Option trading for beginners: how do stock options work?

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Key learning points

  • An option is a contract that allows the buyer to buy or sell stock at an agreed price.
  • Investors can earn exorbitant returns by using options instead of simply owning stocks.
  • Be warned that higher rewards come with higher risk. Knowing how to hedge your positions to protect yourself against potentially unlimited losses is imperative.

Everyone knows that you can make money investing in stocks by buying low and selling high. However, there are ways to make money in the stock market even when prices are low and volatility is high. Selling options is a strategy that can be lucrative but risky.

Read on to learn how options work, the risks involved and how to get started.

What is an option?

Just like it sounds, an option gives you the option (but not the obligation) to buy an asset at an agreed price. While options generally refer to stocks, they are sometimes used in real estate. For example, rental properties may have the option to purchase at the end of the lease.

The buyer pays a premium for the option whether or not they actually purchase the asset. Usually this is a fixed dollar amount per share. This is a win for the buyer, who gets the asset at a price they want, and the seller, who makes money off the deal whether they sell or not.

Options don’t last forever. Like supermarket coupons, they have an expiration date by which they must be used. Otherwise they become worthless.

Types of options

There are only two types of options, including calls and puts. These two varieties can be mixed and matched in endless combinations ranging from simple, including covered calls, to complex, such as iron condors.

Here are the basics of each option type and common situations investors use them.

Call options

A call option allows the buyer to buy (or call down) stock at a specific price. It also obliges the seller of the option to sell his shares at that price if requested.

Let’s say you want to own 100 shares of TSTIME. Let’s say it is trading at $50 per share, and you buy at this price for a total of $5,000. If the TSTIME stock rises 10% to $55 per share over the next six months, your portfolio will grow to $5,500. Your $5,000 investment is now worth 10% more.

Now let’s say that instead of buying the stock, you bought a call option that allows you to buy someone else’s stock at a specific price. In this example, the price (known as the strike price) is $50 per share. You pay a premium for this option, let’s say $1.00 per share ($100 in total). Instead of spending $5,000 to own TSTIME stock, you can buy it for the same price with just $100 for the call option.

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If TSTIME shares rise by the same 10% to $55 per share, your $100 is now worth $400. This is an increase of $5 per share multiplied by 100 shares minus the $100 premium, which translates to a 400% return. In the first scenario, if you spent the same $5,000 on options that you spent on TSTIME stock, you would now have $200,000.

However, you lose money if the stock doesn’t rise more than $1 per share in six months. Exercising your option only makes sense if the share price rises, as you would pay more at the strike price than the market is trading for. If you bought TSTIME stock completely without options, you would still own the asset and could wait to see if it rose in price later.

Buying options is cheaper than buying stocks, but you could lose your entire investment if your predictions are wrong. That’s why it’s important to calculate your potential losses so that you only lose what you can afford.

An additional note to keep in mind, dividends go to the owner of the stock, not the owner of the call options. You do not receive dividends with options.

Set options

A put option is counterproductive. It gives the buyer the right to sell shares at a certain price and the seller the obligation to buy those shares if the option is exercised. Put options are often compared to insurance because they protect your investment against loss due to a fall in the price of a stock, as you can still sell at the original (presumably higher) strike price.

Let’s take the same example of TSTIME stock at $50 per share. If you bought TSTIME stock for $50 but are concerned about the share price falling, you can buy a put option with a strike price of $50 that expires in six months for $1 per share. If the stock drops to $45 per share and you exercise your option, you’ll lose your $100 premium, but you’ll still have $4,900 instead of 100 shares of TSTIME stock worth just $4,500.

Puts are designed as hedges against loss, not lenders. But if you exercise your put in the example above, you can buy back the stock for $45 per share and pocket $400. Here’s how that works, sell the stock at a strike price of $50 per share for $5,000, subtract the $100 put option and you’re left with $4,900. If you buy 100 shares for $45, it costs $4,500 and you have $400 in profit.

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Of course, if TSTIME’s price goes up instead of down, you’re out $100 with no need to show anything. You are better off selling on the stock exchange than at your now lower strike price, so your put is worthless. But like insurance, you usually buy a well hoping not to use it.

Trading options

The interesting thing about options is that you don’t have to own the underlying stock. You can trade options as their own entities. However, this can be very risky.

When the stock price underlying your option changes, it can increase in value and you can sell an option without exercising it. For example, if the stock price rises above the strike price of a call option you purchased, your option is now more valuable. You have the right to buy the shares at a lower price than they are currently trading at, so that you can exercise the option, sell the shares and collect a nice profit.

For your convenience, you can sell the option before it expires. Like bonds, options are traded in the secondary market.

Conditions to know

If you’re considering trading stock options, there are some key terms you should know. These include:

  • In the money (ITM): An option is in the money when the share price has changed in such a way that the option is worth exercising after accounting for the cost of the premium. In the example above, the option would be in the money once the stock falls below $49 per share ($50 initial price – $1 premium per share = $49).
  • Out of the money (OTM): Conversely, an option that is out of the money is not yet worth exercising. Using the same put example, the option would be out of the money at $49 per share or more. It only makes sense to exercise the option if the price falls further.
  • Time Value (Theta): Options become more valuable the farther away from their expiration date. If an option expires in a few days, you are less likely to be able to use it, so it has less time value. The value of an option is calculated based on the price of the underlying stock and how much time value is left. Time value is often expressed as the Greek letter theta.
  • Holder: This is the person who buys the option contract and has the right to exercise it.
  • Author: This is the person who sells the option contract and is obligated to fulfill it if the holder exercises the option.
  • Contract: Options come in contracts of 100 shares each, so you must buy a minimum of 100 shares of the option you are buying.
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The risk of selling options

While there is a huge benefit to options trading, they come with risks. When you buy an option, the worst that can happen is that the stock moves against your position. In this scenario, your option expires, unexercised and worthless. The most you can lose is what you paid for the option.

However, selling an option without any underlying asset, known as a naked call or a naked put, has a loss potential similar to selling short (infinite).

Suppose our TSTIME stock is trading at $50, and you write a naked call contract (meaning you don’t own any TSTIME stock) at a $55 strike price of $1.00 per share. The best-case scenario is that the stock falls or stagnates and the option expires. You would keep the $100 profit, which you basically got for nothing.

However, if the stock price rises and your option is exercised, you are now short on the stock. You must sell 100 shares of TSTIME so that you do not have to honor the call contract, which means you are forced to buy shares at the market price, which theoretically could be infinitely high. Since you can pay any price for the stock you need right now, your losses could also be infinite.

This is why many experienced options traders use combinations of calls, puts, cash and underlying stocks to hedge the risk of selling options. Otherwise, the sky-high risks may outweigh the hefty rewards of trading options.

it comes down to

Trading options has a much stronger advantage than trading stocks, but it takes a lot of knowledge and strategy to minimize the risk. While your money can go much further when buying options than stocks, greed has ruined many a would-be option trader prematurely. Before starting, beginners should educate themselves about the risks involved in options trading.

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