Contracts exist in our everyday lives. For example, you sign a contract when you buy a new car. There’s also one when you sign up for a new phone plan. What if I told you that some people sign contracts to buy stocks? This might sound a bit strange, but that’s exactly what options and options trading is.
Options are a type of financial derivative. That is, their value is based on and derived off something else. This is why they’re called derivatives. In this case, when people mention options, they’re usually talking about options of financial stocks of companies. In other words, the underlying asset is often financial stock.
Almost all derivatives are risky and options are no exception. Coupled with the fact that options also represent leverage as well, it’s no wonder that they have the potential to make big gains or cause catastrophic loses. The margin between making a gain or incurring a loss can often be razor thin.
What is options trading?
Options traders can either buy or sell contracts that give them the possibility, and thus the option, to either buy or sell an underlying asset at a certain price within a certain time frame. The selected price is called the strike price and the time frame specified is referred to by the expiration date. Those who choose to activate their contracts are said to be exercising their contract.
For example, let’s say you purchase an option contract that allows you to buy shares of stock at $100 each and this contract expires in a month. If the underlying stock that the option is based on rises to $200 before the expiration date, you have the ability to exercise your option contract to purchase shares of the stock at your selected price of $100. At this point, you can immediately sell your newly bought shares at the current market price of $200 for a neat profit or you can continue holding onto the shares. As with all trading, option traders make money by speculating on the movement of stock.
One important thing to keep in mind is that one option contract represents 100 shares of the underlying stock. This is one aspect as to why options also represent leverage. Although one option contract represents 100 shares, this does not mean the price of an option contract will be 100 times the price of a share nor does it mean the change of the option contract’s value will be 100 times the change of the underlying stock. In practice, the price and leverage often change and depend on many other factors.
Financial stocks aren’t the only things there can be options of. Many other assets, such as bonds, commodities, etc, can have options as well.
Now let’s briefly cover the 2 types of options. A call option and a put option.
What is a call option?
A call option provides you the right, but not the obligation, to buy an underlying stock at a selected strike price before the option expires at the end of the expiration date. These are called “call” options because they represent the right to “call” for shares of the stock.
Owners of call options are betting the underlying stock price will rise a certain amount within a specified time frame (ideally, rising above the strike price of the option). Assuming the same amount of money is invested and the stock price rises enough, one can make more money by owning a call option than by owning only shares of the stock. However, the reverse is also true. Loses will be magnified as well.
What is a put option?
A put option provides you the right, but not the obligation, to sell an underlying stock at a selected strike price before the option expires at the end of the expiration date. These are called “put” options because they represent the right to put shares of stock up for sale. So the difference between a call and a put option is whether or not the contract allows you to buy or sell the underlying stock.
Owners of put options are betting the underlying stock price will fall a certain amount within a specified time frame (ideally, falling below the strike price of the option). Buying put options can often achieve similar results to shorting a stock.
What happens if you combine call and put options?
Traders often don’t just buy only calls or only puts. Many combine calls and puts together. These combinations are often referred to as option strategies. Due to the many variables at play here with the choice of underlying stock, strike price, timing, etc, you can imagine that there can be many option strategies. In other words, this is an advanced topic that we’ll be covering later in another piece.
How are option contracts priced?
To put it simply, options are valued based on how likely an event will happen. The more likely an event, the higher the option price will be.
One aspect is the distance between the strike price of an option and the current price of the underlying stock. Let’s take a call option first. Ideally, we want the stock price to rise above the call option’s strike price. If the current price of the stock is far away and very low compared to the call option’s strike price, it can be said that there is a low chance of the stock price rising all the way above the strike price since it is far away. Conversely, if the stock price is very close to and just under the call option’s strike price, it can be said that there is a high change the stock price might rise above the strike price since it is so close.
Now the example in the above paragraph only holds true if the current price of the stock is under the call option’s strike price. If the current price of the stock is above the call option’s strike price, one can theoretically exercise the option to buy shares of the stock at the lower strike price to immediately sell back out at the higher current stock price. This potential profit must then be a part of the call option’s value. Therefore, the higher the current price of the stock is when compared to the call option’s strike price, the higher the call option’s value must be.
Another aspect to how likely an event will happen is the time involved. Things are also more likely to happen given a longer timespan. As a result, option contracts with expiration dates further out will generally be more expensive than ones that will expire soon. For example, an option that expires next year will be more expensive than one that expires next week.
Yet another aspect to how likely an event will happen is external information. Within option pricing, this is typically encapsulated by a term called implied volatility. It there is a big event coming up soon that many expect will cause prices to change, an option will have a high implied volatility. The higher the implied volatility is, the higher the value of the option will be. Large swings in price may make it more likely for options to profit and thus the value of those options will be higher to reflect this high probability.
The exact mathematical model that is used to calculate the value of an option is called the Black-Scholes model. It is a complicated equation that we won’t be covering in this introductory piece.
How do you actually trade options?
Just like with financial stocks, options can be traded on almost all brokerage firms. Most will charge a small commission per option contract, but there are also brokerage firms like Robinhood which charge no commission.
By now, with the many variables to juggle, you should know that options can be extremely risky. As a result, many brokerage firms won’t allow you to trade options unless you demonstrate to them that you have enough understanding and experience. Ultimately, approval will be on a case by case basis.
If you do decide to apply for the permission to trade options, brokerage firms will ask about your financial situation and investing experience. Based on your responses, brokerage firms will assign you to a particular access level. Those with less experience will only be allowed access to lower risk option strategies while those with more experience will be allowed access to more risky option strategies.
When trading options, you’ll have to select the underlying stock, the type of option, the strike price, and the expiration date. So there’s a lot to consider.
Why do people trade options?
There are many reasons people trade options. Some traders are interested in the leverage they provide which means they can use less money to potentially make larger gains.
Others are interested in using options to hedge their portfolio. For example, this may include buying a few put options which, if the market drops, may offer a little profit to help offset losses from other parts of their portfolio.
Investors may also trade options for income purposes by using their shares of stock as collateral so that they can periodically sell call options. This particular strategy is called selling covered calls. They are covered because there are shares that exist within the portfolio as collateral.
How risky is options trading?
There’s risk involved with any speculation. In the case of buying an option to open a position, the money at risk would be what you initially paid for that option. If you spent $100 to buy an option to open a position, the most you can lose is $100 while the most you can gain can be theoretically unlimited assuming the price of the underlying stock has no defined max price. If you sold an option to open a position, the situation is reversed where the most you can gain is the price you sold the option at and the most you can lose can be theoretically unlimited.
Ultimately, to actually be profitable with options, you need to be right on almost everything.
The timing is often one of the aspects that make options trading so risky. You could bet on the movement of a stock and be completely right on that movement happening. However, if that movement doesn’t happen within the specified time frame of the option, you’ll still end up losing.
Another factor that increases the risk is the fact that aside from options of the largest stocks, many options are not very liquid. What this means is that isn’t a lot of trading activity going on with few buyers and sellers present. This causes the currently available buy and sell prices to be far apart from each other. In other words, if you want a fair price, you may not be able to get your buy or sell order processed immediately, if at all. If you decide to compromise on the price, you may start off with a loss on your position immediately right out of the gate. So the price of the option would need to rise even higher for you to have a chance at a profit.
What happens when an option expires?
What happens to an option when it expires depends on the price of the underlying stock and what brokerage firm you’re dealing with. First, let’s define a few terms. A call option is said to be “in the money” if the strike price is below the current price of the underlying stock. If the strike price is above, then it is said to be “out of the money”. For put options, it’s reversed. A put option is said to be “in the money” if the strike price is above the current price of the underlying stock and is “out of the money” if the strike price is below. For more information, check out our article on option moneyness.
If an option is “in the money” when it expires, many brokerage firms will automatically exercise the option for you so that the value of the option is not lost. On the other hand, if an option is “out of the money” when it expires, nothing happens and it just disappears from your account.
Should I trade options?
For most people, options are unnecessary and add undue risk. If you do decide on dabbling with options, make sure to properly manage your risk by not allocating too much of your portfolio to options. As with all risky and speculative investments, the money used should only be money you would be fine with losing.