At one point or another, you may become curious about how to trade options. It sounds sophisticated, and guess what? It sure is.
But in this article, we’ll help demystify what options trading is, examine two types of options, explore how to trade options, and look at a few frequently asked questions.
What Is Options Trading?
An option is a contract that gives an investor the right, but not the obligation, to buy or sell an underlying asset. The option contract specifies that the purchase or sale will occur at a certain share price on or before a certain date.
Options trading is the buying and selling of those contracts.
You may have heard options referred to as derivatives since options “derive” their value from the underlying asset.
Investors trade options based on what they think the underlying asset’s price will do in the future.
Options contracts can involve any sort of underlying asset — currencies, commodities, bonds, index funds, ETFs (exchange-traded funds), etc. But for simplicity, we’ll be discussing stock options in this article. Contracts for stock options typically involve 100 shares of the underlying stock.
2 Types of Options: Calls and Puts
When learning about options trading, it’s important to first understand the two types of options: calls and puts.
A call option gives the buyer the right to buy the underlying asset at a specific price, which is called the strike price, until a predetermined expiration date.
Options traders profit from call options when the price of the underlying asset is predicted to rise higher than the strike price.
For example, an investor might purchase a call option to buy shares of XYZ company stock at a strike price of $50 until the end of the month. The investor would make an investment like this if they thought the price might rise to $60.
Makes sense, right? Assuming the investor utilizes, or exercises, the option when the stock price is at $60, the investor gets the stock at a $10-per-share discount.
A put option, on the other hand, gives the buyer the right to sell an underlying asset at a set price until a predetermined expiration date.
Investors can profit from put options when the price of the underlying asset is predicted to decline lower than the strike price.
For example, an investor might purchase a put option to sell stock of XYZ company at $50 until the end of the month. The investor would make such an investment if he or she thought the price might fall to $40 by that time.
Assuming the investor utilizes, or exercises, the option when the stock price is at $40, the investor makes a $10-per-share profit on the transaction.
Why and How to Trade Options
Options investing is available to both retail and institutional investors. And you can trade options on anything from electric vehicles to sports betting.
Retail investors, or DIY investors, can trade options using a simple brokerage account. Equity options can be traded at any time when the market is open on the East Coast (9:30 a.m. to 4 p.m. ET).
Stock options are listed with quotes on trading exchanges like the NYSE.
Investors trade options in order to generate income and/or to balance portfolio risk.
When you deal in options and begin discussing income generation, the word “speculation” is likely to come up.
Speculation is like betting. When investors are looking to generate income using options, they are essentially betting on the future price direction of the underlying asset.
Based on their analysis of the stock market or just based on a hunch, an investor might “speculate” that the price of a stock will increase. In that case, the investor has two choices.
Choice one: Buy 100 shares of XYZ stock at $10 per share.
The stock price goes up to $15 per share. You sell those shares, and you generate income on that $5-per-share increase of $500.
Choice two: Buy a call option for $20 to purchase 100 shares of XYZ stock in the future with a strike price of $10.
If the stock price rises above the strike price to $15 per share, you exercise the option to purchase at the lower price of $10. You pay out $1,000. Then, you can turn around and sell the stock at the current higher market price of $15 to generate income of $500.
Your net profit is $480 ($500 minus the initial investment of $20). If the market price of XYZ never increases above the strike price of $10, you’d only have spent $20. So you can think of the $20 as insurance.
Choice two – investing with a call option – can be attractive since your upfront investment only costs a fraction of the stock price, and the result is almost the same.
Balance Portfolio Risk
Balancing the risk in your investment portfolio can also be called hedging that risk. Options are an effective hedging tool since they mitigate risk in a cost-effective manner.
A good way to think of options is like an insurance policy for market volatility. If you own stocks in the finance sector, you’re hoping the prices of those stocks go up. By purchasing put options on those same stocks in the finance sector, you can limit some losses if stock prices were to plummet.
You’re essentially protecting your investments against a downturn in the market.
Frequently Asked Questions About Options
When it comes to investing, many investors prefer consistent performance and protection against volatility rather than gamble on a slim chance at sky-high returns. And the smartest investors ask good questions to ensure that the money they need for retirement will actually be there.
Here are a few commonly asked questions.
How much do options cost?
An options contract typically costs only a fraction compared to the cost of the underlying security.
Options pricing is variable, and a variety of factors influence that pricing. While pricing involves complex mathematical formulas, some direct factors include:
- Market value of the underlying asset in relation to the option’s strike price: How valuable an option is depends on whether the strike price is favorable when considering the market value. The more valuable the option is, the most expensive it will be.
- Time to expiration: The value of an option declines as the expiration date approaches. And if time passes without any change in the price of the underlying asset, this will also depress the option price.
- Interest rate fluctuation: Like most investments, interest rates impact the pricing of options. When rates rise, call options increase in value and put options decrease in value. The opposite is, of course, true when rates fall.
- Implied volatility: Volatility is a more complicated concept for investors to understand. Backward-looking volatility is easy to analyze. You can find the historical price fluctuations for the underlying asset over time. But forward-looking volatility — or implied volatility — is more difficult to analyze and predict, and therefore is best left to option pricing models.
How is trading options different from trading stocks?
Trading options and trading stocks are two very different things.
First, owning options doesn’t represent any ownership in the underlying asset — only the right to buy or sell it. Then, because the option is only the right to buy or sell something, you can withdraw from the transaction much easier and just forego whatever you paid for the option itself.
For example, let’s say you bought an option to trade XYZ stock with a premium of 25 cents per share for 100 shares, but the stock itself trades at $100 per share. If the stock moves in the wrong direction for your option, you’ve only invested and put at risk $25 (25 cents times 100) rather than $10,000.
Does trading options involve risk?
Absolutely. Just like with most investments, there are no guarantees.
Options traders assume a certain degree of risk, which is why online brokers make disclaimers. They are trying to alert investors about potential risks and the fact that options trading is speculative and inherently risky.
Are Options Trading Strategies Right for Your Portfolio?
Even for those with no options trading experience, options shouldn’t feel intimidating. Now that you have a basic grasp on how to trade options, you can keep building on that knowledge.
With the proper due diligence, options can unlock significant investment opportunities. But of course, if used incorrectly, trading options can be quite risky.
Note: This article originally appeared at Investors Alley.