Watch our video on stock options basics.
What Are the Basics of Stock Options?
- Here are the basics of stock options:
- Calls: you believe price of stock is going up.
- Puts: you believe price of the stock is going down.
- Contract: each contract is made up of 100 shares.
- Expiration: date the contract expires.
- Open interest: number of open contracts.
- Volume: number of contracts purchased that day.
- Strike price: the price target of the options contract.
- Implied volatility: measures the volatility of underlying security.
- Greeks: makes up the price movement of the options contract.
Why is stock options basics important? From where to go on vacation, Bali or Hawaii? To where to dine, Eleven Madison Park or Osteria Francescana. Who doesn't like options?
Unfortunately having options like these don't come cheap. Maybe you really want to buy shares of Facebook (FB), but, at $165 you can barely afford to buy 10.
In Stock Options Basics, I'll show you how you can have your Bali vacation and easily control 100 shares of FB without breaking the bank.
How Does a Stock Option Work?
- How does a stock option work? Put simply, an option is the right, not the obligation to purchase or sell something during a certain period of time. An option is a promise, backed by the stock market. It’s a promise that you can buy or sell a set number of shares (pretty much always in lots of 100 shares) in a company at a fixed price.
But, this promise doesn’t last forever which means the fixed price has both a start date and a expiry date.
1. Paying for Hope
Remember, as a rule, the longer an option has to run, the more it’s worth. This is called time value - you may also consider it a paying for more hope!
The amount you pay for the option is called the premium, and it goes up with time value. Hence the need to learn stock options basics and why trading services like to teach them.
2. Buying Time: Stock Options Basics
As an example, imagine you want to buy a piece of art but your wife is away for a week. And lord help you if you buy it without clearing it with her first. You also know that many other art fans are hoping to get their hands on this painting as well.
So, what do you do? You come to the arrangement with the art dealer where you put down a $1,000 option “deposit” to guarantee you’ll get the first chance to buy the artwork, which is worth $20,000.
If you and your partner decide against it during the week, or never get back to the dealer, you lose the $1,000. Tough, yes - but that’s better than wasting $20,000.What if you decide you want the artwork? You now pay the $20,000 plus the $1,000 fee for the option. In the end, you pay more, but, you have the luxury of time to make up your mind before you do. And, you get the comfort of knowing you’ll get the painting at the price quoted.
Each option for a share has two sets of prices; calls and puts. These are the foundation of stock options basics.
Call prices: They give the right but not the obligation for an investor to buy the underlying shares at this price. You buy a call when you think the share prices will go up in the future.
Put prices: They give the right but not the obligation for an investor to sell at an agreed upon price. You buy a put when you think the share price will go down in the future
4. Strike Price vs. Break Even Price
Since you have “options” in life, you can generally choose between a number of different expiry dates and strike prices. Now this is getting exciting right?!!
With options comes a fancy term called strike price. This is the value your shares have to hit before you can execute your option to buy or sell. This doesn't mean you've made money just yet.
Humor me for a minute. Let’s say you bought one option contract (100 shares) at a $100 strike price. Shares currently are at $98. After a positive earnings report, the shares jump $4 and now they are worth $102 a piece.
If you think you just made $2,000 because 100 shares at $102 a piece equals $12,000, well, don't get excited just yet. This is because options have a premium attached. In this case, let's say premium is $2.50.
Which means, the break-even price that the stock would have to get to is $102.50; anything above that level would be pure profit!!!!
How Do I Learn the Basics of Options Trading?
- Here's how you learn the basics of options trading:
- Learn why people trade options.
- Decide if this is the right trading strategy for you.
- If it is then take a course to help you get started.
- Learn the different components of contracts then practice trading them before using real money.
Let’s start with a simple call option for a company of your choosing in thi stock options basics post. For this example I'll go with Lowe's (LOW). You simply purchase the right (but NOT the obligation) to buy a set number of shares at a fixed price, on or before a stated date.
You reckon the shares of LOW will be worth substantially more sometime over the next three months. You can buy an option that gives you the right to buy the shares in three months time at $100. Right now the share price is $95 - but, because you expect the shares to rise, you go for a strike price higher than the present quote.
So, you buy an option for three months at $10 on 10,000 shares for a cost of $1,000. After the shares go past $110 each you’re “in the money”.
You might have wondered why it took a $10 share price increase before you made money? It is because options have a premium attached to them as well which needs to be accounted for.
After one month, the shares are at $120. You then decide that’s enough of a profit and you take your money and run!
We also have a handy blog post on How To Buy Call Options For Beginners that might be helpful.
1. You're in the Game With Options
If I didn't go the stock options basics route, I would have had to fork out $10,000 of my own cash to buy the shares. Quite frankly, I don't have that kind of cash lying around. Even if I did, I wouldn't drop it all in one trade.
However, with options, a small sum of $1,000 can get me into the game with the heavy hitter stocks.
What's more, I don't have to risk losing all of my initial $10,000 investment, only the $1,000 cost of the option.
At the same time, I like the large cap stocks because of their predictable patterns. Thus, it can be easier to grow a small account - an account that will take you to Bali, not Boise.
2. More Good News
The good news about options is that, unlike with some of the fancy stock market structures, with options, you can’t lose more than you invest. And you can typically make a lot of money in a short time. Its a win-win situation.
Here's a valuable tip for readers - you can trade options at any time before expiry. They’re worthless on expiry, so the nearer you get to that date, the less valuable they become.
3. The Not so Good News: Stock Options Basics
Many (probably most) option trades expire worthlessly. Or, in my case when I first started, I failed to write down my expiry date.
Well, it came and went kinda like the money I spent on it. Rookie mistake. Hence the need to learn stock training.
4. What Can I Buy Options On?
Worldwide, you can choose from thousands of options to trade on. What this means is options are available on all sorts of investments, including bonds, shares and currencies.
It’s important to remember that you never own the shares or other securities with traded options. So, you have no shareholder rights and you don’t get dividends either.
Equity options are the best known and the most likely to be chosen by private investors. Most are called traded options because investors can trade on them, which earns buying or selling during the option period.
To Sum It All Up
What I like so much about options is that you CAN’T lose more than your original stake. Whereas with some derivatives, you can lose your original investment plus more depending on your spread.
If you’re still unsure how the heck options work, don’t feel bad. It took me about 4 weeks to wrap my head around the definition.
Oh, and when I found out there’s different types of strategies I walked away shaking my head. I just got the hang of my day trading strategy and now I had to learn more? Yeah, no thanks.
On the bright side however, I found out that I can apply the same methodology used in day trading to option trading! Check out all our options trading course if you want to learn more. It's what helped me get started on the option road.
You can even talk stock options basics in our trading rooms. Happy trading, I'm off to pack my bags for vacay!