contract expires).
So, call options are also much like insurance – you are paying for a contract that expires at a set time but allows you to purchase a security (like a stock) at a predetermined price (which won’t go up even if the price of the stock on the market does). However, you will have to renew your option (typically on a weekly, monthly or quarterly basis). For this reason, options are always experiencing what’s called time decay – meaning their value decays over time.
For call options, the lower the strike price, the more intrinsic value the call option has.
Conversely, a put option is a contract that gives the investor the right to sell a certain amount of shares (again, typically 100 per contract) of a certain security or commodity at a specified price over a certain amount of time. Just like call options, a put option allows the trader the right (but not obligation) to sell a security by the contract’s expiration date.
Just like call options, the price at which you agree to sell the stock is called the strike price, and the premium is the fee you are paying for the put option.
Put options operate in a similar fashion to calls, except you want the security to drop in price if you are buying a put option in order to make a profit (or sell the put option if you think the price will go up).
On the contrary to call options, with put options, the higher the strike price, the more intrinsic value the put option has.
Long vs. Short Options
Unlike other securities like futures contracts, options trading is typically a “long” – meaning you are buying the option with the hopes of the price going up (in which case you would buy a call option). However, even if you buy a put option (right to sell the security), you are still buying a long option.
Shorting an option is selling that option, but the profits of the sale are limited to the premium of the option – and, the risk is unlimited.
For both call and put options, the more time left on the contract, the higher the premiums are going to be.
What Is Options Trading?
Well, you’ve guessed it — options trading is simply trading options, and is typically done with securities on the stock or bond market (as well as ETFs and the like).
For starters, you can only buy or sell options through a brokerage like E*Trade or Fidelity .
When buying a call option, the strike price of an option for a stock, for example, will be determined based on the current price of that stock. For example, if a share of a given stock (like Amazon ) is $1,748, any strike price (price of the call option) that is above that share price is considered to be “out of the money.” Conversely, if the strike price is under the current share price of the stock, it’s considered “in the money.”
However, for put options (right to sell), the opposite is true – with strike prices below the current share price being considered “out of the money” and vice versa. And, what’s more important – any “out of the money” options (whether call or put options) are worthless at expiration (so you really want to have an “in the money” option when trading on the stock market).
Another way to think of it is that call options are generally bullish, while put options are generally bearish.
Options typically expire on Fridays with different time frames (for example, monthly, bi-monthly, quarterly, etc.). Many options contracts are six months.
Trading Call vs. Put Options
Purchasing a call option is essentially betting that the price of the share of security (like a stock or index) will go up over the course of a predetermined amount of time. For instance, if you buy a call option for Alphabet at, say, $1,500 and are feeling bullish about the stock, you are predicting that the share price for Alphabet will increase.
When purchasing put options, you are expecting the price of the underlying security to go down over time (so, you’re bearish on the stock). For example, if you are purchasing a put option on the S&P 500 index with a current value of $2,100 per share, you are being bearish about the stock market and are assuming the S&P 500 will decline in value over a given period of time (maybe to sit at $1,700). In this case, because you purchased the put option when the index was at $2,100 per share (assuming the strike price was at or in the money), you would be able to sell the option at that same price (not the new, lower price). This would equal a nice “cha-ching” for you as an investor.
Options trading (especially in the stock market) is affected primarily by the price of the underlying security, time until the expiration of the option, and the volatility of the underlying security.
The premium of the option (its price) is determined by intrinsic value plus its time value (extrinsic value).
Historical vs. Implied Volatility
Volatility in options trading refers to how large the price swings are for a given stock.
Just as you would imagine, high volatility with securities (like stocks) means higher risk – and conversely, low volatility means lower risk.
When trading options on the stock market, stocks with high volatility (ones whose share prices fluctuate a lot) are more expensive than those with low volatility (although due to the erratic nature of the stock market, even low volatility stocks can become high volatility ones eventually).
Historical volatility is a good measure of volatility since it measures how much a stock fluctuated day-to-day over a one-year period of time. On the other hand, implied volatility is an estimation of the volatility of a stock (or security) in the future based on the market over the time of the option contract.
Value: Time Value and in/at/out of the Money
If you are buying an option that is already “in the money” (meaning the option will immediately be in profit), its premium will have an extra cost because you can sell it immediately for a profit. On the other hand, if you have an option that is “at the money,” the option is equal to the current stock price. And, as you may have guessed, an option that is “out of the money” is one that won’t have additional value because it is currently not in profit.
For call options, “in the money” contracts will be those whose underlying asset’s price (stock, ETF, etc.) is above the strike price. For put options, the contract will be “in the money” if the strike price is below the current price of the underlying asset (stock, ETF, etc.).
The time value, which is also called the extrinsic value, is the value of the option above the intrinsic value (or, above the “in the money” area).
If an option (whether a put or call option) is going to be “out of the money” by its expiration date, you can sell options in order to collect a time premium.
The longer an option has before its expiration date, the more time it has to actually make a profit, so its premium (price) is going to be higher because its time value is higher. Conversely, the less time an options contract has before it expires, the less its time value will be (the less additional time value will be added to the premium).
So, in other words, if an option has a lot of time before it expires, the more additional time value will be added to the premium (price) – and the less time it has before expiration, the less time value will be added to the premium.
Pros and Cons
Some of the major pros of options trading revolve around their supposed safety.
According to Nasdaq’s options trading tips, options are often more resilient to changes (and downturns) in market prices, can help increase income on current and future investments, can often get you better deals on a variety of equities and, perhaps most importantly, can help you capitalize on that equity rising or dropping over time without having to invest in it directly.
Of course, there are cons to trading options – including risk.
There are a variety of ways to interpret risks associated with options trading, but these risks primarily revolve around the levels of volatility or uncertainty of the market. For example, expensive options are those whose uncertainty is high – meaning the market is volatile for that particular asset, and it is more risky to trade it.
Options Trading Strategies
When trading options, the contracts will typically take this form:
Stock ticker (name of the stock), date of expiration (typically in mm/dd/yyyy, although sometimes dates are flipped with the year first, month second and day last), the strike price, call or put, and the premium price (for example, $3). So an example of a call option for Apple stock would look something like this: APPL 01/15/2018 200 Call @ 3.
Still, depending on what platform you are trading on, the option trade will look very different.
There are numerous strategies you can employ when options trading – all of which vary on risk, reward and other factors. And while there are dozens of strategies (most of them fairly complicated), here are a few main strategies that have been recommended for beginners.
Straddles and strangles
With straddles (long in this example), you as a trader are expecting the asset (like a stock) to be highly volatile, but don’t know the direction in which it will go (up or down). When using a straddle strategy, you as the trader are buying a call and put option at the same strike price, underlying price and expiry date. This strategy is often used when a trader is expecting the stock of a particular company to plummet or skyrocket, usually following an event like an earnings report. For example, when a company like Apple is getting ready to release their third quarter earnings on July 31st, an options trader could use a straddle strategy to buy a call option to expire on that date at the current Apple stock price, and also buy a put option to expire on the same day for the same price.
For strangles (long in this example), an investor will buy an “out of the money” call and an “out of the money” put simultaneously for the same expiry date for the same underlying asset. Investors who use this strategy are assuming the underlying asset (like a stock) will have a dramatic price movement but don’t know in which direction. What makes a long strangle a somewhat safe trade is that the investor only needs the stock to move greater than the total premium paid, but it doesn’t matter in which direction.
The upside of a strangle strategy is that there is less risk of loss, since the premiums are less expensive due to how the options are “out of the money” – meaning they’re cheaper to buy.
If you have long asset investments (like stocks for example), a covered call is a great option for you. This strategy is typically good for investors who are only neutral or slightly bullish on a stock.
A covered call works by buying 100 shares of a regular stock and selling one call option per 100 shares of that stock. This kind of strategy can help reduce the risk of your current stock investments but also provides you an opportunity to make profit with the option.
Covered calls can make you money when the stock price increases or stays pretty constant over the time of the option contract. However, you could lose money with this kind of trade if the stock price falls too much (but can actually still make money if it only falls a little bit). But by using this strategy, you are actually protecting your investment from decreases in share price while giving yourself the opportunity to make money while the stock price is flat.
Selling Iron Condors
With this strategy, the trader’s risk can either be conservative or risky depending on their preference (which is a definite plus). For iron condors, the position of the trade is non-directional, which means the asset (like a stock) can either go up or down – so, there is profit potential for a fairly wide range. To use this kind of strategy, sell a put and buy another put at a lower strike price (essentially, a put spread), and combine it by buying a call and selling a call at a higher strike price (a call spread). These calls and puts are short.
When the stock price stays between the two puts or calls, you make a profit (so, when the price fluctuates somewhat, you’re making money). But the strategy loses money when the stock price either increases drastically above or drops drastically below the spreads. For this reason, the iron condor is considered a market neutral position.
Options Trading Examples
There are lots of examples of options trading that largely depend on which strategy you are using. However, as a basic idea of what a typical call or put option would be, let’s consider a trader buying a call and put option on Microsoft .
For example, if you bought a long call option (remember, a call option is a contract that gives you the right to buy shares later on) for 100 shares of Microsoft stock at $110 per share for December 1, you would have the right to buy 100 shares of that stock at $110 per share regardless of if the stock price changed or not by December 1. For this long call option, you would be expecting the price of Microsoft to increase, thereby letting you reap the profits when you are able to buy it at a cheaper cost than its market value. However, if you decide not to exercise that right to buy the shares, you would only be losing the premium you paid for the option since you aren’t obligated to buy any shares.
If you were buying a long put option for Microsoft, you would be betting that the price of Microsoft shares would decrease up until your contract expires, so that, if you chose to exercise your right to sell those shares, you’d be selling them at a higher price than their market value.
Another example involves buying a long call option for a $2 premium (so for the 100 shares per contract, that would equal $200 for the whole contract). You buy an option for 100 shares of Oracle for a strike price of $40 per share which expires in two months, expecting stock to go to $50 by that time. You’ve spent $200 on the contract (the $2 premium times 100 shares for the contract). When the stock price hits $50 as you bet it would, your call option to buy at $40 per share will be $10 “in the money” (the contract is now worth $1,000, since you have 100 shares of the stock) – since the difference between 40 and 50 is 10. At this point, you can exercise your call option and buy the stock at $40 per share instead of the $50 it is now worth – making your $200 original contract now worth $1,000 – which is an $800 profit and a 400% return.
Common Options Trading Mistakes
There are plenty of mistakes even seasoned traders can make when trading options.
One common mistake for traders to make is that they think they need to hold on to their call or put option until the expiration date. If your option’s underlying stock goes way up over night (doubling your call or put option’s value), you can exercise the contract immediately to reap the gains (even if you have, say, 29 days left for the option).
Another common mistake for options traders (especially beginners) is to fail to create a good exit plan for your option. For example, you may want to plan to exit your option when you either suffer a loss or when you’ve reached a profit that is to your liking (instead of holding out in your contract until the expiration date).
Still other traders can make the mistake of thinking that cheaper is better. For options, this isn’t necessarily true. The cheaper an option’s premium is, the more “out of the money” the option typically is, which can be a riskier investment with less profit potential if it goes wrong. Buying “out of the money” call or put options means you want the underlying security to drastically change in value, which isn’t always predictable.
And while there are plenty of other options faux pas, be sure to do your research before getting into the options trading game.
(Editor’s Pick. Originally published Nov. 9.)
This article was originally published by TheStreet.
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