Stock Options are one of the most misunderstood investment instruments available on the stock market. Just mention ‘Stock Options’ to everyday investors, and you’re bound to hear such misnomers as — “they’re too risky”, “they’re too complicated”, and “isn’t it just gambling?”
Part of the reason options have a ‘risky’ reputation is that novices tend to dive in blind. Lured by the promise of 400%, 500% and even +1000% profits, they jump in without doing their proper due diligence. But as many traders have learnt the hard way, it’s easy to lose money trading options if you haven’t taken the time to develop a strategy and learn the basic concepts.
But for those willing to put in the effort, trading options can be a worthwhile addition to any investment portfolio. Opening the door to unlimited earnings where not even the sky’s the limit.
What is a Stock Option?
Stock options are financial instruments that give an investor the right, but not the obligation, to buy or sell a stock at an agreed upon price and date.
There are two types of option contracts:
- Call Options: The buyer of a call option is betting that the stock price will rise. It gives the buyer the right to buy the stock at a predetermined price and date.
- Puts Options: The buyer of a put option is betting that the stock price will fall. It gives the buyer the right to sell the stock at a predetermined price and date.
Simple, right? Perhaps we can explain a little better.
If an investor thinks the value of shares of a particular company will rise, they can buy call options. This will give the holder the right to buy shares at a set price within a set time period.
During this time period, the market is free to move either up, down or sideways. If the share price increases, the value of your call options will increase. If the share price drops, the value of your options contract will drop.
Before the time expires, the investor can either:
- Sell their call options to another buyer (hopefully for a profit);
- Execute the contract if they wish to buy shares in the underlying company: or
- Do nothing.
After the time period is up, the contract will expire if the option isn’t exercised.
Alternatively, if an investor thinks the value of shares of a company will fall, they can buy put options. This will give the investor the right to sell stock at a specific price and time.. And you get the point.
The Difference Between Options and Stocks
Unlike options, buying stocks is widely considered as a ‘safe’ investment. When an investor purchases shares, they are gaining a small piece of ownership in the company. Money is made by way of dividends and from selling the shares at a profit when the stock price goes up (buying low and selling high). It is not unusual for Investors to hold on to stocks for decades, tying up their capital in the company for that length of time. If the stock price falls or a company goes out of business completely, investors risk losing a part, if not all of their investment.
Options, on the other hand, are derivative contracts. Investors do not gain shares in the company, rather they acquire the right or buy or sell shares. Unlike stocks where you only profit when the stock price rises, there are numerous strategies and ways to trade options, so you can make money even when the stock price goes up, down or sideways.
Generally, options require far less capital investment than purchasing shares. This can, however, be a double-edged sword for traders who trade impulsively. Without rules and a trading strategy, the low capital investment can tempt traders to over leverage their portfolios, take on too much risk, and potentially end up blowing up their accounts.
With options, risk is limited to the premium paid for the option contract. For calls, the maximum profit is infinite. For puts, the maximum profit can be calculated before entering the trade. The ability to map out both risk and reward is a feature of option trading that can potentially make it less risky and more profitable than stock trading, while also not tying up too much capital.
Components of a Stock Option
If you want to learn how to trade options, you need to understand the components of an options contract and how to read an options alert.
There are two different option styles available on the markets: American and European. Contrary to their names, the styles actually have nothing to do with geographical location. Rather, they relate to the differences in the option holders’ right of execution.
- American — allows the holder of the contract to exercise the option any time before expiration.
- European — are less common and only allows the holder of the contract to exercise the option on the expiration date.
There are four ways or ‘actions’ you can take when trading options.
- BTO — Buy to Open — buying an option as part of opening a new position.
- STC — Sell to Close — selling an option that was previously bought to close position.
- STO — Sell to Open — selling an option as part of opening a new position.
- BTC — Buy to Close — buying back an option that was previously sold to open.
The asset or stock that the option is based on. In the example above the underlying asset would be shares of Apple.
The expiration date is the time value, the last day you are able to trade the option.
The strike price signifies the price of the stock if the holder chooses to exercise the stock option. If a trader purchases call options, they expect the stock to be above the strike price at expiration. If the trader purchases put options, they expect the stock to be below the strike price at expiration.
One options contract is equal to 100 shares of the underlying stock. So, if a trader buys five option calls, they are purchasing the right to buy 500 shares in the underlying stock at the expiration date.
Premium is the per share cost of the option. As option contracts represent 100 shares of the underlying stock, you will need to multiply the premium by 100 plus add the commission to determine the true cost of the option contract.
Now that you have the basic components down, the next chapter of your trading journey is learning the Greeks: Delta, Gamma, Theta & IV. Stay tuned, for that’s a tale for next time.