Options trading is a more advanced form of investing than traditional stock trading. Think of an option as a two-party contract between a buyer and seller. As a buyer of an option contract you have rights to buy or sell a stock at a specific price by a certain time in the future. As a seller of an option contract you have obligations to buy or sell a stock at a specific price by a certain time in the future. Let’s take a look at an example between Jim and Bob. Jim thinks Disney is undervalued and believes that it will go up in price in the future. Bob believes that Disney has many problems with its ESPN business and thinks that the stock price will go down in the future. It is February and Disney is currently trading at $90 dollars a share. Jim buys an options contract from Bob to be able to purchase Disney stock for $95 a share by July of that same year. Jim’s thinking is that Disney’s share price will push beyond $95 during that time frame. If this occurs and Disney jumps to $105 a share, Jim will be able to exercise his options contract to buy Disney at $95 a share at that time.
On the other side of the contract Bob sells Jim this options contract for $95 dollars and wants to see Disney’s share price go down in value by July. If Disney jumps to $105 like in the previous paragraph, Bob has the obligation to sell Jim shares of Disney at a price of $95, taking a loss of $10/share per contract. If, however, Disney did fall in value, Bob would be able to keep the payment he received from Jim initially to set up the contract.
So as you can see options are basically making a bet about the price of a stock in the future. The options contract itself you can think of as an IOU to another person that they can choose to exercise or not in the allotted time frame. 1 option contact represents 100 shares of the underlying stock.
Two Parties Involved in Options Contract
|Pays Premium to seller. There is a debit to the account of buyer.||Receives premium from buyer. There is a credit to the account of seller.|
|Has rights to exercise (buy or sell stock)||Has obligations at exercise (must buy or sell as required by contract|
- Strike Price
o This is the exercise price of the stock at which the purchase or sale of the stock will occur. In our earlier example between Jim and Bob the strike price they selected was $95. The closer you get with a strike price with the stocks actual price, the more expensive the contract will be.
- Expiration Date
o The expiration date is the life cycle of the contact and is very important. In our earlier example, Jim had selected a date in July for the expiration. This is the time frame he has to exercise the contract before it becomes worthless. Expirations with options can be one week away, months away, or even years away. The farther away you get from the current date, the more expensive the contract will be.
- Trade Separately from Stocks
o Option contracts trade at their own price separate from stocks. They basically have their own market for you to buy and sell. They are expressed in dollars and cents. For example, you will see an option contract for sale for .40 cents. Recall that 1 option contract represents 100 shares of stock. For this reason, we need to move the decimal over 2 places to determine that it will cost $40 dollars to buy one contract.
Calls vs. Puts
There are two types of options contracts: calls and puts
For the sake of simplicity of this article, I will only be discussing buying calls and puts. Remember as buyers we have RIGHTS. This makes our contracts much less risky than if we were sellers.
- Long call: Investor has right to buy 100 shares of a specific stock at certain price before expiration, you are bullish on the underlying stock.
- Long Put: Investor owns the right to sell 100 shares of a specific stock at the strike price before expiration, you are bearish on the underlying stock.
Although you have the right to exercise your contract to buy or sell stocks at the strike price set in forth by the contract, typically options contracts are bought and sold for their individual market value and no exercising takes place. For example, let’s say you buy 4 options contracts on Disney at $95 strike and expiration is 3 months away. These option contracts are a price of .40 cents per contract which would be a $160-dollar investment ($40/contract x 4). Disney’s share price moves up to $105 in just one month and the price of your options has moved from .40 cents to .60 cents. You can sell those options to close out your position and make a $80-dollar profit ($60/contract x 4= 240, 240-160=$80). As you can see you just made a 50% profit on your investment in just one month. If you instead decided to exercise the contracts you would need a $38,000 investment to buy Disney at that strike price (4 contracts x 100 shares/contract x $95/share). While this selection is at your disposal, you can see that it is a much greater investment.
Option trading is an advanced trading strategy and I do not recommend it to anyone just starting out. If you feel like you have a firm grasp on stock trading, then options trading may be a good supplement for you. Options trading can get highly speculative so I recommend only using a small portion of your portfolio to invest in options.
Homework: Go back through this article and ask yourself the following questions. What do buyers and sellers of option contracts do? Who takes on more risk in the contract? What is my trading strategy when I buy calls? What is my strategy when I buy puts? Grasping this knowledge is essential to understanding options