Updated February 14, 2019

Trading Options: What You Need to Know

Read more about Options Trading

Options offer leverage when trading stocks. Can they boost your portfolio? Learn the benefits and risks before you invest.

Read on to learn the basics of the options process and how you can get started.

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What Are Options?

An option is a contract that gives you the "option" to buy or sell a stock at a specific price by a specific time. Like any other contract, an option has a "good-through" date and specific terms.

So why purchase an option versus buying a stock outright? Options give you leverage. You put up a small amount of capital with the potential for much larger rewards.

Of course, that's only true if you correctly predict the stock's direction. Otherwise, your entire investment is at risk. But that investment is a fraction of what it would cost to buy the stock outright.

Key Fact: You are not obligated to make a trade with an options contract. You could let the contract expire unused.

It's rather like an insurance policy - you buying something ahead of time that can be put into play as needed (if the stock price goes in the direction you think it will).

Things to Consider When Trading Options

Buying an options contract gives you the right to buy or sell stocks at a specific price.

If you purchase an option to buy a stock, then you're intending to buy the stock at a lower price.

If you purchase an option to sell stock, you want the stock price to decrease, making you a profit.

If you don't buy or sell the stock before the expiration date, then your options contract is invalid.

Each options contract is worth 100 shares of a stock. You don't pay the full price of the stock. Instead, you pay the contract premium.

Consider this example:

If a call option sells for $1.50 per share, the contract would cost $150.

Let's say the current market value of that stock is $25. If you bought the shares direct from the market, you'd pay $2,500 ($25 x 100 shares).

Instead, you buy the "insurance policy" to buy the shares at what you hope is a lower price in the future. Basically, you tie up less money trading options.

Before you can trade, you must:

  • Predict how the stock will change. Will it increase or decrease?

  • Calculate how much you think the stock price itself will change. This will help you determine which contract is worth buying.

    For a call option, you want a strike price below the current market value.
    For a put option, you want a strike price above the current market value.

  • Choose an expiration date. Again, you must predict how long you think it'll take the stock's value to hit your strike price.

    You'll find expiration dates that range from days to years. Beginning investors should stick to long-term expiration dates. The further the date, the more time the stock has to move.

What Benefits Do Options Provide?

Options might seem overwhelming and complicated. But you can earn some distinct benefits:

  • Options require a smaller upfront investment
    You only pay a small fraction of the stock's price. Yet you own the right to buy the stock at the strike price if it works out.

  • They give you time to figure out how to act
    If you want to ride out the stock for a while, you can buy the option (or "insurance policy") against major changes. If you still decide to buy the stock, you can do so at the specified strike price.

  • Options give you a chance to earn if you want it
    Again, it's like paying an insurance premium. You might or might not use it. But you have the policy in case you need it.

  • Put options help you hedge against losing your whole investment
    You can buy a put option at a strike price that you are comfortable with. This way, you can control your losses.

    If you have a strike price of $20 on a stock you own and it drops to $15, you can still sell at $20.

What Are the Drawbacks of Options Trading?

Of course, there are downsides to options trading.

  • Trading options can be complicated
    As a beginner, these trades can be overwhelming. Without the right options broker, you could end up over your head.

  • Options only have limited worth
    The more time that passes, the less your contract is worth. Once the contract expires, it is worthless. You'll be left with a loss equal to the premiums paid.

  • Securing information on options contracts is difficult
    Brokers have options quotes, but they are more confusing than standard stock quotes.

  • Brokers are picky
    They will evaluate your experience and financial status before allowing you to trade options. Once evaluated, you'll be assigned to a trading level, which determines which options you can trade.

Choosing the Right Broker

Picking the right broker is essential when trading options. Many people make the mistake of shopping based on fees. But we suggest looking at the fees last.

First, you want to find a broker that provides quality customer service and proper education.

The cheaper brokers usually provide less support. If you are a beginning options trader, that support is important.

Ask questions and look at the platforms yourself. This way, you can decide which broker suits your needs the best.

Most brokers have some type of account minimum. You might find a few brokers without one, but they may offer less support.

Terms You Should Know

Here are some terms that may impact your transactions when trading options:

Call: This is an options contract to "call the stock to you."

In other words, you have the option to buy the stock. Your purchase price is the price stated in the contract.

Put: This is an options contract to "put the stock on someone else."

In other words, you have the option to sell the stock to the contract holder. Your selling price is the price stated in the contract.

Strike Price: The specified price you can buy or sell the stock when exercising your contract.

Premium: The price you pay for the contract. It's on a per-share basis.

For example, if a call option is available for $2, it costs $200 ($2 x 100 shares).

Expiration Date: The last date you can exercise your right to buy or sell the stock. After this date, the contract is worthless.

In The Money: A call option is "in the money" when the strike price is lower than the stock's current price.

A put option is in the money when the strike price is higher than the stock's current price. It's not a guaranteed profit. It just means exercising the contract is worthwhile.

At The Money: A call or put option is "at the money" when the strike price is the same as the current market price.

Out Of The Money: A call option is "out of the money" when the stock's market value is below the strike price.

A put option is out of the money when the stock's market value is above the strike price.

Option Chain: This is another word for the option's quote. It looks a little different than a stock quote.

The option chain includes the strike price, bid/ask price, and the stock's volatility.

Holder: The investor holding the contract is the holder.

As the holder, you have the right to buy or sell a stock with your contract. You are not under any obligation to exercise your contract.

Writer: This is the investor on the other side of the contract.

The writer can lose a lot of money on an exercised contract. Writers must buy or sell the stock when an option is exercised.

Calculating an Option's Value

Options have two values: intrinsic and time value.

The Intrinsic Value
This is the difference between the strike price and the price of the call or put.

  • If you have a call contract, your intrinsic value is calculated as follows:

    Stock's market value - Strike price = Intrinsic value

  • If you have a put contract, your intrinsic value is calculated as follows:

    Strike price - Stock's market value = Intrinsic value

An option is not in the money unless it has a positive payoff. In the case of a call, you are in the money when the stock price increases above the strike price.

A put option is in the money when the stock price falls below the strike price.

Key Fact: Even if the stock's price does hit the in the money value, you don't have to exercise the option. Any options that are at or out of the money have an intrinsic value of zero.

Time Value
This is the value of the time left on your contract. The longer you have until the expiration date, the higher the time value.

For example, an options contract that expires 6 months from now has MORE value than one expiring in 1 month. The 6-month contract has a greater chance of being in the money.

You can calculate the time value of an option with the following calculation:

Premium paid for the option - Intrinsic value = Time value

A put or call with an intrinsic value of zero has equal time value and premium. This doesn't mean the contract is worthless. As long as there is time value, you have a chance to make a profit.

The Bottom Line

A new investor in options trading should start out as a holder. That way, you control your risk level and potential losses.

Begin by researching brokers to find one that offers the support you need. Most brokers will only allow minimal options trading when you begin.

Once you gain experience, you can venture into the more complicated world of writing options.

Write to Kim P at feedback@creditdonkey.com. Follow us on Twitter and Facebook for our latest posts.

Read Next:

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