There are many ways to invest in the stock market. One way that offers some unique opportunities is using Stock Options. While they are not for everyone, using them can add new ways to grow your money that differs from standard stock investing. Keep reading for the basics on what stock options are and how to get started using them.
What is an Option?
Options are financial instruments that are derivatives based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset. Unlike futures, the holder is not required to buy or sell the asset if they choose not to.
- Call options allow the holder to buy the asset at a stated price within a specific timeframe.
- Put options allow the holder to sell the asset at a stated price within a specific timeframe.
Each option contract will have a specific expiration date by which the holder must exercise their option. The stated price on an option is known as the strike price. Options are typically bought and sold through online or retail brokers.
That can be a bit hard to understand, let me try to simplify:
An option contract represents 100 shares of the underlying stock associated with a given price “strike”. Each contract gives you the right to either sell or buy the stock from the writer of the contract.
Option contracts are traded between buyers and sellers through an exchange.
Unique Characteristics of an Option
- Each contract represents 100 shares of the underlying stock
- Each contract has a strike price for the underlying stock
- Each contract has a finite date of expiration
- Every contract has both a buyer and a seller (i.e. zero-sum game)
- Options contracts allow leverage of the underlying stock
- Buyers pay a premium on the contract for the value of time (time value)
Many great sites offer in-depth reading on options. You can read all about the basic and advanced strategies at the options guide.
Understanding the basic pricing of options
Unlike stock quotes, Options are presented in option chains. You can see a live option chain for SPY on Nasdaq.
Option Pricing Components
- Strike Price: The price of the underlying stock for that particular contract.
- Expiration Date: The date the contract expires.
- Calls: Options that give you the right to buy the stock at the strike price.
- Puts: Options that give you the right to sell the stock at the strike price.
- Bid/Ask/Volume: Same as stock quotes, represents the price range and volume of an option at each given strike price.
- Greeks: In some charts, you will see the greeks. These are theoretical values that are used in more advanced strategies that help identify types of risk profiles.
- IV: Implied volatility. This is the market’s view of the chance of the stock moving from its current price. Also used in more advanced strategies or screening.
In our example, if you bought one call option at a fill price of $88, then it means that you have the right to purchase 100 shares of SPY for $309.50 anytime before expiration of 11/18/2019.
You might be thinking so what.
Here are why options are so powerful. In our example, you are basically leveraging $30,950 for a small investment risk of $88. If SPY increases to $312 before the expiration date, the value of your option increases to at least $2.50 giving you a net profit of $162 or 2X your money.
That sounds great, but remember options are bound by time, if the option does not pass the strike price before expiration your option will become worthless for a 100% loss.
Key Fundamentals to use when trading options
- Fully understand your risk of each trade (maximum loss)
- Fully understand that time works against you or for you in some strategies. Know how time impacts your trade
- Start small and test some strategies that interest you via paper trading or low-risk investments
- Remember that most strategies are a win or lose, not much in between
- Only venture into complex strategies when you have a firm understanding of investing, stocks, and option terminology
Can I lose money with options?
Options are a zero-sum game meaning there is both a winner and loser to each side that net out to zero. For that reason, options can be very risky, however, for that same reason they can be used in unique ways to minimize risk or enhance investment returns.
In the example above, if you had strong reason to believe SPY was going to increase in the next five days, your way to invest without options would be to buy shares limited to how much capital you wanted to put in. That may be more risk than you want to make. With options, you can risk a maximum of $88 for potential unlimited gains (within five days). To get the same $162 return on a straight stock purchase, you would need to invest over $16K.
Other unique ways to use Options
- Bearish
- Neutral
- Bullish
Using certain ways to construct your trade, you can cover almost any direction you think the market or stock is going to take. Options can be used to reduce the price of entering a stock, used for extra income on shares you own, speculation, earnings surprises, long term speculation, or simply to leverage your buying power.
One strategy that is nice with Options is using them as insurance on stocks you may own that have had a large run-up but ones you still want to keep. For example, if you owned 100 shares of SPY at a cost of $250 per share for a net profit of $5,900, you could buy a put at any price between the current price and your cost that protects you from downside loss. If you bought a $300 strike put expiring in 3-months for $2, you are basically using $200 to insure your investment. You have capped your downside loss at $300 per share for the next 3-months. Learn more about placing protective puts.
Each strategy comes with unique risks and complexities, so make sure you understand what you are trading before entering into any of them.
What are the most common ways to invest in Options?
Speculation (buying calls or puts)
The most simple strategy is buying calls or puts and typically represents speculation (on the call or put side) or protection of current investments (on the put side or on the call side if you are short positions). This strategy is very simple with your maximum risk being the amount you pay for the contracts and your maximum profit being equal to the amount the stock moves beyond the strike (higher for a call, lower for a put)
Covered Calls
The next most common strategy involves using calls to generate income on a stock. The basic principle requires you to sell calls (collect the income) against shares of a stock you own to generate income. If the stock rises above the strike price you risk losing the shares at the strike price and keeping the income of the contract. If the stock price is below the strike price at expiration, you keep the shares of stock and keep the premium collected.
Naked Puts
The last basic strategy is selling puts to enter a position or collect premiums. In this strategy you sell a put for a stock to collect the premium for a given strike price. If the stock drops below the strike price, your are required to buy the stock at the stock price to cover the put (100 shares per 1 contract you buy). If the stock price stays above the put strike price at expiration, the option expires worthless and you keep the premium collected. You will be required to have funds to cover the purchase of the stock if your shares are assigned to you. On SPY, one contract will require up to $30K in funds to cover this strategy.
These are just a few basic strategies to get your ideas generating. The most important thing to do before trying any of them is to understand how they work, know your maximum loss, know your maximum gain, understand what happens at expiration, know how time impacts your position, and understand how you would exit if needed.
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