October 16, 2017

Trading Options: What You Need to Know

Read more about Options Trading

Getting into options trading involves knowledge. Read this guide to learn what options mean and how you can add options to your investing portfolio.

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

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What Are Options?

When you buy an option, you're buying a contract. This contract gives you the "option" to buy or sell a stock at a specific price by a specific time. The contract, like any other contract, has a good-through date and specific terms.

Why would you want to do this and not purchase a stock outright? Options give you leverage. You put up a small amount of capital with the potential for much larger rewards than if you bought the stock outright. This is, of course, assuming you predict the stock's direction correctly. If you don't, your entire investment is at risk. But again, it's a fraction of what it would have cost to buy the stock outright.
With options, you are not obligated to make the trade. You could let the contract expire unused.

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

One options contract includes 100 shares of a particular stock.

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.

Things to Consider When Trading Options

Buying an options contract gives you the right to buy or sell stocks at a specific price. Each options contract is worth 100 shares of a stock. You don't pay the full price of the stock, though. You only pay the contract premium.

For 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, though, you must consider the following:

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

  • Predict how much you think the stock price itself will change. Again, you must decide if the stock will increase or decrease, but also how much. 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 longer term expiration dates for the greatest results. The further the expiration date, the more time the stock has to move.

What Benefits Do Options Provide?

Options might seem overwhelming and downright complicated. Why would an investor even consider trading them? 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.

  • Options give you more time to figure out how to proceed. 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 that insurance premium. You might or might not use it. But you have the policy there in the event that you need it.

  • Put options help you hedge against losing your entire 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 that you should understand.

  • Trading options can be complicated. If you are a beginner, it can seem overwhelming. Without the right options broker, you could end up over your head rather quickly.

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

  • It can be difficult to secure information on options contracts. Brokers have options quotes, but they are more confusing than standard stock quotes.

  • Brokers are very choosy about who they allow to trade options. Brokers will evaluate your experience and financial status. Once evaluated, they assign you a trading level. This level determines which options you can trade.

Choosing the Right Broker

Since options are so in-depth, you must choose the right broker. Many people make the mistake of shopping based on fees. We suggest the opposite. Look 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, the support is worth its weight in gold. Keep in mind, though, all brokers have some type of account minimum. You might find a few brokers with no account minimum, but they may offer less support.

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

Terms You Should Know

Trading options involves much more than trading stocks or bonds. You'll hear many terms that have an impact on your transaction.

  • 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 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.

Again, 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 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, there is more time value in an options contract that expires 6 months from now 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, there is a chance that you could make a profit.

The Bottom Line

Investors just starting out in options trading do best starting as a holder. You control your risk level and potential losses. Most brokers will only allow minimal options trading when you first start out. Once you gain experience, you can venture into the more complicated world of writing options. Until then, research your brokers, and find one that offers the support you need.

More from CreditDonkey:

How to Trade Options

Options Trading Strategies

Calls and Puts

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What if you could minimize your losses on a stock? It sounds like a dream come true, right? The collar option gives you that chance. It comes at a cost, though. You'd have to maximize your profits. Is it worth it?

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