Personal Finance Series: Options Trading
For those interested in different avenues of stock trading and being a more active trader, options are a quick way to foster gains in a short amount of time - it is also a great way to quickly lose a large chunk of your investments as well so make sure to be well informed on the trades you execute.
In this guide, we’ll be going over the basics of options trading and key points that are important to know for beginners.
What is an option?
First, let’s start by distinguishing what options trading is and how it is different from purchasing stock shares. An option is a contract which gives the investor the right (but not obligation) to buy or sell a security, ETF or index at a predetermined price (strike price) over a given time frame (expiration date). What makes an option different from a stock is that you do not own shares in the company as you would if you were to simply purchase stock.
Below are a few terms that are useful to know:
Strike Price: The price you want to buy the stock/asset should you exercise the contract. In other words, it is the price you expect or speculate a stock or an asset to reach before or at the expiration date.
Exercise Price: The price at which the contract is valued. Note: The actual COST of the contract you purchase should be multiplied by 100 as a contract generally requires the purchase of 100 shares. Ex: a contract with an exercise price of $1.50 costs $1.50 x 100 = $150.
Expiration Date: The last day in which you can exercise (sell/buy) your contract.
There are two types of options in which an investor can purchase or sell a security - a call option or a put option.
Call Option
A call option is a contract which gives the investor the right to buy a certain amount of shares (typically 100 per contract) of a particular security at a specified price up until a specified date. Generally, purchasing a call option means that you’re bullish about the stock price and you expect it to go up in value in the near future. You gain profits when the value of your contract goes above the purchase price in which you initially bought the contract for.
For example, imagine you buy a call option for Microsoft (MSFT) at an exercise price of $1 with a strike price of $10 at an expiration date of 1 month out. About a week before the expiration date, the MSFT stock is trading at $16. You decide to exercise your option as you believe it’ll maximize your profits (remember that you are not obligated to exercise your option at $10 on the exact date of expiration). The gain from the sale is the stock price subtracted by the strike price ($16-10=$6). You profit approximately $5 because you take into consideration of your original $1 purchase of the contract. However, take into consideration that the $5 is simply the value of the contract gain. Your actual profit is $5 x 100 = $500.
Note: Your gain/loss from exercising the contract contains many factors, not just the value of the underlying asset. How much you make/lose on an option depends on what the value of the contract is - not the stock price.
Put Option
Conversely, a put option is a contract which gives the investor a right to sell a certain amount of shares of a particular security at a specified price. Purchasing a put option means that you’re bearish about the stock price and expect the underlying asset to go down in value in the near future. Similarly, you gain profits when the value of your contract goes above the purchase price in which you initially bought the contract for.
To better understand how you make money from options trading, much of your profits are determined by the value at which you exercise your contract at. Let’s go back to the MSFT example - we mentioned that other factors determine the value of the contract. Much of that is driven by how other traders also value the contract. If MSFT is trading at $16 and you bought a contract at $1 with a strike price of $10 many weeks ago, your contract would be highly valued because it reached the strike price and the contract, itself, has surged in demand (to $6). This is also driven by the fact that the underlying stock is performing well.
You can trade options on any brokerage account that offers options trading (TD Ameritrade, Vangaurd, Charles Schwab, Robinhood, etc.)
Source: https://www.thestreet.com/investing/what-is-options-trading-14772273#:~:text=What%20Are%20Options%3F-,An%20option%20is%20a%20contract%20that%20allows%20(but%20doesn't,trades%20contracts%20based%20on%20securities.
