If you are new to investing, then you probably realize that there are many different ways to get involved in the stock market.
Options Trading is is a method used to make plays in the stock market based on future predictions. Tons of traders make plays everyday in order to attain new assets, or protect current ones.
However, in order to fully understand options trading, you have to understand what buying stock is.
Purchasing stock of a company means that you own a tiny slice of it, better known as a share. By purchasing a share, or multiple shares in the company, you believe that the company has a promising future and that the price of the share will go up in the future.
If this happens, then you can sell the shares for a profit in the future.
However, options are not the same as buying stocks because you are not actually buying ownership in the company. Options contracts give you the right to buy, or sell, hence the name.
What Exactly is an Option?
An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on, or before a certain date.
Usually, the options contract is for 100 shares of the asset being purchased.
So essentially, if you think a stock is going to hit a certain price target by a certain date, you would buy an options contract in order to make a profit. However, once that date comes you are not obligated to purchase these shares. As mentioned earlier, you have the option, hence the name.
Along with this, you will be required to pay a premium upfront in order to purchase the contract. The premium fee is usually a small percentage of the contract.
Types of Options Trading
There are two types of Options: “Puts” and “Calls.” Some of this terminology can sound intimidating, so lets look at the simplified definition.
Call Option: is a financial contracts that give the option buyer the right, but not the obligation, to buy a stock, bond, commodity, or other asset or instrument at a specified price within a specific time period. (via Investopedia)
Imagine you have a coupon from Dave’s Used Car Company that gives you the option to buy a car for $150, and the coupon is good for 6 months. Along with this, you know the car market can either go up or down within those 6 months. This is basically what a call option is.
It gives you the opportunity to purchase the car for $150, and it expires on a certain date. It’s up to you whether you use it, or not.
Obviously, you would only use the coupon if it holds value, so if Dave’s cars are currently selling for $100, it wouldn’t make any sense to use the coupon.
However, if Dave's Car Company is selling their cars for $300 after 3 months, then the coupon has $150 of real value, so you would therefore want to use the $150 coupon in order to get the car at the lower price.
Now, lets say that Dave’s Car Company is traded publicly on the stock market. A January 150 call option for Dave's Car Company would give you the right to buy 100 shares of the company’s stock for $150 per share on, or before the call’s January expiration date.
If shares are trading for less than $150, you most likely wouldn’t exercise the call. It’s the same as using the $150 coupon on a $100 car; it doesn’t have any value. You would most likely hold onto the stock, hoping that it would go above $150 a share.
Now, lets imagine that the stock does in fact go above the $150 price to $200. You could now exercise that option and buy the shares for $150 a share. You could then re-sell them on the market for $200 each and make a profit, or you could hold on to them and see if they go even higher.
Either way, you exercised your option and bought the shares at an undervalued price. You could also sell the options contract to somebody else, so you never actually would own any shares of the company.
I used the term coupon to help explain what an option is, but I do not want you to get confused. A coupon is typically free, while an option is not. You have to buy an option, and even if you don’t exercise the option, you don’t get your money back.
Remember to calculate your risk before trading options.
Put Option: Contract giving the option buyer the right, but not the obligation, to sell—or sell short—a specified amount of an underlying security at a predetermined price within a specified time frame. (Via Investopedia)
Put options give you the opportunity to protect your stock if you believe that the price is going to go down in the future. Essentially, it allows you to sell the stock at a certain strike price at an allocated time, if there is a downturn.
Let's say you own 50 shares of ABC Pizza, and the stock is trading at $100 a share. Lets say you believe that the price is eventually going to drop to $80.
You can buy a $90 put, so that way if the stock price does fall, you still have the option to sell the stock at the $90 price point.
This strategy allows you to protect your profits, or limit your losses.
What are the Benefits and Risks of Options Trading?
Cost Effective- An investor can gain a similar position using options, but have a huge cost savings.
100 shares of a $100 stock would cost you $10,000.
Two $10 calls of the same stock would cost you $2,000.
This is obviously a simple example. Nothing is guaranteed, so do your research.
Lower Risk- You are able to hedge your puts and calls with options trading, so if you are well versed their isn't as much risk. There is less financial commitment and it gives an investor time to see how things play out.
Larger Potential Returns: When options trades are successful, you are getting stock at an undervalued price, so you are going to make much more of a profit if you were just to purchase an individual stock outright.
The one obvious risk of trading options is you can lose money. Duh!
Options are a bit more tricky than just purchasing stocks. You have to know what you are doing, its simple as that.
Anytime you are trading or investing there is some type of risk. This is why you need to do extensive and concise research before making any type of play.
If you want to get involved with options trading, I recommend practicing with fake money first. There are tons of websites that offer this practice.