How to Trade Options
Why Learn How To Trade Options?
Many stock traders shy away from trading options because they do not understand what options are and how to trade options. Trading options seem intimidating because they are perceived to be complicated financial instruments. Options themselves are not a difficult concept to understand, but some of the trades used by options traders are quite complicated and can be difficult to understand and implement.
Developing an understanding of what options are and the basic principles of trading options can alleviate traders' and investors' fear of trading options and open up a whole new realm of trading choices. Options can be utilized in many ways, from earning a profit as a result of the price movement of stocks and commodities to hedging stock market or commodity positions investments against unexpected events or losses.
What Is an Option?
An Option is a financial contract that is traded on an options exchange. An option consists of a contract to buy or sell a specific amount of a stock or commodity futures contract at a fixed price on a specified future date.
A Call Option is a contract to buy a specific amount of stock or commodity futures contract at a fixed price on a future date.
A Put Option is a contract to sell a specific amount of a stock or commodity futures contract at a fixed price on a future date.
The fixed price to buy a Call Option or to sell a Put Option is known as the option’s Strike Price. If the price of the underlying stock or commodity futures contract that a Call Option is written for is below the Strike Price on the date that the option expires, then the option will expire worthless. If the price of the underlying stock or commodity futures contract that a Put Option is written for is above the Strike Price on the date that the option expires, then the option will expire worthless. This is the downside of buying options. Options can expire worthless, causing a total loss of the investment made in these financial instruments. However, there is also a great upside potential associated with trading options, which is outlined below.
To make a profit from an option trade, the price of the underlying stock or commodity must be above or below the Strike Price (depending upon if it is a Call or Put Option) by an amount that is sufficient to cover any premiums and commissions that were paid to buy the option. When an option is purchased, a Premium (fee) is paid to the person who is selling the option. There is also brokerage commission associated with buying and selling options.
Options can be freely traded before their expiration date. If the underlying stock or commodity that an option is based upon makes a significant move above (Call Option) or below (Put Option) the option’s Strike Price before its expiration date, the option can be sold for a profit. The amount of profit is directly correlated to the amount of movement the underlying stock or commodity has made away from the option’s Strike Price.
Options that have expiration dates that are further out from the current date are more expensive than options that expire closer to the current date. For example, a Call Option to buy 100 shares of IBM at $175 would cost more if the option expires nine months from now than it would if the option expires in two months. This is because a greater premium is paid to the seller of the option that expires in nine months to compensate for the additional risk (to them) that price of the underlying stock or commodity that the option is based upon will exceed the option’s Strike Price either in an up (Call Option) or down (Put Option) direction over the longer period of time.
If the price of the underlying stock or commodity futures contract that an option is based upon does not change in price as the months pass by, an option will slowly lose its value as the option expiration date draws closer, as the premium is reduced. This is known as Option Time Decay.
For example, the Call Option to buy 100 shares of IBM at $175 that expires in nine months might cost $5.00 nine months out from the expiration date, but if IBM does not move in the price above $175 per share, the Call Option will lose value each month until it expires worthless on the options expiration day during the month in which it is written to expire if the Strike Price has not been reached.
How To Trade Options: A Stock Call Option Trading Example
Stock options are sold in lots that represent 100 shares of a stock. For example, if Apple Inc.’s stock AAPL is currently trading at $400 per share, and a trader buys a Call Option that has an expiration date two months from the day they brought the option, with a strike price of $400, the option would give them the right to buy 100 shares of AAPL at $400 upon the expiration of the option in two month. If AAPL is trading at $420 per share on the option expiration day, then exercising the Call Option and buying 100 shares of AAPL at $400 per share while it is trading at $420 per share would mean a quick profit of $20 per share or $2,000, if the 100 shares were sold at $420 per share.
Advantages of Buying Stock Call Options
There are a number of advantages to buying a Call Option that gives you the right to buy AAPL at $400 per share versus buying AAPL’s stock outright at $400 per share.
First off, a trader’s downside risk associated with the long trade (the amount of money a trader can lose) is quantified when buying a Call Option. A trader only risks the premium paid for the option, plus the commission. If AAPL reports terrible news, and the stock drops to $300 per share, the trader will not suffer the $100 per share loss that would have suffered if they had brought the stock outright; instead, the trader’s loss will be limited to the premium paid for the option, plus the commission.
Second, a trader does not have to commit nearly as much money to the trade when they buy an AAPL Call Option at $400 per share versus buying 100 shares of AAPL’s stock outright at $400 per share. Buying 100 shares of AAPL stock at $400 per share would cost a trader $40,000. Whereas, buying an AAPL Call Option that expires in two months with a strike price of $400 might cost a trader only $25. That leaves the trader with $39,975 that they can invest elsewhere while maintaining the right (via the Call Option) to buy 100 shares of AAPL at $400 per share if the stock were to make a move above $400 per share before the option expires.
Third, the percentage of gains from options can be much greater than those from the underlying stock. For example, if Apple reported good news and the stock rose quickly to $450 per share, the holder of the stock that was brought at $400 per share can book a $50 per share profit, which is a 12.5% gain. Not bad! However, if a trader brought 100 options of AAPL at a strike price of $400, it might cost them $25 for each of the 100 options, for a total cost of $2,500. Once AAPL is trading at $450, the 100 options of AAPL with a strike price of $400 will be worth approximately $50, for a significantly higher 100% gain on their AAPL trade, with much less money committed to the trade.
How Options Can Be Used to Lock in a Profit In a Stock
One useful way to use options is to lock in a profit in a stock in which one has a significant gain, but does not want to sell, in case the stock continues to move higher. Buying a Put Option allows a stockholder to hedge their stock position against an unexpected drop in the price of the stock to guarantee a profit.
For example, if an investor brought AAPL at $200 per share a few years ago and was now concerned that with Steve Jobs no longer running Apple the company might report negative earnings surprises, Put Options could be purchased below the current trading price to ensure that any profits that have been realized will be locked in at the Put Option’s strike price.
If AAPL is trading at $400 per share, an investor who went long AAPL at $200 per share a few years ago might purchase Put Options at $350 per share in amounts large enough to ensure that they can sell all of their AAPL shares at $350 per share, should a negative surprise affect Apple’s stock price. If Apple released a bad earnings report and lackluster forward earnings guidance, and the stock responded by selling off from $400 to $300 in short order, the holder of the Put Options at $350 will have locked in their profit at $350 per share. If the opposite were to occur, and AAPL continued to report positive earnings and earnings guidance, and continued to move higher, then the $350 per share Put Options would expire worthless, but the stockholder would still hold their original AAPL shares and continue to benefit from the increase in the price of Apple’s stock.
Why Put Options are Safer Than Shorting
Another useful way to use options is to buy Put Options to play stocks on the short side (if one is expecting a stock to fall in price), which allows a trader to protect against losses, in case a short trade does not work out as anticipated and the stock rises in price. If the stock does not lose value after Put Options are purchased, the loss associated with buying the Put Options option is limited to the premium and commissions paid to buy the Put Options. If a trader were to sell the actual stock short, and the stock rocketed higher due to unexpected good news, such as a buyout offer, then the loss could be significant.
Put options protect traders from unexpected and unquantifiable losses from unexpected moves higher, while allowing them to make money if the stock trades lower, as anticipated. This same principle can be used to play stocks on the long side (if one is expecting a stock to rise in price), by buying Call Options.
Options Can Also Be Used to Trade Commodity Futures Contracts
The same principles that are used to trade stock options can be put to use trading commodity futures contracts. The risk of entering a commodity trade can be quantified by use of Call Options and Put Options to go long or short a commodity futures contract. The gains that result from trading options based on commodity futures contracts can also be significantly greater than the gains from actually buying or selling short commodity futures contracts, if the commodity futures contracts move in the anticipated direction. If the commodity futures contracts do not move in the anticipated direction and the options expire worthless, the losses are limited to the premium and commissions paid to buy the options.
How To Trade Options: Options Are Useful Trading Instruments
The bottom line is that options are useful trading instruments that, when used correctly, can significantly reduce the risk of incurring losses while trading stocks or commodities, and can also significantly increase profits if the underlying stock or commodity moves in the anticipated direction.
This article is a basic options trading introduction. There are numerous options trading strategies that both casual and professional options traders utilize that are worth learning about if one is considering trading options.
A Word of Caution
This article was not written by a financial professional or a registered financial advisor. This article is for informational purposes only and is not intended to be solicitation or recommendation to purchase options. Please consult a registered financial advisor to ensure you understand the risks and rewards associated with buying and selling options before undertaking options trading.
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This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2011 John Coviello