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How to Trade Options


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What are Options?

how to trade options

Learning how to trade options is a pretty difficult concept to grasp. However, if you have a solid foundation and understanding of how to trade stocks, trading options can be a great way to maximize your investment.

An option gives the buyer the right, but not the obligation to buy or sell an asset on or before a certain date. An option is a legally binding contract between a writer and a holder. Options are considered more risky than investing in stocks, because they carry higher risk of losing your entire investment. However, options also give traders the opportunity to make much more then they could buying and selling stocks.
 

How Options Work

There are 2 types of options, calls and puts. There are also two people involved in an options contract an options writer and an options holder. The options writer is sells the contract to the options holder.

Call Options

If purchasing a call option your are long on an underlying asset. For instance, say you liked Apple’s business you think they are headed in the right direction and you want to maximize the return on your investment. An option gives you the choice to lock in Apples current stock price. On or before the option expires you have the right, but not the obligation to exercise the option. Apple is currently trading at (just for purposes of this example) $400.00 per share. When you are purchasing a call option you are expecting the share price of Apple’s stock to increase for over a certain period of time, say 3 months. Lets say during the coarse of the three months Apple’s stock shoots up to $1,000.00 per share with a call option you have the right to exercise the the option and buy Apple’s stock at $400.00 per share from the options writer. You can then turn around and sell Apples stock at market price of $1,000.00 per share. For this ability to lock in a certain price you pay a premium for the options contract. We will get to premiums in a little bit.

Put Options

how to trade call optionsA holder of a put option is short on a stock and expects the price of the stock to go down. Going back to our previous example this time you think Apple’s stock is going to fall. It’s currently trading at $400.00 per share so you decide to purchase a put options contract that expires in 3 months. With a put option you still have the right, but not the obligation to exercise the option. With a put option you are gaurenteed to sell Apples stock at $400.00 per share. Lets say during the 3 months Apple’s stock goes down to $100.00 per share. As a holder of the put option you are able to purchase Apple’s shares at $100.00 (current market price) and sell those shares back to the options writer for $400.00 per share. If Apple’s stock had gone up over the period you would not exercise the options and would lose the premium for purchase of the contract.
 

Understanding Options Contracts

Okay, by now we know that options give us a chance to lock in an asset at a certain price to either buy or sell that asset at a later period in time. Now we need to know what effects the value of an option. There are a few critical factors you need to look at when buying an option.
• Expiration date
• Strike price
• Premium

Premium

For the ability to lock in a price on an asset you are going to have to pay a premium. Options contracts come in lots and represent 100 shares of a stock. the factors the effect the premium are the strike price and the length of the contract.

Length of Contract

With an option the longer the contract the better chance you have of reaching your goals. Going back to the Apple example I used earlier. If you had one year to wait for Apple’s stock to increase as opposed to only 3 months, wouldn’t you be willing to pay more for that contract? The length of the contract has a big factor in the premium you are going to pay for the options contract. Similarly, as time moves on and an option moves closer to its expiration date the less valuable the option contract becomes.

Typical Lengths of Options Contracts:
• 3 month
• 6 month
• Leaps (a long term options contract lasting from 9 to 30 months)

Note: an option always expires on the Saturday immediately following the third Friday of the month. Also, An options contract does not have to be purchased (by an options holder) on the date it was written. An option holder can purchase options that are almost expired.

Strike Price

options table

Courtesy of Yahoo! Finance

The strike price is the agreed upon price between the options holder and the options writer of what the stock can be bought (call options) or sold (put options) at. If you look at an options table you will see a series of strike prices you can purchase an options contract at. How close the actual stock price is to the strike price is going to determine how much of a premium you are going to pay to purchase the contract. Going back to our Apple example lets say Apple is trading at $400.00 per share. You are looking to purchase a call option. There will be an options table that lists all the options that are currently available for Apple’s stock. As an example lets say there are 2 call options available one with a strike price of $200 and one with a strike price of $600.

At a current trading price of $400.00 per share the option with a $200.00 strike price is already in the money. This means if you bought this option you could theoretically turn around and force the options writer to sell you Apple’s stock at $200 per share and you can then sell the stock at the market price of $400.00 per share. Since this option is already in the money your premium for this contract will be very substantial because this options contract is already worth money. However, if you were to look at the premium for the option that has a strike price of $600.00 per share the premium will be very small because the market price is still $200.00 away from the strike price. In this case you would not want to exercise the option and buy the stock for $600.00 only to have to sell it at market price of $400.00 per share.

The strike price is the most confusing and toughest concept for new options traders to grasp. Still confused?

When you are purchasing a call option your goal is for the price of a stock to increase. Remember you always have time working against you as an options holder. The closer you get to the expiration date the less likely you have of your option becoming in the money. An option is said to be in the money when it has surpassed the strike price. For a call options holder they want the price of the stock to go above the strike price. For a put options holder they want the stock price to go below the strike price for the option to become in the money. Again, the strike price is the agreed upon price between the options holder and the options writer that the holder can choose to either purchase (call) or sell (put) the stock to the writer at the agreed upon strike price.
 

How to Trade Options

Trading options is similar to trading stocks. You first need to decided whether the company’s share price is going to increase or decrease. When you are trading options you are not actually buying or selling stock you are buying a contract for the right, but not the obligation to purchase or sell a stock at a determined price (strike price). Once you determined if you want to purchase a call option or put option you need to think about what strike price you want to lock in.

The closer the stock price is to being in the money, the more expensive the option premium will be. In the example above the $600.00 option would be very cheap, but since the $200.00 option is already in the money by $200.00 that option would be very expensive.

To learn more about how to determine the value of a stock versus its current market price click here. To learn more on when to know if its good to buy or sell a stock click here.

When you are trading options your contract is for a sum of 100 shares of stock. Whether it’s a put or call option the contract will be for 100 shares. It’s also a lot less expensive to purchase options then it would be to purchase the stock itself. Since an option is a derivative it does not have any value once the contract expires. If the option did not go into the money before the expiration date the option holder will lose all of his investment, because he will have lost the ability to purchase or sell stock at the agreed upon strike price.

When choosing a strike price you need to assess the risk you want to take. An option that is far away from being in the money will have a small premium, but the likelihood of you being able to cash in on that option is very small. Similarly a option that is close to being in the money is going to be very expensive, but the likelihood you will be able to cash in is substantially greater. As an options holder you need to determine a price you believe the stock could go to and that is how you can choose the best strike price for your investment needs.

Lastly,you do not necessarily have to exercise the option. You could also sell the option if it increases in value Or decreases), but you want to close out your position. As long as the option has not expired you can resell the option on the open market. This will not make you an options writer, however, you will close out your position on the options contract.

Note: you don’t actually have to buy and sell stocks. If you are using a broker or online broker you just have to exercise the option and the broker or online broker will do the purchasing and selling of the stock. Sometime people buy options so they can bet on a 100 shares of stock they otherwise could not afford. You don’t actually need money to purchase 100 shares of stock you just need to pay the options contract premium and the amount the broker charges you per options contract.

Being a options writer is significantly more difficult than being a options holder. Options writers also carry unlimited liability because a stock price could theoretically keep increasing. Learning how to be an options writer is above the scope of this article.
 

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2 Responses to “How to Trade Options”

  1. Chitra says:

    A great article. It provided me more information about the trading options and was very useful to me as i am a beginner.

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