One of the investment vehicles produced by the stock market is options trading!. This article will be discussing options trading for beginners.
Like most investments strategies that look simple and easy, there is more than what meets the eye. They are more complex than you may think.
Are you ready?
What is Options Trading?
An option is a contract that gives an investor the right to buy or sell a specific amount of stock or underlying assets at a pre-determined price, on a specific date.
However, you are not obligated to buy or sell the underlying asset at the specified date in the contract. You can choose to allow the contract to expire.
To buy options on any asset class, you have to pay an amount known as “Premium”.
Options trading carries substantial risk as will be seen as we continue the discussion. That is why investors are advised to speak with a broker before going ahead to buy options on any asset class.
Types of Options?
There are two types of options that could be traded on any asset class. They are as follows:
If an investor buys a call option, it gives her the right to buy the underlying asset for a specific price, and within a specific period. This specific price is known as “strike price”, while the specified period is known as “expiration”.
After buying a Call option, an investor can do any of the following:
- Buy the underlying assets at the strike price before the expiration of the option.
- Sell the option to another investor (and recover the money or premium spent acquiring it).
- Allow the option or contract to expire and lose only the premium spent purchasing it.
How does call options work?
For instance, if a company’s stock sells at $25 per share. And an investor buys a call option on that stock, at $25 (strike price), at a premium of $3 per share, with an expiration of three months.
If the investor purchases call options on 200 shares, he will pay $600 as Premium.
If the stock price of that company increases and remains higher than $25 before the expiration of the call option, the investor could exercise her right to buy that stock at $25 per share for 200 shares.
For instance, if the price of the stock increased to $40, the investor could buy 200 of these shares at $25, then resell them at $40 per share, and make $8,000.
If the money spent buying the shares ($5,000), and the money spent on Premium ($600), is deducted from $8,000, the investor would be getting $2,400 as a return on investment.
Not a bad figure right?
However, if the stock fails to increase in price or even drops in price, the investor is not obligated to buy the underlying shares or assets. He could walk away and lose only the money spent on the Premium.
In some cases, some stock prices only increase enough for an investor to draw even, that is, recoup the funds spent on Premium.
An investor can also choose to sell a call option contract before the date of its expiration. Although this only happens when the value of its underlying shares or assets has remarkably increased in value, and other investors are interested in buying it.
In such cases, the call option is sold at a higher price than what the initial investor bought it!
NB: Please note that options can be bought on some asset classes other than stocks. Stocks were simply used here as an example to explain how the process works.
In addition, there are usually several strike prices shown to an investor when buying an option. It is the investor that selects the strike price that he is most comfortable with.
The principle here is simple, the lower the strike price, the higher the premium, and vice versa for Put options.
A put option is a contract that gives an investor the right to sell the stocks of a company at an agreed strike price before the expiration of the contract.
After buying a Put option, an investor can do any of the following:
- Sell the underlying assets at the strike price before the expiration of the option.
- Sell the option to another investor (and recover the money spent on premium).
- Allow the option or contract to expire and lose only the premium spent purchasing it
How does Put Options Work?
Using our previous example, if a company’s stock sells at $25 per share. And an investor buys a Put option to sell the stock of that company at $25 (strike price), with a premium of $3 per share and an expiration of three months.
If the investor decides to buy Put options on 200 shares, he will pay $600 as Premium.
If the stock price of that company decreases below the $25 strike price (to $12), before the expiration of the put option, the investor could exercise her right to sell that stock at $25 per share for 200 shares.
But if the price of the shares increases above $25, the put option will be allowed to expire, since it has become worthless. It becomes worthless because it cannot be used to sell the underlying assets above the strike price.
If you own the underlying assets on which the Put options were purchased, you could use it to protect your investment from major losses.
For instance, if you own two hundred shares of a company and buy Put options for two hundred shares. If the price of the shares drops, you can use your Put option contract to sell the shares at the strike price and cut down your losses.
You will only have lost the amount spent on the Premium.
However, if you do not own the underlying assets, and the price of the shares drops. You can buy the same amount of shares your put option covers, at the current lower price, and then use your Put option contract to sell them at the higher strike price, and make a profit.
Just like Call options, put options can also be sold to another investor when the price of the underlying assets falls below the strike price. The lower it falls, the more valuable your put option contract becomes.
Why Investors trade Options
There are three major reasons investors trade Options. We will be discussing each in detail in this section.
Hedge against risks
Everybody loves to be protected from unexpected attacks or situations. That is why governments all over the world spend millions and billions of dollars on security.
The same reason motivates investors to trade options to protect their investments from unexpected fluctuations in the stock market or other markets.
For instance, an investor may choose to buy put options on their investments in the stock market, if they are afraid that the price of their stock may drop in value.
If their fears turn out to be true, they can go ahead to activate their put option and sell their shares at the strike price. Thereby reducing their losses to the amount spent on premium.
If the stock price increases in value and never drops, they can still go-ahead to sell their shares at a higher price and get back the money spent on the Premium.
In either case, the investor is significantly protected from unexpected changes.
Buying time to study the market
An investor may also buy options to afford them time to decide on which assets they wish to invest in!
How does this happen?
If you are unsure of which company’s stock to buy, you can buy options on a company’s stock with an expiration of about 6 months.
Within that period, if the value of that stock increases remarkably, and you bought Call options in it, you can go ahead to buy that company’s shares equivalent to the Call options you have.
You can then sell these shares at the higher current market price and makes some profit.
However, if the price drops remarkably, you can allow the call options contract to expire, thereby losing only the money spent buying the contract.
The same goes with Put Options!
So, trading options give investors time to study the market before making a decision.
Although you may never have guessed it, many investors love to predict the market. Sometimes they are right and win, other times they are wrong and get their investment burnt.
To ensure that they are not very exposed when speculating, investors may choose to buy call or put options on the asset they are speculating. If their hunch is right and the asset increases in value or decreases in value, they can exercise their Options contract to make some profit.
Furthermore, it is cheaper to speculate with options than using actual stocks or any other asset.
For instance, it will only cost a few dollars to buy a Call or Put options on a company’s shares than to buy their stocks.
If the company’s stock costs $50 per share, buying an option on each share may not cost more than $5, depending on the duration of the option, and other factors.
So, with Options, an investor can predict the market at a small cost and can speculate on several asset classes at a fraction of the cost.
Does Options Trading come with Risks?
As you read through the above texts, it will not come as a surprise if you are beginning to imagine that options trading has little or no risks associated with it.
You could not have been more wrong!
Options trading does have risks associated with it. We will be discussing a few of them here.
You could lose your Premium
What options traders do not say enough is that many times they have lost the funds they spent on Premiums because the stock or underlying asset went in an opposite direction to their prediction.
If you predict that the value of the stock or underlying asset will go up, and it doesn’t, or it goes down, the value of your options becomes worthless. You will have to allow the contract to expire to avoid further losses.
You could draw even
This happens when the value of the stock or underlying asset increases or decreases just enough for you to get back the money you spent on Premiums.
For instance, you paid $2 Premium on a Call option, for 200 shares for a stock that costs $20 per share, with an expiration of four months.
If the value of the underlying stock increases to just $22 before the expiration of the contract, the investor can only make the $2 he spent on the Premium if he decides to exercise his Call option.
This is a common experience among Option Traders.
Your timing has to be accurate
For you to make any profit in Options trading, you do not only have to be right in which direction the value of the stocks is heading, you also have to be right in your timing.
What does this mean?
Your guess on the period this increase or decrease will happen has to be correct.
If you guess that the value will go up and it goes up, but only after the expiration of your Option contract, you will benefit nothing from this increase.
For instance, you predicted the value of the underlying stocks will go up in three months, and they remain dormant making little or no progress throughout the three months you predicted.
If after your options contract expires by the third month, the value of the stock doubles, you will get nothing from the recent spike in price.
This makes trading options a lot more complicated than a lot of persons can tolerate.
Related Article: Top Trading Ideas Investors Should Know
Costs of investing/trading
Although the general idea is that it is cheaper to invest in Options than stocks or underlying assets, it is not that cheap investing in Options.
Apart from the cost of premiums which can increase depending on its duration and other market factors, investors also have to pay commissions to their broker.
So, if the underlying asset does not perform very well, an investor may spend the whole money he made replacing the money spent on Premiums and settling commissions.
Option Trading Terminologies
As you begin trading options, here are a few terminologies you will come across.
In the money: A call option can be described as “in the money” if the strike price is below the stock price, whereas a put option is in the money if the strike price is above the stock price.
At the money: A Put or call option is said to be “at the money” if the stock price and strike price are the same.
Out of the money: If the stock price is below the strike price in a call option, it can be described as “out of the money”, while in a put option it is out of the money if the strike price is below the stock price.
Premium: This is the money paid to buy an options contract. It also refers to the money an investor makes when he sells an options contract.
Derivatives: A derivative is a financial product that derives its value from the performance of another financial instrument or asset. Options can be described as derivatives because their value is based on the performance of an underlying asset.
Spread: Spreads are an advanced options trading strategy in which an options trader buys and sells multiple contracts at different strike prices.
Trading options can be a smart investment vehicle if you do it correctly.
One great step that will help you avoid unnecessary losses is to get a smart broker that will guide your trading strategy.
To your success as you proceed to advance your financial future.