Options are a way to unlock a whole new dimension of the stock market or any other financial market. They offer a way to extend, or leverage, the value of your investment.
Options give you the ability to be creative and more advanced with your investing, and this means you can make more money using less of your capital. However, trading options without a good understanding can lead to massive losses.
Let’s explore the basics of option contracts.
An option is a type of derivative and a financial instrument that is based on the value of an asset. In this case, a stock option is a derivative based on the value of a stock. An option allows you to buy or sell an asset at a fixed price within a certain period of time.
There is a lot of value and flexibility that we can access with options. A stock option allows you to buy or sell 100 shares of the underlying stock within a certain period of time. After the defined period, your options expire and have a $0 value.
Options are priced in terms of the value per share, rather than the total value of the contract. For example, if the exchange prices an option at $1.50, then the cost to buy the contract is $150, or (100 shares * 1 contract * $1.50).
The price of an option is referred to as a premium. The premium is what you paid at the beginning to get the contract, so that is the threshold for you to make a net profit.
There are two types of option contracts: call and put options.
Someone who buys a call option wants the stock price to rise above the fixed price of their option contract. This fixed stock price is called the strike price.
If you bought a call option for 100 shares of company X at a strike price of $10 and the stock price rose to $20, you could exercise your contract to buy 100 shares for $1,000. You now own $2,000 worth of stock for only $1,000.
If we assume the premium was $1, the total cost of the contract was $100. In this example, your net profit is $900 with a return of investment of 900% ($900/$100).
Someone who buys a put option wants the stock price to fall below the strike price of their option contract. This means they can sell their stock for more money than it’s worth.
If you bought put options for $100 for company X at a strike price of $20 and the stock price falls back to $10, you could exercise your put option and sell your shares at a higher price of $20.
This means you sell your shares for $2,000 while they are only worth $1,000. In this example, you’ll make a $1,000 gross profit minus the $100 premium for a net profit of $900.
You can see how a put option can be used to protect, or hedge, the value of your investment in case something goes wrong.
The main appeal is that option returns are magnified and can also be used to hedge against your portfolio if you feel uncertain. In addition, whenever an option trade goes wrong, you only lose the cost to buy the option itself. This cost is an upfront payment that is a fraction of the actual share price.
An option strategy allows you to combine option contracts like building blocks in order to accomplish unique things. There is a lot of room for creativity here, and there are a bunch of interesting names for different strategies.
One basic option strategy is a married put. This means buying a stock normally and then buying a put option at the same time. So say you bought 100 shares of company X at $20 for $2,000 and also bought a put option with a strike price of $20.
If the stock price goes up, you’d profit as you normally do by owning stock. If it goes down below $20, then you can still sell your stock at $20 by exercising your put option. This way your investment is protected from the loss by paying a small premium for the put option.
Getting started with options is easy, you just need a retail broker that offers options and approves your account for trading them. However, you need to be able to read option chains.
This is a simplified example of a table that shows prices for option contracts, also known as an option chain. You can see the strike price in the center for various contracts. The row in blue represents the current price of the underlying stock.
So, in this case, the underlying stock is at $240. The bid is the price that you’ll get for selling the option. The ask is the price that you’ll get for buying the option.
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For example, if you thought the stock price will go up, you could buy a call option at a strike price of $240 for an ask of $7.05 per option.
As each contract is worth 100 shares, this would cost $705 to buy one call option. If you just bought the 100 shares normally, it would cost $24,000. You paid only 2.9% of the cost to buy the shares at that price, but you’ll still need $24,000 to exercise the contract if it goes up.
If the stock price goes up to $250, you make $10,000 while only risking $705. While you need $24,000 to exercise the contract, that’s a 1,418% return on the premium. If the stock price goes down, the option ends or expires worthless and you only lose the $705 premium.
This is a very expensive stock, there are much cheaper shares and options you can buy.
Instead of buying a call or put option, you can sell the option to someone else. This is called option writing and the seller is called the writer. Before computers and electronic trading, an option seller would write the terms on a physical paper contract and sell it to another trader.
Now, most option contracts actually expire worthless. It takes a skilled option buyer to find good contracts and make those big profits. That’s the reality of options.
However, an option writer is kind of like the house in a casino. They make cash instantly by writing or selling the contract for an upfront premium, but if the buyer wins and exercises the contract, they have to meet their end of the bargain and provide the stock or buy the shares.
A popular strategy is a covered call. Say you buy 100 shares of the above company normally. If you want to take profit at a fixed price or make some extra money, then you could sell a call option at the strike price of $247.50 at the bid price of $3.40 per share.
At $3.40, you would sell or write the option for $340 and that cash goes instantly into your account. However, if the stock price goes up to $247.50, then the buyer will likely exercise their contract and buy your stock at the strike price. Now, you already own the stock, so you still make a profit of $750 for selling your shares plus your premium of $340 for a total profit of $1,090.
This is called a neutral strategy because you make money either way. However, your normal stock profits are limited at the strike price of the option. If the price of the stock goes down, you still take a loss as you normally would by buying shares.
You may be thinking, can’t you buy and sell options at the same time? You certainly can, and this adds another layer of complexity and possibilities for option contracts. This strategy is called option spreads and can be used to reduce your premiums or take special strategies.
One basic spread is the bull call spread. This involves buying one call option at a certain strike price and selling another call option at a higher strike price. So, we just combine the two above examples. Say you bought a call option at $240 and sold a call option at $247.50.
So, the call option at $240 would cost $705 just like before, but you’d make $340 from selling the call option at $247.50. In total, your premium cost on buying the call is reduced to $365.
You paid only about half price for an option that is already much cheaper than buying the share outright. However, your upside potential is capped at the strike price of $247.50. The bull call spread will reduce premium cost while limiting upside potential.
If the stock price goes down, you only lose $365 instead of the $705 as you would before. If it goes up to $247.50, you exercise your call and buy the stock to sell at $247.50 to the buyer that purchased a $247.50 call from you.
So you make $750 profit minus the total premium of $365 for a maximum profit of $385. That’s a return of 105% on the initial premium. You are risking $365 rather than the $24,000 to buy the shares outright. Your cost to take the position is reduced by 98.47% and your upside is increased from 3.12% to 105%.
However, most importantly, remember that you still need $24,000 in your account to buy the shares and exercise the call option that you own. While options increase your buying power, you still need capital to finance the option.