Stock options

E-Z Guide to Stock Option Basics

What do you know about options trading? If your answer is “not too much,” don’t worry. You’re not alone. While many people know something about the concept behind trading stocks, options trading is a different matter altogether.

Options trading is not for everyone. But for those who understand what options are and how to leverage them to build wealth, options trading can be a lucrative and exciting form of investment. This guide explains the basics of stock options to give you a good foundation if you choose to pursue this kind of investing. Topics covered are:

  • What is an option?
  • What are “call” and “put” options?
  • What does it mean to write an option?
  • What is a strike price?
  • What does “out of the money” and “in the money” mean?
  • How does the expiration process work?
  • What does “exercising your option” mean?
  • What affects the price of an option?
  • How do you open a brokerage account?
  • What fees are associated with options trading?

What is an option?

Simply put, an option is a contract between two people giving them the right to buy and sell stocks at an agreed upon price within a specific timeframe.

An option does not necessarily obligate either party to do anything. Rather, it acts as a sort of insurance policy or placeholder for a specified period. In other words, options traders pay for the right to control a certain stock for a certain period. If, in that period, market conditions are favorable to the trader, he or she will likely either buy or sell the stock, per the options agreement.

Conversely, if the stock move is not favorable to the trader within the agreed upon timeframe, he or she will lose the money paid for the option.

Let’s illustrate. XYZ Company’s stocks are currently $20 per share. John purchases an option to buy stocks of XYZ Company for $21 per share within the next three months because he thinks the stock price is going to climb well above $21 within that timeframe. Two months pass by, and the XYZ’s stock price has climbed to $25 per share. John exercises his option and purchases the shares at $21. He has made a good investment.

On the other hand, suppose the price of XYZ’s stocks has tanked and is valued only at $16 in that 3-month period. John decides not to buy the actual stock and loses the money he paid for the option.

Entering into an options agreement is, in essence, betting on the way a stock price will fluctuate within a certain timeframe.

What are call and put options?

There are two types of options: calls and puts. Investopedia explains the difference between the two this way:

“When you buy a call option, you have the right but not the obligation to purchase a stock at the strike price any time before the option expires. When you buy a put option, you have the right but not the obligation to sell a stock at the strike price any time before the expiration date.”

A call option gives you the right to buy a stock at a specified price within a certain length of time. You profit from a call option when the price of the stock goes up during the agreed upon timeframe.

A put option gives you the right to sell a stock at a specified price within a certain length of time. A put option becomes increases in value when the price of the stock goes down during the agreed upon timeframe.

Generally, for the simplest kind of options trading, you would buy a call option if you expect the price of a stock to go up, and you would buy a put option if you expect the price of a stock to go down.

Options trading gives you the ability to make money both if a stock goes up or goes down, depending on whether you have a call or put option in place.

What does it mean to write an option?

People who sell options are known as writers, and people who buy options are known as holders. Holders are not obligated to buy or sell the underlying stocks they option. Writers, on the other hand, may be obligated to buy and sell if the option is exercised (more on that later). When an options seller writes a call, he or she may be obligated to sell shares at the strike price any time before the expiration date. When the options seller writes a put, he or she may be obligated to buy shares at the strike price any time before expiration.

What is a strike price?

A strike price is the price at which an option can be exercised. This price is specified in your options agreement. A strike price for a call option is the price at which you can buy a stock within the timeframe your options agreement dictates. A strike price for a put option is the price at which you can sell a stock within the specified timeframe.

Strike prices are in increments of $2.50 up to $30.00 and $5.00 above that. Profit on a stock option is determined by the difference between the market price of a stock and the strike price of an option.

What does “out of the money” and “in the money” mean?

If you do much reading about options trading, you will see the terms “out of the money” and “in the money” used quite a bit. Here’s what they mean.

When the strike price of a call option is above the current market price of the stock, the call is out of the money. Conversely, when the strike price of a call option is below the current market price of the stock, the call is in the money.

It works in reverse for put options. A put option is out of the money when the strike price is below the current market price of the stock, and in the money when the strike price is above the current market price of the stock.

Here’s an illustration. Suppose there are two option contracts for a stock that has a current market value of $125. One contract is a call option with a strike price of $100. This contract is in the money because the strike price is $25 less than the market price of the stock. The other contract is a put option with a strike price of $100. This contract is out of the money because the strike price is $25 less than the market price of the stock.

If the stock price and strike price are identical, this is referred to as “at the money.”

How does the expiration process work?

All options come with a built-in expiration date, which means that an option contract is valid until the date that is specified in the agreement. Standard options expire on the Saturday following the third Friday of the month. NASDAQ notes:

“Certain options exist for and expire at the end of a week, the end of a quarter or at other times. It is very important to understand when an option will expire, as the value of the option is directly related to its expiration.”

The timeframe for normally listed options can be up to nine months. At any time from the date you enter into an options agreement until the date of expiration, you can exercise your option.

There are also options with holding times of a one year, two years, or even longer. These options are known as long-term equity anticipation securities or LEAPS. These options are basically like the options already discussed, with the major difference being the time frame until expiration.

What does “exercising your option” and “trading out your option” mean?

Remember that an options contract does not obligate you to buy or sell stock at any point. Sometimes, an options trader will simply resell or trade out the option position rather than exercise it. Exercising the option simply means choosing to buy or sell the stock according to the terms of your options contract.

According to the Chicago Board Options Exchange, about 10 percent of options are exercised, 60 percent are traded out, and 30 percent expire worthlessly.

What affects the price of an option?

The price that you pay for the options upfront is known as the premium. If you are the buyer of an option, you cannot lose more than the premium you pay for the options contract, no matter what happens to the price of the actual stock. Even if the stock price goes down considerably, you will not lose more than you invested. And if the stock price goes up, your potential profit is limited only by the number of stock options you choose to exercise.

What about the seller of an options trade? Investopedia explains,

“In return for the premium received from the buyer, the seller of an option assumes the risk of having to deliver (if a call option) or taking delivery (if a put option) of the shares of the stock. Unless that option is covered by another option or a position in the underlying stock, the seller’s loss can be open-ended, meaning the seller can lose much more than the original premium received.”

There are several factors that affect the pricing of options, but the three most important factors are:

  • Stock Price
  • Time
  • Volatility

Let’s take them one at the time. The very first thing to consider when looking at options pricing is the price of the underlying stock. Once you know the stock you are interested in, it is a simple matter of checking the current price of that stock.

Time is another factor you must consider when figuring out an options price. Time is not on your side in options trading. Each day that you hold on to an option, it loses a little bit of its value. This is known as time decay. The closer the option gets to its expiration date, the greater the rate of time decay because, with each day that passes, there is less time for the underlying stock to rise in value and become profitable.

Another important factor is volatility, which is simply the fluctuation in the price of the underlying stock over time. InvestorPlace.com explains how volatility affects price:

“Options on stocks that have been stable for years will be more predictably priced and, accordingly, priced lower than options on stocks whose charts are all over the place – up and down like a carousel horse gone amok.”

History isn’t the only determining factor. Implied volatility also affects an option’s price because it’s based on the amount of volatility the market maker believes the stock is likely to experience in the future. A stock on the move will go up in price as more and more people want to get in on the action.

As the stock starts to move, the options market maker (the professional trader working on the floor) usually adjusts the implied volatility upward, which means the options premium will rise, even if all other factors (like the stock price) haven’t changed. The options will be worth more to investors who want to lock in a certain price at which they’d be willing to buy the stock.

So, when you buy an option, you want the volatility of the underlying stock to increase, causing the value of the stock to rise. Conversely, if you are the seller of an option, you would want the volatility of the stock to decrease, causing the value of the underlying stock to drop.

How do you open a brokerage account?

In the U.S., options are traded via Options Exchanges, the largest of which is the Chicago Board Options Exchange (CBOE). Buy and sell orders for options contracts are transacted through brokers. Brokers are either individuals or firms that charge a fee or commission for executing buy and sell orders submitted by an investor.

To find the right brokerage account for you, you need to consider what type of trader you plan to be. Are you looking to buy and sell simple call or put options, or are you planning a more elaborate strategy? How much risk can you handle? What kind of capital are you willing to invest? The answer to these questions will help you determine which broker offers the best value for your particular needs.

When choosing a broker, compare the 3 “F’s,” namely:

  • Features
  • Functionality
  • Fees

Full service or traditional brokers offer a wide range of services, including advice on favorable stock options to consider. These services come at a price, however (more on fees later).

Discount brokerages do not offer advice to their clients. They simply execute your orders, usually for a fraction of the cost of a full-service brokerage.

You can either choose a full service broker or discount broker, according to your needs

Stock options

When it is time to open a brokerage account to handle your options trading, your broker will ask if you want to open a “cash” or “margin” account. Options are cash-only trades. They settle in one day, so you need to have enough money in your account to cover the cost of your trade, including the premium price and any applicable fees.

Here’s how a cash account works. You can execute trade options on a cash basis as long as there are sufficient funds in the account to cover the cost of the option premium. When the option is sold, the money made is deposited into your cash account for future trading, minus any fees and commissions for the broker. If you are only planning to buy options to sell or exercise later, a cash account is usually sufficient for your purposes.

Margin accounts work a little differently. With a margin account, you still need to have sufficient funds in your account to cover premiums when buying options. However, if you decide to sell options, you must also have funds to cover any margin requirements that the broker has in place. Margin accounts are useful to options traders with more experience and a high tolerance for risk.

What fees are associated with options trading?

There are two types of charges involved in every options trade. There is a per trade fee and a per contract fee. The per contract fee is charged for every contract involved in a trade. As for the per trade fee, there is usually a minimum fee per transaction, no matter how many contracts are involved.

Commissions are figured in one of two ways. Usually, the total commission you pay is the per trade fee plus the per contract fee. Some brokerages figure the commission based on the per trade fee or the per contract fee, taking whichever fee is higher.

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