Options are derivative securities, which means their value is based on the prices of other securities. On the speculative side, options give investors the opportunity to make a leveraged bet on the direction of stock movements. But options can also be used to hedge an existing long position or short position in stocks. Here’s a look at the basics of options trading, including how options work and how they can be used.
- What Are Options?
- What Does It Mean To Trade an Option?
- Option Pricing
- How Much Money Do You Need for Options Trading?
- Uses of Options
- Can You Make Money Trading Options?
- Futures vs. Options
- How Do You Trade Options?
What Are Options?
Two types of options exist: call options and put options. When you buy a call option you get the right to buy 100 shares of the underlying stock at a certain price within a specific time period. Buying a put option is similar, except your right is to sell the stock rather than buy it.
When listed in print, an option quote looks like this: IBM Jan 150. If this is a call option, it means you have the right to buy 100 shares of IBM stock at the strike price of $150 per share before the option expires. If it’s a put option, you have the right to sell 100 shares of IBM stock at $150 per share before the option expires.
What Does It Mean To Trade an Option?
Although an option might seem like an obscure security, the truth is that options trade on exchanges just like stocks. If you want to buy or sell an option, you can enter an order just like you would if you were buying a stock. Most online brokers will let you trade options through their self-directed trading platforms.
Since options can be complex and hard to understand, you must get your account approved for trading options before you can begin. All brokerage customers must indicate they have read a booklet titled “The Characteristics and Risks of Standardized Options” before they’re allowed to trade options.
Options have two price components: intrinsic value and time value. For example, if you have an IBM Jan 150 call and the stock price of IBM is currently $155, your option has an intrinsic value of $5 per share. Because options contracts offer the right to control 100 shares, the intrinsic value of your option would be $500.
However, options always cost more than their intrinsic values because time value is added to the price of options. The more time you have before your option expires, the more chance you have that the stock price will move in your direction, thus increasing its time value. Options that expire in nine months will have more time value than options that expire in one month, for example.
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How Much Money Do You Need for Options Trading?
With the “race to the bottom” in terms of commissions at online brokers, it’s cheaper than ever to trade options. At online brokers like Charles Schwab, options trades are commission-free, though there is $0.65-per-contract fee. However, you’ll still need to pay for the price of the option.
If you’re just buying one simple call option, you won’t need much money at all. Lots of options trade for less than $1,000 per contract. Some even trade for less than $100 per contract. Of course, you should only invest as much as you’re willing to lose. A standalone call option can expire worthless, putting all of your investment at risk. Selling a covered call option is less risky but could still result in the loss of the underlying stock that you own.
Although you technically don’t need a lot of money to trade options, it’s not a prudent financial strategy to invest in options only. Options are typically used by professional investors as hedges against existing positions or as occasional speculative bets — not as a complete investment strategy. With that in mind, it usually makes more sense to build a diversified portfolio before dabbling in options trading.
Uses of Options
Options can be used to generate speculative gains. Let’s say it’s October and the price of IBM stock is currently $140 per share. If you think the price of IBM will go up, you might buy the IBM Jan 150 calls. With the stock at $140 there is no intrinsic value, but there is time value, which might be $3 per contract. If the stock moves up to $182 per share by the time the option expires, the intrinsic value would be $32 per contract because the stock is $32 above the 150 strike price. So even though the stock price moved up 30% from $140 to $182, your option gain might be more than 1,000% because the contract price went up from $3 to $32.
You can also use options to hedge your portfolio. If you already own IBM stock, you can sell a call and receive the premium, which is the cost per option sold, generating income. If IBM stock never reaches the strike price, you keep both the stock and the premium. You could also hedge by buying a put option. If your stock trades down in value, the put option will go up in value, helping to hedge your loss.
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Can You Make Money Trading Options?
As with any other investment, of course you can make money trading options. However, risk and reward work both ways, particularly with leveraged investments like options. Although speculative call options can double or triple your investment — or even more — you can also easily lose 100% of what you put in.
Here are two simplified examples of how options can make (or lose) money.
Let’s say an IBM Feb 150 call trades at 10, while the underlying stock trades at $140 per share. If the stock never climbs above $150, you’ll lose all of your $1,000 investment in the call option unless you sell it before expiration. That’s because a call option with a 150 strike price doesn’t have any intrinsic value until the stock climbs above $150.
But let’s flip the scenario. Let’s say you buy the same call option but IBM skyrockets up to $200 per share. At expiration, that option will have an intrinsic value of 50, or $5,000. In this case, you’ve just made five times your money, as it grew from $1,000 to $5,000.
Futures vs. Options
Futures are similar to options in that both have strike prices, expiration dates and are leveraged investments. The main difference is that futures contracts are an obligation to buy or sell a security at a certain price on a specific date, whereas options give the contract owner the right but not the obligation to buy or sell.
Futures are also considered a bit more speculative than options and are typically used by speculators and arbitrageurs. This is partly because futures usually have unlimited gain and loss potential, which amps up the risk-reward characteristics of the trade.
How Do You Trade Options?
The bottom line is that there are even more ways to trade options than there are to trade stocks. As leveraged, derivative securities, options are flexible enough to be used in countless ways.
Conservative investors can sell covered calls against existing stock positions, earning income off the sale and not having to forfeit their stock unless it moves above the strike price. Extremely aggressive investors can sell naked calls, which could result in theoretically unlimited losses.
In between these two extremes are a variety of exotic-sounding strategies such as spreads, straddles and collars. These types of investments are beyond the reach of beginning investors, but they do demonstrate the many ways you can trade options if you become familiar with their risks and characteristics.