If you’re new to the stock market, you may be wondering what are options trading and how do they work?
In short, options are contracts which give the buyer the right to buy or sell shares of a stock.
Options give the option contract holder great leverage; a little money can control a lot of stock.
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Options are truly amazing tools.
Used one way, buying an option requires a much smaller outlay of money than purchasing the actual shares of stock they control, while benefiting from the rise of the stock price.
This also reduces risk.
Options can be used as either conservative (low risk) or speculative (high risk) strategies. They can be used to:
• give some protection from declining prices of stocks you own.
• earn additional income from currently-owned stocks.
• position you to buy a stock you want to own, but at a lower price.
• benefit from the rising stock price of a high-priced stock, but without requiring you to actually own the stock.
What Are Options in Trading?
There are two types of option contracts: calls and puts.
The buyer of a call option has the right, but not the obligation, to buy a specific stock at a set price, called the strike price, anytime on or before the contract’s expiration date.
The buyer of a put option has the right, but not the obligation, to sell the underlying stock (the stock that it controls) at a set price anytime before the expiration date.
One option contract controls a block of 100 shares of a stock. Contracts have expiration dates, and if a contract is to be exercised (used), it must be done so before it expires.
When you buy an option, the price you pay is called the premium. Similarly, when you sell an option, you receive a premium.
Consider Also: Understanding Broken Wing Butterfly Options Trading
Think of buying a call option contract as being similar to a manufacturer’s coupon that you might use at the supermarket.
For example, let’s say you have a coupon to buy one box of Yummy brand frozen pizza for $8.00, which is less than the usual price of $10.00.
The coupon has an expiration date one month from now. The coupon’s current value is $2.00, ($10 minus $8).
You can exercise the right to buy that pizza for $8,00 any time between now and the expiration date on the coupon. Once that date passes, the coupon becomes worthless.
If, however, the price of the product goes up to $12.00 during the month, you have a coupon that locks in your price at $8.00.
The value of that coupon, which was $2.00 before the price hike, is now worth $4.00!
In a similar way, a call option allows the holder to lock in the price of a stock at which it can be purchased on or before the expiration date.
However, traders typically buy a call option to benefit from the rising price of the option itself as the underlying stock price rises, without every having to own actual shares of the stock.
The option itself increases in value and can be sold for a profit.
Let’s look at a real stock example to help clarify. It’s February 4th, and the Coca-Cola Company’s stock price is at $58.58 (ticker symbol KO).
Your research points to a strong possibility that the price will go up in the next few weeks.
Buying 100 shares of KO would cost you $5,858.00 (plus a small commission if you aren’t using Robinhood.com or some other commission-free brokerage).
That’s a lot of money. A call option for the right to buy Coke for $59 a share between now and February 14th, however, is going for $0.45 a share.
We could buy one call option contract for $45.00, since one option represents 100 shares of stock. If the stock doesn’t perform, we only have $45 at risk, rather than $5,858.00.
We are hoping that the stock price will go up. As the price of Coke’s stock increases, so does the value of the call option.
We could choose instead to use the option to buy 100 shares at $59, no matter how high the stock price rises. It would be like buying the stock “on sale.”
So, buying a call option can be used to either attempt to buy a stock at a lower price or to make money by selling the option itself as it’s value increases.
Here’s an example where a trader never has the intention of using the call option to buy the underlying stock, but rather sell the call when it’s value increases.
Let’s assume it’s May. The flowers are blooming, and spring is in the air.
Your favorite tech stock has been doing very well the last few weeks, and your technical analysis convinces you that the stock should continue to climb.
In order to buy 100 shares of the stock, which is trading at $100 per share, that would cost you $10,000!
Instead, buy a call option that gives you the right to buy the stock at $100 a share anytime between now and a July expiration date.
The July $100 call strike price is trading at $8 per share. You only have to invest (and risk) $800 rather than $10,000 to potentially make a profit in a short time. (The cost is $800 because $8 a share times 100 shares is how many shares one option contract controls.)
If the price of the stock does go up, as you predict, to say, $116, the value of the option will also go up. Depending on several factors, the option value could go up to $16 per share.
If it does, the stock moved $16, but the option value increased 100%, from being worth $800 to $1,600. That’s the leverage power of options.
At this point, you could sell the call you bought and pocket the profit, or you could choose to exercise the option and buy 100 shares of the stock at the lower price of $100 per share ($10,000), then immediately sell it for $11,600.
Put Option Contracts
You can use options to make money on stocks that you believe will drop in price, too. Buy a put option when you have a “bearish” opinion on a stock.
The value of the option will increase as the stock price decreases.
Put options can also be used as protection against falling prices of stocks you own. For example, suppose you own 100 shares of the XYZ Corporation, which is currently at $68. Your investment is $6,800.
You are afraid that it might drop in price, so you buy a put option with an expiration date several months from now, with a strike price of $60.
Currently, the price to buy the put option is $1 per share, or $100 total, because one put option controls 100 shares of stock.
If the stock falls by $10 to $58, the put option will increase by about $10 per share, depending on several factors.
Now the put option is worth $1,000 ($10 x 100). Remember, you only paid $100 for the option. So, $100 buys you several months of “insurance” from a big drop in your stock’s price.
Similar to a “deductible” with insurance policies, you lose $800 if the stock price drops to $60.
If the stock falls even further, however, you can exercise your put option, and “put” the stock (stick it to) someone else for $60 per share, no matter how low the price drops.
They must buy the stock from you at $60 a share. So, buying a put option limits your loss if the stock price goes down.
The drawback to buying options is that they lose value as time goes by, and they have an expiration date.
Time erosion is the enemy of option buyers. When you own shares of a stock and the price dips, you can wait and hope that the price eventually recovers.
Unfortunately with options, you don’t have the luxury of waiting, since options can expire worthless.
Time erosion, however, is a friend to option sellers.
Option sellers can make money betting on the direction a stock price won’t get to, but this is a subject for another video.
Know that if you buy a call option and the underlying stock does not go up, or if you buy a put option and the stock price does not go down, you might lose part or all of the money you spent purchasing the option.
You will need to do your “due diligence” on selecting stocks to feel confident of their direction before you buy an option.
Our Final Thoughts: Options Trading
Traders can use combinations of call and put options to enhance profits even more.
To learn more about these strategies, we recommend the book “Trading Vertical Options On Robinhood” by Dan Keen.
You will find this book valuable even if you are not using Robinhood as your broker.
Not a member of Robinhood yet? Sign up here for free and receive a free stock: Robinhood
All of this sounds pretty deep and technical, but relax! Buying call and put options is easy to do, once you understand the basics of options trading.
There is a lot to learn about options trading, so we advise reading books on the subject as well as watching YouTube tutorials, of which there are many excellent videos.
Do lots of “paper trades” before risking real money buying options.
When you feel comfortable and are ready to place actual trades, only use a very small percentage of your trading capital on any one trade. Preservation of capital is top priority.
Check out our line of stock market log books on Amazon, which you can use to record your paper trades.
The good news is that options can often be purchased for only a few hundred dollars, making them perfect for those who have small trading accounts.