Options trading is the trading of an actual legal contract that relates to securities. Options are a type of contract where the option purchaser has the right, but not the obligation, to buy or sell a security at a specific price during a specified period of time.
Stock options are the most commonly traded options. Stock options are contracts that are created between an option seller and an option buyer. The option seller, also called the option writer, will create an option that is based upon a specific stock giving the option buyer the opportunity to buy or sell the stock at a specific price within a specific period of time. Each option controls 100 shares of the underlying stock but due to their construction, they cost a fraction of what purchasing 100 shares of the stock would cost. This added purchasing power, or leverage, is one of the things that makes options very appealing to many investors and traders.
There are two types of options; call and put options. Call options are purchased when we believe that the price of the underlying stock will rise and put options are purchased when we believe that the price of the underlying stock will fall. The buyers and sellers of options have opposite opinions about what the price of the underlying stock will do during the life of the option.
All options have a specific expiration date so they all have a finite life unlike the underlying stock whose life is considered to be perpetual or ongoing. All options have a strike price which is also called the exercise price. This is the price at which the options can be exercised at and it is the price that the underlying stock is either bought or sold for. When an option buyer exercises his rights, under the terms of the option agreement, the option seller must perform; this means that the seller of the option will either have to buy the underlying stock from the option purchaser or sell the underlying stock to the option purchaser at the strike price.
Options can live for various timeframes such as a week, a number of months or even for years but they all expire at some point in the future. Weekly options actually live for about ten days, they expire on the Friday following the week that they were written in or created in. All monthly options expire on the 3rd Friday of the month of their expiration. Longer term options will also expire on the 3rd Friday of the month of their expiration.
There are risks in all types of trading but when you are buying options your risk is limited. The risk to the buyer of the option is if the price of the underlying stock does not move in the direction that they expected the option can never be exercised and it will expire worthless. In this case the buyer will lose the total amount of money that they paid to the seller, the option premium, but they cannot lose more than that amount so their risk is limited. You are not risking your entire account or your home or your retirement savings; you are simply risking what you have already spent to enter into the position.
The seller, or the writer of the option, potentially has a much larger risk. The option seller’s maximum profit is the amount of money that they received when the option was sold, the option premium, but the risk can be far greater than that amount. If the option seller does not own the underlying stock when he sells the option his position is naked or uncovered, in this case his risk is theoretically considered to be infinite.
The terms in-the-money and out-of-the-money are terms that are used to describe if a position is profitable or not. A call option is considered to be out-of-the-money when its strike price is higher than the stock’s current market price. An example would be if an option buyer buys a call option for $5.00 with a strike price of $50.00 and the current market price of the stock is $47.00. A put option is considered to be out-of-the-money when its strike price is lower than the stock’s current market price. An example of an out-of-the-money put would be if an option buyer buys a put option for $5.00 with a strike price of $50.00 and the current market price of the stock is $53.00. In both cases the option is considered to be out-of-the-money or not exercisable.
A call option moves in-the-money and is exercisable if the price of the stock were to move above $50.00. The further the price of the stock goes above $50.00, or the strike price, the more profit the call option buyer can realize and the bigger the potential loss is that the option seller may have.
A put option becomes in-the-money and exercisable if the price of the underlying stock were to move below $50.00. The further the price of the stock goes below $50.00, or the strike price, the more profit the put option buyer can realize.
The value of call options rises as the value of the stock rises which means that the call option buyer can either sell the option on the open market or he can exercise the option. If the buyer of the call option chooses to exercise the option when the price of the stock is at $55.00, the seller of the option is required to sell the stock to him at $50.00. The buyer can immediately sell the stock on the open market at $55.00 for a $5.00 per share profit. Remember, since every option controls 100 shares of stock, this is a $500.00 profit for the option buyer.
The seller of the option has to provide the stock at $50.00 and if he does not own the shares, he will have to buy them on the open market at the higher price or borrow them from the broker which means that he will end up with a short position in that stock. The option seller’s total profit or loss will then be determined by how much he has to pay to buy the stock back so he can return the shares to the broker. If he pays more than $50.00 per share to buy it back he will lose money and if he pays less than $50.00 per share he may make a profit.
Put options work in the exact opposite way except that the price of the option will only rise as the price of the underlying stock falls. Likewise, if the price of the stock rises the value of the put will decrease.
Options can be a good way to earn regular income or they can be used as a speculative tool but either way they can be used as a very effective way to increase wealth if they are used properly.
To learn more about options trading click here.