Intro To Options Trading
Trading options can be exhilarating, and stomach turning. There is a very real possibility you can lose everything. However, you can find yourself on the right side of the deal, too, with a healthy profit in your pocket. I’ll explain how they work and let you decide whether or not they are right for you.
Call option: Buyer wants the price to go up.
Put option: Buyer wants the price to go down.
Strike price: Price where an option either makes or loses money
Expiration date: Date the contract ends
Options contracts are for 100 shares of the underlying asset (stock in this blog).
The more likely an option is to make money, the more expensive it is, and the less likely an option is to make money, the cheaper it is. Less risk = more expensive, more risk = less expensive
An option is known as a “derivative” because it derives its price from an underlying asset, a stock, commodity, future, etc. So, when you hear the term “derivatives trading,” options are included under this umbrella.
The most common exchange in the US where options are traded is the CBOE, Chicago Board Options Exchange, which operates a lot like the NYSE or Nasdaq. An option on the exchange is known as a “listed option,” just as a stock on the NYSE or Nasdaq is a “listed stock.”
When you buy an option, you are actually entering into a contract with another person/entity that says, “At any point in the next X timeframe, the person buying this contract has the option to buy 100 shares of XYZ stock for X dollars, and the person selling this contract is required to sell them 100 shares at said X dollars.” In other words, if you buy a 3 month option for Apple at a $170, at any point in those three months you can exercise that option to buy 100 shares of Apple at $170, and the person selling you that option is required to sell you 100 shares at $170.
Here is a key differentiator about buying options. Right now, a 30 day call option for Apple at $175 is selling for $2.65/share. Remember, the contract is for 100 shares. Apple’s current stock price is around $172 (as of 11/3/17). For one share of Apple, you pay $172, but an option contract for $265 gives you control of 100 shares of Apple for 30 days.
In other words, buying 100 shares of Apple outright will cost you $17,200, while an option contract controlling 100 shares for 30 days will cost you $265.
If you buy a call option, you hope the underlying stock price goes up, also known as being “long” the option. If you buy a put option, you hope the underlying stock price goes down, known as being “short” the option. In both cases, you pay a premium for the contract, and the seller hopes you are wrong and they can pocket your premium as profit.
Contract lengths vary: 1 week, 1 month, 2 months, 6 months, 9 months, 12 months, and everything in between, with typically 4 trading cycles in a year. Each contract has a predetermined strike price, which represents the price per share the owner of the contract can buy shares of the underlying stock at.
Think of a strike price as the “moneyline” in betting. The strike price determines whether an option is “in the money” or “out of the money,” aka whether you win or lose. Call or put options are very much like taking the “over” or “under” when betting against a moneyline. Buying a put is like taking the “under,” and buying a call is like taking the “over.”
Going back to that Apple example, let’s say you buy a 30 day, $170 call option for $2.73 (Remember, buyers of call options want prices to rise.), and on day 22 of 30, Apple’s stock is trading at $180. Let’s also say this option contract is now trading on the open market for $5.50.
At this point, you have a couple options: ride out the contract and exercise the option when it ends, or trade the option and have someone else buy your contract at $5.50.
Let’s look at the first option: exercise the option at expiration. If Apple shares are selling at $180 when the option closes, your strike price (guaranteed price you can pay per share) is $170. That means you can buy 100 shares of Apple stock at $170 and sell them right away at $180. Factoring in the $2.73/share you paid as a premium for the contract, you’re making $7.27/share, or $727, or 38% in 30 days.
If you look at option two, you’re selling your contract at $5.50 and never buying any shares of Apple. Instead, you’re trading the contract, which happens the majority of the time in options trading. You paid $273 for the original contract ($2.73/share x 100 shares) and sold it for $550. You made $227 or about 50% on that deal in 22 days.
Keep in mind, though, if Apple stock went south after you bought the option, and the option closes a penny less than $170, you lose everything you paid for it. You don’t get it back.
Buying a put option works just like buying a call option, only in reverse. Instead of wanting the price to be above a certain number, you’re betting on a stock declining, and the further the stock price falls below the strike price, the more money you make.
Yes, I'll use any excuse to post a picture of my kids.
Options trading is risky. Without a predetermined game plan (what to buy and why, when/how to exit), you’ll likely lose your shirt. However, if done correctly with the proper (very small) percentage of your investments, it can be a fun alternative investment strategy to run.
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