Options Trading 101
When it comes to trading, there are many vehicles including stocks, futures and forex. However, one commonly overlooked trading vehicle is options. Options have some advantages compared to common stock trading. These include leverage as well as hedging because it is possible to bet on upward movement as well as downward movement in equities. Options can also potentially allow you to earn an income through premiums. There are conservative ways to trade options as well as very risky ways. This guide aims to provide you with the basics of options trading in easy to understand language.
An option is a contract that gives the investor a right, but not an obligation, to buy or sell an underlying investment at a predetermined price and time. Options are bought and sold just like regular stocks, on the open market.
There are two basic types of options:
• Call options
• Put options
A call option gives the holder or investor the right to purchase the underlying investment at a specific price on or before a specific date. The underlying investment can be just about anything: a stock, a bond, etc. The main trading strategy for a call option is to purchase the option when the security is at a low price in anticipation of the underlying security to rise in value.
A call is structured so that the seller of the contract names the price of the security and the term at which that security can be purchased at that price. For instance, Company XYZ is currently valued at $10 per share on the open market. Investor A wants to own 100 shares of Company XYZ’s stock because he thinks that the value of the company will be higher by the end of the 3rd quarter. Instead of paying $1,000 for 100 shares of stock, the investor decides to buy a contract, or call option, that would allow him or her to buy Company XYZ’s stock at $11 per share for the next 90 days, but not obligate him to do so, in the event that the value of the stock goes down.
Investor A monitors Company XYZ’s stock and decides to exercise his option, or right, to purchase the stock after 90 days since the value of the stock has risen to $12 per share. After an immediate sale, the investor realizes a $1 per share profit (minus the cost of the call option cost and brokerage fees). If the value of the stock had decreased in value instead of increasing, the investor could have allowed the contract to expire without exercising his option to buy, thus reducing his loss to only the cost of the call option and brokerage fees.
A put option, on the other hand, gives the holder of the option the right to sell a security at a particular price on or before a predetermined date. It works in much the same manner as a call option; however these are structured to take advantage of a declining stock. The main trading strategy for a put option is to buy the option when the security is at a high price in anticipation of the underlying security decreasing in value.
Continuing with Company XYZ’s example above, instead of increasing in value to $12 per share, the company’s stock decreases in value to $9 per share. Investor B, is looking to take advantage of the downward trend in value and purchases a put option which allows him to set a selling price of the stock for 90 days to $10. Company XYZ’s stock appears to be in a free-fall and at the 90 day mark is trading at $9. He exercises his option to purchase shares of XYZ stock at current market value ($9 per share) and exercises his option to sell at $10 per share, theoretically earning him $1 per share, or $100, minus the option cost and brokerage fees.