How do stock options work

What Are Stock Options And How Do They Work

Publish Date: 29 Nov 2019

If you haven’t noticed yet there are a lot of different vehicles you can choose when investing in securities. Whether you choose stocks and shares or exchange traded funds (ETFs) you probably know the basics of what I’m about to tell you. But what exactly are options, and how do you trade them?

The main takeaways from this article will be: The key terminology used in option trading, some triggers to look for when researching, and the best platforms to use based on your goals.

 

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What is a stock option?

Stock market trading can be compared to gambling in the casino, you’re betting against the house, so if all the players have incredible luck, they all could win.

Trading options is more like betting on horse racing at the track. Each person bets on a horse against others where only one can win. The track takes a small cut for providing the service, so trading options, like betting on a horse is a zero-sum game. The option buyer’s gain is the option seller’s loss, and vice versa.

Buying and selling options is done on the options market, which trades contracts based on securities. Buying an option that allows you to buy shares at a later time at an agreed price is called a ‘call option’, whereas buying an option that allows you to sell shares at a later time is called a ‘put option’.

Options are considered low risk compared to stock trading due to the fact you can withdraw an options contract at any point. The price of the option is thus a percentage of the underlying asset or security.

 

How do stock options work?

The most important difference between stocks and options is when you invest in a stock you are given a small piece of ownership in the company. But when you trade options you are given a contract that gives you the right to buy or sell stock at a specific price by a specific date.

You must understand that are two sides of every option transaction, a buyer and a seller. In other words, for every option purchased someone else must be selling it.

  • Call Option

A call option is a contract that gives the investor the right to buy a certain amount of shares, normally 100 shares per contract, of a certain security or commodity at a specified price over a certain amount of time. For example, a call option allows you to buy shares of either stocks, bonds, or other instruments like ETFs or indexes at a future time, by the expiration of the contract.

If you’re buying a call option, it means you want the stock price to go up so you can make a profit when exercising your right to buy the shares at the agreed price.

Call options are a lot like insurance. You are paying for a contract that expires at a set time but allows you to purchase the security at a predetermined price. However, you will have to renew your option, typically in a monthly or quarterly basis. For this reason, options are always experiencing what’s called time decay, meaning their value decays over time.

For call options, the lower the strike price, the more intrinsic value the call option has.

  • Put Option

Much like a call option, a put option is a contract that gives the investor the right to sell a certain amount of shares, again normally 100 per contract, of a certain security or commodity at a specified price over a certain amount of time. Just like a call option, but a put option allows the trader to sell not buy.

Put options operate in a similar way to calls, but you want the security to drop in price, that way when you buy a put option and the share price drops, when it comes your time to sell you make a profit on the sale.

Another difference between put and call options, the higher the strike price, the more intrinsic value the put option has.

  • Long & Short Options

Unlike other securities, option trading is typically a ‘long’ trade, meaning you are buying the option with hopes the price is going to go up, in which case you would buy a call option. However, even if you are buying a put option, you are still buying a long option.

Shorting an option is selling that option, but the profits of the sale are limited to the premium of the option, and the risk is unlimited.

For both call and put options, the more time left on the contract, the higher the premiums are going to be.

 

Understanding options terminology

  • Underlying Asset

The underlying asset of an option trade can be stocks, futures, indexes, commodities, or currency. The price of the option is derived from its underlying asset. The most common underlying asset is a stock.

  • Expiration Date

The last day the contract can be exercised by the holder.

  • Strike Price

This is the price at which the holder of the option can purchase or sell the underlying stock, this is a very important part of choosing an option, read the three strategic plan below to see why.

  • Hedging

This is a conservative strategy used to reduce risk by implementing a transaction that offsets an existing position.

  • Premium

The per-share price you pay for an option. The premium consists of these two values:

  1. Intrinsic Value - The value of an option based on the difference between a stock’s current market price and the options strike off price.
  2. Time Value - The value of an option based on the amount of time before the contract expires. Time is valuable to investors because of the possibility that an option’s intrinsic value will increase during the contract’s time frame. As the expiration date approaches, time value decreases. This is known as time decay or “theta,” after the options pricing model used to calculate it.
  • In The Money

This is the point at which the share price of the underlying asset has passed the strike price set for the option, for a call option this would be above the strike price, for a put option it would be below the strike price.

 

The Greeks

  • Delta

How much an option’s price moves for every point of movement in the underlying market. Delta is a measure of how movement in the underlying market will impact the price of your option, otherwise known as directional risk.

  • Gamma

How much an option’s delta moves for every point of movement in the underlying market. Gamma shows whether directional risk will increase if the underlying market moves.

  • Theta

How much an option’s price declines over time, or its time decay risk. An option with high theta (usually one with a short-term expiry) will rapidly depreciate in value as it nears its expiration date.

  • Vega

How much an option’s price moves when the volatility of the underlying market changes. An option with a vega of two will move two points when its underlying market’s implied volatility changes by 1%.

  • Rho

How much an option’s price moves when interest rates change. Rho can either be positive or negative, dependent on whether the option’s price will improve when rates go up (positive) or down (negative).

 

Historical & Implied volatility

Volatility in options trading refers to how big the price swings are for a given stock.

Just as you think, the higher volatility with stocks and shares means higher risk. Conversely, low volatility means lower risk. When trading options, stocks with high volatility are more expensive than those with low volatility.

Historical volatility is a good indicator of volatility since it measures how much a stock fluctuated day-to-day over a one year period. However, implied volatility is an estimation of the volatility of a stock in the future based on the market over the time of the option contract.

 

Trading options requires a 3 step strategic plan

1. Decide which direction you think the stock will move

This step determines what type of option you want to take on. If you think the price of a stock will rise, you’ll buy a call option. If the price is likely to fall, then you would but a put option. It’s as simple as that.

2. Predict how much the price will move up or down from the current price

An option only remains valuable if the stock price closes the options expiration period ‘in the money’. This means either above or below the strike price (for a call option, you want the value to be above the strike price. For put options you want the value below the strike price). You will want to buy an option with a strike price that reflects where you predict the stock will be during your options lifetime.

So if you expect a company’s share price to fall to $80, you would buy a put option with a strike price above $80. If the share price falls below $80, you are ‘in the money’. This is a simplified version of an option contract.

3. Determine the time frame in which the stock is likely to move

Every option contract has an expiration date that indicates the last day you can exercise the option. You can’t just pull a date out of thin air. Your choices are limited to the ones offered when you call up an option chain.

Expiration dates can be anywhere from days to years. Normally the less time on the contract the riskier the trade. Longer expiration dates allow the stock to move more and gives you better indication of value come the end date. Longer expiration dates are also useful because the option can retain time value.

 

Options trading examples

We will go through two cases so you can better understand a call and put option.

To make it simple I will use easy numbers:

  • Price of stock when the option is written: $100
  • Premium: $5
  • Expiration date: 1 month after the option is bought

 

Example 1

The price of the stock at the options expiration date is $110 and the strike price is $120

Example 1

 

 

Example 2

The price of the stock at the options expiration date is $120 and the strike price is $110

Example 2

These examples maybe simple however when you understand the basics behind an option trade you will be able to expand your knowledge and delve into more complicated formats.

 

Common mistakes when trading options

Everyone makes mistakes, even the top traders on Wall Street, but the successful investor makes less mistakes than his colleague.

The most common mistake I see from new traders is they think they need to hold their call or put option until the expiration date. This is not the case, if your options stock skyrockets overnight, you can exercise your contract immediately and take your profit.

Another beginner mistake is not thinking about your exit plan for your trade. For example, you might want to exit your option when you either suffer a loss or when you’ve reached a desirable profit. You don’t want to enter an option trade when the only way out is your expiration date.

The final mistake, and the hardest to beat is thinking that cheaper is better. For options, this isn’t always true. The cheaper the options premium is, the more ‘out of the money’ the option typically is, which can be a riskier investment with less potential for profit. When buying ‘out of the money’ options means you expect the underlying security to change drastically, which isn’t easy to predict.

 

Pros & Cons of option trading

The major pros of option trading revolve around their supposed safety compared to other securities. The Nasdaq’s options trading tips say that options are often more resilient to changes in market prices, they can also help increase income on current and future investments, also options allow you to capitalize on the equity of a security rising or dropping over time without having to invest directly.

With every investment options also carry a fair amount of risk. There are a lot of ways to quantify the risk associated with option trading, but these risks a mainly interpreted by the level of volatility in the market. Expensive options have a high range of uncertainty, meaning the market is volatile and this makes it more risky to trade it.

 

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