What is an Option?
An option is a type of security that grants the trader the right to buy or sell an underlying asset. The underlying instrument is commonly a stock, but options can also be traded on a variety of ETFs and futures. There are two types of options: call options and put options. Traders can trade options by either selling, buying or a combination of both.
A call or put option is a contract between two unknown parties, a buyer and a seller. The option buyer and option seller will have different rights and obligations if they hold their options until the date it expires. Depending on whether you have bought or sold the option, you may be able to decide whether you want to own the stock (when you buy the option) or you can be assigned stock (when you sell options). There may also be actions that need to be taken depending on whether the option you traded has value by the date it expires.
|Buying To Enter Trade||Selling To Enter Trade|
|Calls||This Trader has the right but not the obligation to Buy||This Trader has the obligation to deliver long shares if assigned|
|Puts||This Trader has the right but not the obligation to Sell Short||This Trader has the obligation to deliver short shares if assigned|
Options are traded in contracts, and generally each option contract represents 100 shares of stock. The price or premium of an option contract is determined by a number of pricing factors that include:
- The underlying stock price
- The contract strike price at which you can buy or sell the stock
- The expiration date of the contract
- Stock dividends and interest rates to a lesser degree when applicable. Economic or other related news events can also have a significant effect on options prices.
The price quoted for a stock option is the per-share price of the option. So, if an option is quoted at $5.00, the cost to buy that option would be $500.00 ($5 X 100 shares). Remember, one option contract generally represents 100 shares of stock.
Although stock options have an expiration date, most option contracts allow the trader to go into the open market and close their options position(s) prior to the expiration date, to either take profits or limit losses.
Learning which stock options to buy or sell and when to buy or sell can feel overwhelming at times, especially with all of the terminology specific to options trading. While it may require traders to understand the language of options trading, it can be a rewarding way to trade.
Although stock options have an expiration date, most option contracts allow the trader to go into the open market and close their options position prior to the expiration date, to either take profits or limit losses.
Learning which stock options to buy or sell and when to buy or sell, when to hold your position and when to close your position requires knowledge and experience you can gain through education and coaching.
Why Trade Options
Options offer several advantages to just trading stocks.
Limited Risk – Buying a call or put option offers the trader unlimited potential profit and limits maximum risk to the price premium paid for the option. Conversely, the options seller has unlimited risk and can only profit by the amount of option premium collected. For this reason, most retail options traders are call and put buyers.
Leverage – Options buying allows you to control a larger stock position with less capital than buying the stock directly. However, with this larger market exposure comes the potential for losses. Always have appropriate risk management in place to guard against a big move against your futures position.
Flexibility – When buying or selling stock, you can only trade two directions- up or down. Combining both buying and selling options in the same position, offers a wider variety of market conditions you can trade, such as up, down, quiet markets, active markets and increasing or decreasing volatility.
Income Generation – One of the reasons traders and investors trade options is to help produce income. There are options strategies that can be employed to allow you to collect option premium.
Hedging – Anyone who has a portfolio of stocks can use options to help reduce risk in the event of a market downturn by buying put options.
Note: Most options contracts expire worthless, where the price of the underlying stock did not exceed the strike price target, which means the premium paid by the option buyer was lost.
What You Need to Know About Trading Options
Trading options will require a trader to commit to understanding the terms used when trading options, as well as to consider some additional tools to trade. Options trades are traded on an options chain. There are a lot of options to choose from, different strikes and different expires. Sometime having the choice to buy or sell a variety of options can feel overwhelming but with a trade plan, and a system to collect information about the underlying instrument you are trading, and an understanding of how options are priced, you can learn appreciate the benefits of options trading.
Experienced options traders always have a plan before entering a trade. This plan includes how many contracts to buy or sell, how much risk they are willing to take, or how much money they are willing to lose on a single trade and at which price point to exit a trade for profit.