Do you know how stock options work? Options have a reputation for being difficult and hard to understand. With a little patience and willingness to study you can learn how to trade options. You can make money in any market.
An options contract gives you the right but not the obligation to buy or sell a stock at an agreed upon price during a certain time. Options have expiration dates so you can’t buy and hold forever.
Options contracts allow you to trade large cap stocks without putting up as much capital. They are risky though so you need to know what you’re doing.
HOW STOCK OPTIONS WORK
When you’re learning how stock options work, remember that they have more components than stocks. One options contract is made up of 100 shares of a stock.
The great things about options is the fact that you control 100 shares without having to pay the price. For example, lets say you wanted to buy 1 options contract that costs $1.42.
Multiply that by 100 because you control 100 shares and you’re risking $142. Lets say you decided to buy 100 shares of the stock outright and the stock is trading at $68.50 a share. You’d be spending $6,850.
So you can see that buying an options contract is much cheaper. Now of course it’s more complicated than that because of expiration and the Greeks. But we’ll get into that a little later.
HOW STOCK OPTIONS WORK – CALLS AND PUTS
There are 2 kinds of options contracts. They’re known as calls and puts. You buy calls when you believe a stock is going to go up. They’re basically the bullish option.
Puts are bought or sold when you believe a stock is going to go down. This is the bearish option. The great thing about put options is that it’s like shorting. While some broker may not have shares to short, most brokers have put options.
You can buy or sell a put option. Selling a put is just like shorting. You sell to cover at a lower price later. You can buy the put option though and sell it as price falls. That way you can profit of the loss of a stock.
Calls and puts can be used to make all kinds of fancy spreads as well. Those spreads allow you to profit in a market that’s trading sideways.
The spreads are complicated so you do need to study them. It’ would also be smart to practice trading them in a simulated account like Thinkorswim.
Read our post on put and call options explained to learn more about calls and puts.
HOW STOCK OPTIONS WORK – THE OPTIONS CHAIN
As you learn how stock options work, you’ll find that you use an options chain to buy your stock options. The options chain is the matrix that holds the answers.
There you’ll find your strike prices, expiration dates along with bid and ask prices. You’ll see volume as well. The volume tells you how many people are buying that specific strike and expiration.
This helps you gauge the interest of traders. You cans where they speculate a stock will head. That isn’t a buy signal though. Do your own due diligence.
You can add things to the layout like implied volatility, time decay and open interest. Each of these can show you how price will be affected.
Read our post on the implied volatility formula and it’s meaning to learn why it’s an important part of options trading.
HOW STOCK OPTIONS WORK – OPTIONS PRICING
An important part of how stock options work is the pricing. The price of an option is called a premium. You can’t lose more than the premium you pay.
If you paid $625 for an options contract and it doesn’t go your way by expiration date you’re going to lose the entire $625. Whereas with a stock, you won’t lose the whole amount and you can hold until it recovers.
Remember that you risked a whole lot more with stocks though. Also theoretically, you have unlimited profit potential with options. Buying options in, at or out of the money can affect the price of an option as well.
In the money means a call’s strike is below market price while a put is above market price. At the money means a call and put options strike price is the same as the market price. Out of the money means a call strike price is higher and a put option strike is lower than the market price.
HOW STOCK OPTIONS WORK – PRACTICE
When you’re learning how stock options work, you need to practice trading them. They are more complicated than stocks. Practicing in a simulated account lets you work out the kinks before you put skin in the game.
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