Options trading can help you diversify your portfolio beyond stocks, bonds and mutual funds. But what are options exactly? And how do you get started with options trading? This rookie’s course answers those questions and more.
Options trading basics
What is an option? In simple terms, it’s a contract that gives an investor the right to buy or sell an underlying security (generally meaning a stock, index or exchange-traded fund). To keep things simple throughout this course, we will mainly refer to the “stock” that options are based on. However, “stock” can often be substituted with a different underlying security, depending on your trading style. Bear that in mind as you follow along.
Options aren’t a new concept; in fact, they’ve been around longer than the stock market. Two basic types of options exist: calls and puts. A call option gives the contract buyer the right to buy a stock at a fixed price (called the strike price) by a set date. A put option gives the contract buyer the right to sell a stock at a fixed price by a set date.
For every buyer of an option contract, there has to be a seller of the contract. When someone sells an option contract, they collect a premium, which is the amount an investor pays to buy the contract. For receiving that payment, the seller must take on an obligation to sell (if a call) or buy (if a put) the underlying stock from the buyer of the contract. You’ll often see the seller referred to as the writer of the option contract.
Calls, puts, strike price and premium are some of the key terms to know when you’re getting into options trading. Understanding these terms can help you understand an option quote, which tells you a lot about the terms and conditions of the option contract.
A stock option quote has five parts:
- Stock symbol. This is used to identify the underlying asset attached to an option contract.
- Expiration date. This is the date on which the option will expire.
- Strike price. The price at which you’re able to exercise the option.
- This refers to the type of option involved, i.e. a call or put.
- The cost to buy the option contract itself.
Options trading can give you exposure to stocks without having to buy shares of stock. Keep in mind that the owner of an option contract receives a right, not an obligation.
Understanding call and put option contracts
Now that you know some of the basics of options trading, it’s time to take a closer look at how call and put options work.
What is a call option?
Buying a call option gives you the right to buy a stock at a set price (called the strike price). The seller or writer of the option is obligated to sell the stock to you at that set price if you as the owner decide to invoke the right embedded in the call option.
Since the owner of the call option has the choice to buy the stock at a specific price, the owner wants the stock to increase in price after the option contract is bought.
What is a put option?
A put option is the opposite of a call option. When you buy a put option, you have the right to sell the stock at a set price (again, called the strike price). The seller or writer of the option is obligated to buy the stock if you as the owner decide to invoke the right embedded in the put option.
Since the owner of a put option has the choice to sell the stock at a specific price, the owner wants the stock to decrease in price after the option contract is bought.
Note: Buying a put option may be used as an alternative to selling a stock short.
Your options when owning options
So, what do you actually do with an option contract that you own? You have three possibilities:
- Sell to close the position in the marketplace before the contract expires
- Allow the option contract to expire worthless
- Exercise the option and invoke the right embedded in the contract
This is where it helps to understand a few more terms, specifically what in, at, and out of the money option contracts are.
These are intuitive terms that reference the difference between the option’s strike price position relative to the current market price of the underlying stock.
- In-the-money (ITM): When an option’s strike price is favorable compared to the stock’s market price, so it has intrinsic value
- At-the-money (ATM): When an option has a strike price equal to the stock’s market price
- Out-of-the-money (OTM): When an option’s strike price isn’t favorable compared to the stock’s market price; therefore, it doesn’t have intrinsic value
Where option prices come from
Understanding the different classifications (In, At, Out) of an option contract is central to build the understanding of where option prices come from. The premium for an option contract is based on the sum of the option’s intrinsic value and time value. Intrinsic value means the difference between the strike price and the stock’s market price. Time value is the difference between the price of the option and the intrinsic value (if ITM). Of course, if the option is OTM, then the price of the option is considered all time value.
How to read an option chain
You can use what you now know about option prices to read an option chain. It allows you to see all the option contracts associated with a stock. You’ll typically see a section for calls and a section for puts. Within the chain, you can track:
- Strike price and expiration date for each option contract
- Which options are in-the-money, at-the-money or out-of-the-money
- Last price at which an option traded
- Bid price, ask price and volume
You can also see open interest or OI, which shows the number of contracts in existence for a particular option. Generally, the more open interest, the better, because that means more trading volume and more liquidity in the option marketplace.
Options trading strategies
As an option trader, you have numerous strategies you could utilize. Some are bearish in nature, others are bullish.
When implementing option strategies, it’s important to look out for some of the most common options trading mistakes. Those include:
- Not having an exit strategy
- Doubling up to try and make up past losses
- Trading illiquid options
- Waiting too long to buy back short strategies
- “Legging in” to spread trades
You can read more about options trading mistakes to avoid in the Rookie’s Corner of our Options Playbook.
When buying puts and calls, there’s a certain amount of speculation involved. You have to be fairly confident the stock’s price will move in a favorable direction, based on the strike price and the type of option.
Understanding different options trading strategies can help you decide which ones to implement. For example, a covered call strategy involves selling call options while also holding shares of the stock. Married puts and protective collars are also strategies that are centered around trading options on stocks you already own.
Before applying any options trading strategies, you have a few things to consider: First, you’ll need to decide what type of options you want to buy, based on which way you think the stock’s price will move. Next, you’ll look at the strike price to see how that aligns with what you think is going to happen to the asset’s market price. And finally, you’ll need to consider how long you want to hold the option contract. All of that can help you to manage risk and potentially maximize profits while trading options.
Put your learnings to work for you.
Options trading can seem intimidating. But once you’ve gotten a grasp on the terminology and some basic strategies, you should feel confident in your ability to incorporate this type of investment into your portfolio.
Your knowledge can go a long way.