If you have been dabbling in the stock market, you have probably had an opportunity to learn about a wide range of investment topics. Among those topics has likely been something related to options trading. Indeed, trading stock options is another way to participate in the stock market. If you are interested in learning more about options trading, you can use the following information as your beginners guide to options trading.
What Are Stock Options?
Most major stock issues have an underlying options market. Each option represents the right to buy or sell 100 shares of the underlying stock at a predetermined price (strike price) with a stated expiration date at some time in the future. All expiration dates fall on the third Friday of the month of expiration. Each stock will normally list available options for at least six months out, one month at a time.
There are in fact two types of options: Calls and puts. A call option represents the right to purchase 100 shares of the underlying stock from the individual who sold or “wrote” the call option. If the same individual who wrote the option owns the stock, they have a “covered” position. Otherwise, it’s referred to as a “naked” position, which means they would first have to go into the market and buy the stock before they could sell it to the investor who exercises their right to buy the stock at the stated strike price.
A put option is the right to sell 100 shares of the underlying stock. Again, if the put buyer owns the underlying stock, the put option would be a “covered” option, meaning the investor actually has 100 shares of stock to sell. If they don’t have the underlying stock, it’s considered a “naked” position, meaning they would have to go and actually purchase the stock in order to fulfill their obligation if they decide to exercise their put option.
Benefits of Trading Options
Investors use options for one of two reasons. Some investors don’t have the needed capital to purchase hundreds of shares of stock. In lieu of doing so, they can simply buy/sell options. It’s the perfect way for investors to limit their exposure in the market while “investing” in securities of interest.
The other reason people use options is as a hedge against stock movements on the underlying stocks they already own. They can use certain option strategies to lock in profits and accumulate premiums as an extra source of income. A premium is the difference between the price of the option relative to where the stock is versus the strike price.
How Options Work
The best way to describe options trading is to layout examples.
Example: Disney (DIS) is currently at $130 a share. An investor purchases 1 call option on DIS at a strike price of $130 with an expiration date of November 2019. The cost of the option is $3.50 a share or $350 for the right to buy 100 DIS shares at $130 by Nov. 15. Since the stock strike price is right on the actual price, the entire $3.50 is considered premium. The premium exists because there is a presumption the stock price will rise over the next month. The premium is paid by the option buyer and collected by the option seller (writer).
The premiums are also applicable to puts. Premiums exist on all options (puts and calls) all the way up to the expiration date. If DIS stock sits at $135, the option is in the money. If DIS falls below $130, it’s considered out of the money. The premium will typically rise or decrease as it moves away from the strike price.
The buyer of an option can exercise or sell their options at anytime up until and including expiration day. They will likely make their final decision based on how DIS stock trends.
If DIS stock were to rise to say $140 before the option expires, the call buyer can either exercise the option and buy the stock, if capital is available, or sell the option on the open market and collect a little extra premium in the process.
Hopefully, the above information will serve you well as a beginners guide to options trading. To be clear, options represent a chance for high returns with a limited investment. However, time limitations and premiums do make options more riskier that investing in the underlying stock.