Options have different characteristics than stocks, and there is a lot of terminology beginning option traders must learn. Many traders think of a position in stock options as a stock substitute that has higher leverage and less required capital. After all, options can be used to bet on the direction of a stock’s price, just like the stock itself.
One important difference between stocks and options is that stocks give you a small piece of ownership in the 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
Trading options requires three strategic choices: deciding which direction you think a stock will move, how high or low the price will go and the time frame it will all take place.
Suppose a trader wants to invest $5,000 in Apple (AAPL), trading around $165 per share. With this amount, he or she can purchase 30 shares for $4,950. Suppose then that the price of the stock increases by 10% to $181.50 over the next month. Ignoring any brokerage, commission or transaction fees, the trader’s portfolio will rise to $5,445, leaving the trader with a net dollar return of $495, or 10% on the capital invested.
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 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 explains one of the main sources of options, since neither the associated company nor the options exchange issues 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. Option Pricing
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.
Each contract includes a pre-negotiated price and an expiration date which specifies how long the price is valid.
There are a few key words to understand within an option contract, and here’s what you need to know:
• Premium – The price at which you can buy or sell an options contract. The buyer of an option cannot 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.
• Strike price – The pre-negotiated price of the security if it’s bought or sold according to the option contract
• Expiration – The date and time the contract ends where you no longer have the ability to buy or sell
You should be aware that there are 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. Most exchange-traded options are American style, and all stock options are American style. A European-style option can only be exercised on the expiration date. Many index options are European style.
Most option traders use options as part of a larger strategy based on a selection of stocks, but because trading options is very different from trading stocks, stock traders should take the time to understand the terminology and concepts of options before trading them.
How to Trade Stock Options
There are various online brokerage outfits that allow you to trade stock options. For most outfits, you can buy options without any special requirements. If you’re looking to sell options, because your risk is much greater (or unlimited for selling naked/uncovered calls), you generally need to sign up for a margin account and agree to risk notifications.
A brief word on options pricing. The relative price of an option has to do with the chances that an event will happen. But in order to put an absolute price on an option, a pricing model must be used. The most well-known model is the Black-Scholes-Merton model, which was derived in the 1970’s, and for which the Nobel prize in economics was awarded. Since then other models have emerged such as binomial and trinomial tree models, which are also commonly used.
A history of the stock’s average daily price change (volatility) provides a good clue to the correct answer. It is a poor strategy to buy (OTM) call options with a strike price of $50 if the average stock price move is $0.05 per day. However, it is a reasonable play when the average daily stock price change is $0.50 per day. Be aware of just how volatile the stock price has been in the past.
New and beginning investors have the potential to benefit from trading options and can use strategies to protect against risk and increase the potential for profit.
If you consider the time value, volatility, and interest rates, you can introduce a lot of flexibility in your investment strategy by trading options.
When buying options, do not plan on holding them until expiration arrives. Options are wasting assets and your plan should include getting out of the trade as soon as it becomes feasible. It is easy to fall in love with a profitable option trade and hold onto it, looking for a much larger profit.Do not allow that to happen. Sometimes you earn the target profit. At other times it means giving up on the trade and selling the options while they still have value. If the stock price reaches your target (or gets near that target price), it is time to take your gains and sell the option. Avoid using options to gamble.