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Options Trading


Trading Options: The Basics

Welcome to your introduction to trading options! Many of us have heard of it, but don’t have a clue how it works.

Trading stock is a common investment practice among even laymen, but still presents significant risk. When prices fall dramatically, we may not be able to handle the stress, and end up selling and losing almost all of our initial investment. Options provide a way to offset these risks, and are purchased with funds you don’t even have access to.

Options are contracts that give you, the investor, the option to purchase or sell an asset at a stated price on or before a set date – thus the name. These assets may include real property such as real estate, stocks or bonds.

The basic idea of option trading is to invest very little money today to control something of considerably higher value. As the investor, you are speculating that the price of this asset will either rise or fall before a selected date, when you then sell the assets and profit from the difference.

As an example, let’s consider the Internet search juggernaut Google. If shares are priced at $400 each, 1,000 of these would require a $400,000 investment. Most of us don’t have access to that kind of money. Buying them by borrowing would get you closer, but not completely there. Your stock broker most likely will only lend up to 50% of the total cost of these shares.

However, you can buy an option at $20 a share (also known as the ‘premium’). This still presents a significant investment of $20,000, but is a little more easily reached. When an investor controls more than he or she actually owns, this is referred to as ‘leverage’ in the practice of investing.

Each and every option also has a date of expiration by which the investor is required to ‘exercise his option’, or decide to buy or sell or risk losing his entire investment. Some of these dates are set within a 24 hour period, and others may be as far away as several months.

Options trading also requires understanding the ‘strike price’, or the stated price that the buy or sell action must occur at when the option is exercised.

With the same example, let’s assume that the Google option expires in 30 days, and the strike price is $410. Since you’re ‘borrowing’ the shares at a cost of $20 per share, you will break even at $430, or $20 over the strike price. Selling at the price of $410 results in a $30,000 loss for you.

However, if Google makes some type of announcement that causes its stock prices to rise to $440 before hitting the expiration date, you can exercise your option and ‘close your position’ at this price. Typically, when this happens, the option’s price will also rise; in this case, let’s assume a $25 price per share. This means your total profit equals ($25-$20) x 1,000, or $5,000.

Not every trade turns out this way, so do your homework and make sure you are confident before entering the world of options trading.

Options Trading Terminology and Strategies, Part 1

Investors employ an entire arsenal of strategies when it comes to trading stocks and bonds, including the ‘buy and hold’ method and using advanced technical tools to help in trading decisions. Options trading operates within a similar realm.

Options are essentially contracts for the right to buy, which is called a ‘call option’, or sell, a ‘put option’, an underlying asset that may be real property, stocks or bonds. These options are set at a certain price, or a ‘strike price’, with an expiration date.

When investing in ‘American’ options, they may be ‘exercised’ at any point prior to reaching the expiration date. Another variety, ‘European’ options, are only exercised on the expiration date. Although these names indicate a geographical connection, this is no longer applicable in modern trading. Today, American options are supported by stocks and bonds, and European options by indexes.

Expiration of options occurs on the Saturday after the third Friday of the expiration month, but due to markets being closed on this day, the date is typically set for the Friday before.

Options trading allows for two different choices when selling these investments. An investor may hold the option until the expiration date, or sell before it. Many will hold the option to expiration and exercise the option to trade the supporting asset; here, we’ll assume this asset is stocks.

Let’s take the example of an investor buying a call option at $2 on a stock that has a $25 strike price – remember these options are usually sold in 100 share lots, so the total investment is ($2 + $25) x 100 = $2700. Essentially, the investor has the right to control the underlying asset with a much smaller investment than the total stock price when trading options.

At any time before the expiration date, the investor could decide that the price of the stock has peaked, and can sell the options. Sometimes, the market price will fall below the strike price close to expiration, and it may be best to sell at a loss before it plunges further. This is where options trading investors employ speculation to decide how best to minimize risk.

However, there’s another action available in options trading that allows the investor to simply let the option expire. In the world of options, there is no requirement that the investor must sell the asset at any time. Taking into consideration the premium, strike price and market price of the asset, a smaller loss may be experienced by simply allowing it to expire and losing the premium investment dollars.

Much like bonds, options trading employs the use of expiration dates; like stocks, profits can be made or losses experienced with changes in the asset’s market price and thus the option contract. Of course, with options trading there is only a specified time period that any put or call options can be executed. If you’re a seasoned investor, though, you’ll be able to employ some of the speculative and prediction exercises you are accustomed to.

Options Trading Terminology and Strategies, Part 2

If you’re new to trading options online, the process can become very confusing in a short amount of time. Several new terms and strategies will need to be learned in order to succeed and prevent unnecessary losses due to complicated methods and rules.

In order to help you speculate about the possible movement of an underlying asset’s value, several tools are available for use, and most online options trading software packages will offer these to you. LEAPS (long-term contracts), choosers, barriers, compounds (exotics) and technical analyses help you to determine the volatility of any of these investments.

Lucky for you, there are many simple investing strategies that can prevent the complicated terms and tools from confusing you. Some special techniques are required when trading options, and the following are based on the fact that these contracts have an expiration date and strike price.

A popular options trading strategy is called the ‘calendar spread’ or ‘time spread’, and includes both buying and selling the same options at the same time with identical strike prices, but with different expiration dates.

As an example, you may purchase two options for a stock at the strike price of $30, with expiration dates of June 8th and August 23rd, respectively. This strategy allows you to gain from differences in the market prices as both options near their expiration date.

The ‘straddle’ strategy requires the investor to place both a call and put option on the same asset, with the same strike price and date of expiration. Although this may seem like one will simply cancel the other out, in reality it’s a great way for the investor to hedge against risk.

Yes, the straddle strategy is risky, but large price movements can result in equally large profits. Also remember that other investors speculating that an option may present a large price movement can also cause them to be priced higher.

The ‘strangle’ strategy is a practice where the investor holds both call and put options that have the same expiration date, but the strike prices are different. These trading options are purchased ‘out of the money’ and are priced lower. This term simply means that a strike price is higher in a call option and lower in a put option than the market price of the underlying asset. Thus, the premiums for these options are priced lower, because selling the option now would result in a loss.

For example, let’s assume an asset is priced at $30 a share. One call option is $3, and one put option is $2. The call option has a $35 strike price, but the put option has a $25 strike price. The investment here is $500, assuming a standard lot of 100 options.

If the asset price stays between $25 and $35 during the contract, the investor will experience a $500 loss. However, if it drops to $15, the put option will profit; if it rises above $35, the call option will profit, so larger variations can still produce profits in options trading, even if the price of the asset falls when employing this strategy.