What Are Options, and How to Trade Them Profitably
If you google “what are options,” you’ll get lots of results. And lots of overcomplicated, useless information.
The options world is awash in jargon – “derivative,” “put,” “call” and so on.
To some degree, this complexity makes sense. Options trading is an intricate and high-risk form of investing. It’s not for the faint of heart.
But the basic concept is simpler than Wall Street would lead you to believe.
The House Analogy
Suppose you want to buy a house for $500,000. You don’t have the money now, but in six months you’ll be able to afford it. So you work out a deal with the seller.
You pay them $10,000 for the right to buy the house at a set price of $500,000 in six months.
The thing is, house prices change over time. So your contract with the house seller is an investment that could gain or lose value.
During those six months, the house might suddenly balloon in price to $750,000. That would mean that, at the end of your agreement, you can buy the house for the original price of $500,000 – a more than 30% discount. And, if you wanted, you could turn right around and sell it for an instant $250,000 profit.
On the other hand, the house might decrease in value over those six months. If it goes down to $300,000, then you’d wind up paying more than the house is worth. You’d be $200,000 in the red. Fortunately, your contract just gives you the right to buy the house in six months. It’s not an obligation. So you could walk away from the trade and – instead of losing $200,000 – you’d just have to forfeit your original $10,000 payment.
The contract you made with the house seller is basically an option.
It’s an agreement in which a buyer gains a right (with no obligation) to buy or sell something at a given price in the future. The seller of the option has an obligation to sell or buy something at a given price in the future.
If you’re confused by the “buy or sell” phrasing, don’t worry. We’re not being vague; that’s just part of the options market.
Puts and Calls
A stock market transaction has only two participants – the buyer and the seller. The options market, meanwhile, has four.
In addition to buyers and sellers, we must also differentiate puts from calls.
Call buyers have the right (but no obligation) to buy the option’s stock at a given price at a given time in the future.
Similarly, put buyers have the right (but no obligation) to sell the underlying stock at the given price and time.
People buy calls when they think the underlying stock will go up. They buy puts when they think the underlying stock will go down (like a short).
Call sellers are obligated to sell the option’s stock at the given price and time. Put sellers are obligated to buy the underlying stock.
The house seller from the example above is a call seller. They’re obliged to sell the house in six months if the buyer doesn’t walk away. And since the call seller gets paid a $10,000 premium, they’re hoping that the house will decrease in value so that the buyer walks away. That way, they keep the house and earn $10,000 in profit.
How to Profit From Options Trading
For simplicity’s sake, we’re going to explain a successful options trade from the perspective of a call buyer. We’ll look at a call option for a fictional company called Bullmarket Industries.
Bullmarket stock is currently trading at $8 per share.
You think Bullmarket Industries stock is going to go up. You’re pretty confident that it’ll break $10 within two months. So you buy an option to buy 100 shares of Bullmarket at $10 per share in two months.
The $10 per share is called the strike price. You pay the call seller a premium of $200, which is the strike price minus the current price times the number of shares. (10 – 8) x 100 = 200.
Suppose Bullmarket stock goes up to $15 per share. Since it’s above the strike price, your option is in the money; it’s profitable for you as the call buyer.
Your take would be (15 – 10) x 100 = $500. You still have to pay the premium, so your profit is $300.
What Are Options and Their Risks?
Now let’s look at another made-up company, Bearmarket Holdings.
Its stock is also currently trading at $8 per share. Just like in the last example, you think the stock will go up. So you buy a call option for 100 shares of Bearmarket at $10 per share in two months. Once again, the premium is $200.
This time, though, you’re wrong. Bearmarket drops to $7. Since that’s below the strike price, your option is out of the money. You’d be 30% down if you exercised the option and bought the stock, so you walk away.
That means you lose the $200 you paid at the beginning.
There are a couple things we’ve left out of these examples for ease of understanding. For one thing, these advanced trades require a broker, so you’ll also need to pay a commission. Option premiums also have a time value which decreases as the option nears its expiration date.
To further your understanding, check out these resources on Investment U:
- Get Paid to Own the Stocks You Want at a Lower Price
- Four Essential Rules for Smart Options Trading
- The Essential Options Manual (available here in the Investment U Bookstore).
In summary, an option is a contract that lets you bet on stocks with a small, fixed amount of risk. If things go well, you get to keep gains on the stock. If things go badly, then you just lose the premium you paid (and you won’t get that back either way).
Option trading is more intense and technical than regular stock trading. If you’re a new investor who’s just getting a feel for the market, it may not be right for you. But if you take what you’ve learned from this primer and keep reading, you should get the hang of it in no time.
Financial education is one investment that’s always in the money.
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