Getting Acquainted With Options Trading

Fact checked by Kimberly OvercastReviewed by Thomas BrockFact checked by Kimberly OvercastReviewed by Thomas Brock

Trading options is very different from trading stocks because options have distinct characteristics from stocks. Investors need to take the time to understand the terminology and concepts involved with options before trading them.

Options are financial derivatives, meaning that they derive their value from the underlying security or stock. Options give the buyer the right, but not the obligation, to buy or sell the underlying stock at a pre-determined price.

Key Takeaways

• Options give a buyer the right, but not the obligation, to buy (call) or sell (put) the underlying stock at a pre-set price called the strike price.
• Options have a cost associated with them, called a premium, and expiration date.
• A call option is profitable when the strike price is below the stock’s market price since the trader can buy the stock at a lower price.
• A put option is profitable when the strike is higher than the stock’s market price since the trader can sell the stock at a higher price.

How Stock Options Trading Works

Trading options is more like betting on horses at the racetrack: Each person bets against all the other people there. The track simply takes a small cut for the facilities. So trading options, like betting at the horse track, is a zero-sum game. The option buyer’s gain is the option seller’s loss and vice versa.

One important difference between stocks and options is that stocks give you a small piece of ownership in a company, while options are just contracts that give you the right to buy or sell the stock at a specific price by a specific date.

It’s important to remember that there are always two sides to every option transaction: a buyer and a seller. In other words, for every option purchased, there’s always someone else selling it.

Important

Options are not meant for novice traders. They are complicated and sophisticated financial assets that should only be traded once you develop a lot of experience.

Types of Options

The two types of options are calls and puts:

• When you buy a call option, you have the right, but not the obligation, to purchase a stock at a set price, called the strike price, any time before the option expires.
• When you buy a put option, you have the right, but not the obligation, to sell a stock at the strike price any time before the expiration date.

When individuals sell options, they effectively create a security that didn’t exist before. This is known as writing an option, and it explains one of the main sources of options since neither the associated company nor the options exchange issues the options.

When you write a call, you may be obligated to sell shares at the strike price any time before the expiration date. When you write a put, you may be obligated to buy shares at the strike price any time before expiration.

There are also two basic styles of options: American and European. An American-style option can be exercised at any time between the date of purchase and the expiration date. A European-style option can only be exercised on the expiration date. Most exchange-traded options are American style, and all stock options are American style. Many index options are European style.

Option Pricing

The price of an option is called the premium. The buyer of an option can’t lose more than the initial premium paid for the contract, no matter what happens to the underlying security. So the risk to the buyer is never more than the amount paid for the option. The profit potential, on the other hand, is theoretically unlimited.

In return for the premium received from the buyer, the seller of an option assumes the risk of having to deliver (if a call option) or taking delivery (if a put option) of the shares of the stock. Unless that option is covered by another option or a position in the underlying stock, the seller’s loss can be open-ended, meaning the seller can lose much more than the original premium received.

Please note that options are not available at just any price. Stock options are generally traded with strike prices in intervals of $0.50 or $1, but can also be in intervals of $2.50 and $5 for higher-priced stocks. Also, only strike prices within a reasonable range around the current stock price are generally traded. Far in- or out-of-the-money options might not be available.

Options Profitability

When the strike price of a call option is above the current price of the stock, the call is not profitable or out-of-the-money. In other words, an investor is not going to buy a stock at a higher price (the strike) than the current market price of the stock. When the call option strike price is below the stock’s price, it’s considered in-the-money since the investor can buy the stock for a lower price than in the current market.

Put options are the exact opposite. They’re considered out-of-the-money when the strike price is below the stock price since an investor wouldn’t sell the stock at a lower price (the strike) than in the market. Put options are in the money when the strike price is above the stock price since investors can sell the stock at a higher (strike) price than the market price of the stock.

Expiration Dates

All stock options expire on a certain date, called the expiration date. For normal listed options, this can be up to nine months from the date the options are first listed for trading. Longer-term option contracts, called long-term equity anticipation securities (LEAPS), are also available on many stocks. These can have expiration dates up to three years from the listing date.

Options expire at market close on Friday, unless it falls on a market holiday, in which case expiration is moved back one business day. Monthly options expire on the third Friday of the expiration month, while weekly options expire on each of the other Fridays in a month.

Like shares of stock, options settle under the T+1 rule. This means they settle the next day. To settle on the expiration date, you have to exercise or trade the option by the end of the day on Friday.

What Is a Stock Options Contract?

A stock option contract entitles the owner of the contract to 100 shares of the underlying stock upon expiration. So, if you purchase seven call option contracts, you are acquiring the right to purchase 700 shares. And, if the owner of a call option decides to exercise their right to buy the stock at a particular price, the option writer must deliver the stock at that price.

What Do Stock Options Cost?

Options contracts usually represent 100 shares of the underlying security, and the buyer will pay a premium fee for each contract. For example, if an option has a premium of $0.55 per contract, buying one option would cost $55 ($0.55 x 100 = $55).

How Do You Make Money Trading Options?

You can make money by being an option buyer or an option writer. If you are a call option buyer, you can make a profit if the underlying stock rises above the strike price before the expiration date. If you are a put option buyer, you can make a profit if the price falls below the strike price before the expiration date.

Is Options Trading Better Than Stocks?

Options trading can be riskier than trading stocks. However, when it is done properly, it can be more profitable for the investor than traditional stock market investing.

The Bottom Line

Options are complex financial contracts that are based on the price of an underlying security like stocks. bonds, and ETFs among others. They come with expiration dates by which the contract holder must exercise their option. Because they are sophisticated securities, options aren’t meant for novice traders. Rather, they should only be traded by experienced investors who understand their nuances so the risk of loss is minimal.

Read the original article on Investopedia.