When you trade options, you need to have a more specific view on the stock market than when you trade stocks. If you are optimistic a stock will rise higher, you can buy a stock and hold it. Or if you are pessimistic a stock will fall lower, you can short the stock and cover it at a lower price to profit.
Options require you not only to have a view on share price direction, but also to have an expectation of when the movement in the share price will occur, for how long the price move will last and how far the shares will move.
When trading options, you need to have a view of:
- The direction of the share price
- How much the stock will rise or fall
- When the move will occur
Table of Contents
Options Basics: Call Options, Put Options And Order Types
Call options and put options can be purchased and sold. You can begin a trade by buying a call or a put. You can also start a trade by selling a call or a put. When you start a trade by buying calls or selling puts, you can make money when stocks rise. And when you begin a trade by buying puts or selling calls, you can make money when stocks fall.
Two types of options exist: calls and puts. A call option is defined simply as the right to buy a stock while a put option is defined as the right to sell a stock.
Calls and puts can be bought and sold. Most stock traders understand the concept of buying stock to begin a trade and selling stock to end a trade. Where options get a little tricky to understand is that you don’t have to begin a trade with a purchase. In fact, you can begin a trade by selling an option, and later end the trade by buying it back!
Because buying and selling is straightforward when trading stocks, no clarification is needed when you buy and sell. But when you trade options, your options broker will ask you to specify whether you are looking to start your options trade with a purchase or with a sale.
The terminology used by online options brokers is Buy To Open when you start a trade by purchasing an option, either a call or a put. When you wish to end the trade, you can specify a Sell To Close order.
But what if you start the trade with a sale? Then you begin the trade by entering a Sell To Open order and end the trade with a Buy To Close order.
When you combine the option types, calls and puts, with the order types, buy/sell to open/close, you will be taking a view on the direction of the market. When you Buy To Open a call option, you are expecting a stock to rise. And when you Buy To Open a put option, you will want the stock to fall in value to profit.
Buying calls and puts is fairly easy to understand. Where trading options gets a little more challenging is when you begin trades by selling calls and puts. For example, when you Sell To Open a call option, you are expecting the stock to fall (or at the very least not rise). And when you Sell To Open a put option, you are expecting the stock to rise (or at the very least not fall).
Estimate How Far Stock
Will Rise Or Fall
When buying call and put options, you should have an expectation not only that the underlying stock traded will rise or fall respectively, but also have a view on how far it will rise or fall. Because options premiums suffer from a factor called time-decay, you will need the share price movement to offset the effects of time-decay in order to profit.
To make money trading options, you need to be skilled not only at predicting the direction the stock will move but also how far it will move. The reason for this is because options expire at fixed points in time according to a regular schedule that is pre-defined. Each day, an option premium loses a little value due to a factor called time-decay. So when you buy an option, you need the movement of the stock to overcome the value erosion from time-decay.
For example, imagine a stock is trading at $100 per share. Perhaps you have a positive view of the stock and expect it to rise in value, so you purchase a call option at strike 100 for say $5 per contract. This call contract gives you the right to buy the stock at $100 per share, even if the stock rises to say $120 – what a deal! Or is it?
When you exercise your right to buy the stock at $100, you lose the $5 you paid for the call option. But that’s okay because you made $20 on the stock as it rose from $100 to $120, and the option toll you paid for so doing was $5 – the cost of the call option. Overall, you end up with a handsome $15 per share profit.
But what if the stock had not risen in value but instead lingered around $100 after you purchased the call. All else being equal, each day the call option would suffer from time-decay and so the $5 you spent buying the call would disappear to zero by a fixed date, called the expiration date.
To mitigate the risk of such a bad outcome, you should have an expectation that the share price can appreciate by at least $5, the cost of the call option, before it expires. As it happens, you don’t have to hold an option you purchased all the way to the expiration date. Instead, you can sell the option at any time before then if you wish to close out the trade. Nevertheless, it’s important to realize that you must be right not only in the direction you expect the stock to move but also by the amount it needs to move by in order to make money.
Similarly, when purchasing put options you should expect the stock to fall by a certain amount in order to make money by the expiration date. With the stock at $100 per share, if you purchase a put option for $5 per contract, the stock will need to decline below $95 per share for your put option to be worth at least $5 on its expiration date.
INTRINSIC & EXTRINSIC VALUE
The reason the stock needs to move up or down by $5 when buying the call or put options respectively in the above examples is that on an option’s expiry date the only value the option has is labeled its intrinsic value. The intrinsic value is calculated as the absolute difference between the share price and the strike price.
For example, a strike 100 call option would have $5 of intrinsic value when the the stock is trading a $105. And a strike 100 put option would have $5 of intrinsic value when the stock is trading a $95.
Prior to the expiration date, an option has a premium over and above its intrinsic value, called its extrinsic value. It is this extrinsic value that time-decay erodes each day.
To select an option with your broker, you will view an options chain on the broker’s trading platform. Options chains list the prices at which calls and puts are bought and sold, how many contracts exchanged hands over time, and at which strike prices.
Options chains are listed for varying time frames: weekly, monthly, quarterly and even yearly. If you need any help reading or understanding options chains, support staff at options brokers are generally knowledgeable and can help you get up to speed quickly.
Time-decay is known in the options world as theta, and it’s not the only factor affecting the value of an option each day. Other factors that affect option pricing are called options greeks, and include delta, vega, gamma and rho.
Delta tells you how much an option’s price changes when the underlying stock changes. For example if a call option’s delta is 0.35 then when the stock rises $1, the option increases by $0.35.
Vega informs you how much an option’s price will change when implied volatility rises or falls. During periods of high uncertainty or fear in the stock market, expectations increase that volatility will spike. These spikes can increase the value of options while declines in volatility can lower the value of options.
Gamma is not something a beginner options trader needs to focus on too much at the outset but it is important to understand after you have got your options training wheels on so to speak. Gamma measures the rate of change of delta.
Similarly rho is not a factor to concern most options traders as it relates to the impact on options prices of interest rates, which tend to move much more slowly than other options greeks.
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HOW TO TRADE A CALL OPTION
Call options allow traders to control stock at lower cost than purchasing stock. Higher percentage gains may be enjoyed when stocks rise and lower dollar losses suffered when stocks fall.
Perhaps the simplest and most intuitive of options trades is the purchase of a call option. Take the example above where the share price is $100 and you wish to make money if the stock rises, but you don’t want to shell out $10,000 buying 100 shares.
A cheaper alternative is to purchase a call option contract, for say $5 per contract. And because an option contract generally corresponds to 100 shares of stock, it will cost you $500 to buy the call.
You will also pay a transaction cost for purchasing the call option. The best online options brokers have very reasonable rates.
IF THE STOCK RISES
Imagine the stock rises as you had hoped it would to a price of say $120. You have three choices:
- Exercise your right to buy the stock and hold the shares
- Exercise your right to buy the stock and sell the shares
- Sell the call option
Exercise your right to buy the stock and hold the shares
With the stock at $120, your call option purchase will be nicely profitable and you will be spoiled with choices. If you choose to exercise your right to buy the stock for $100 per share and hold the shares, you will need to have the capital in your brokerage account to own 100 shares at the purchase price of $100, for a total of $10,000.
Exercise your right to buy the stock and sell the shares
Most options traders prefer not to hold the shares because of the high costs and instead choose to either sell the stock right away or simply sell the call option. When selling the stock for $120 after exercising your right to buy it for $100, you profit $20 from the share price appreciation.
Keep in mind that anytime you exercise an option, you lose the amount paid for the option, which is $5 in this case. So your total gain is $15 ($20 from the stock minus $5 from the option).
Sell the call option
To avoid the headache of exercising the stock and choosing to hold it or sell it, the simplest choice and typically the most popular among options traders is to simply sell the call option to a buyer.
With the stock at $120, the minimum value the call option will have is $20, the difference between the share price of $120 and the strike price of $100 at which the call option was purchased.
Having bought the call for $5 and sold it for at least $20, the percentage gain is large, 300%! Quickly you can see how enticing it is to purchase call options as opposed to buying stock. If you had bought the stock you would have had to shell out $10,000 to control the same 100 shares that cost just $500 to control with a single call option contract. And when the stock rose from $100 to $120, a 20% share price gain, you realized a call option gain of 300%.
IF THE STOCK FALLS
The outcome isn’t always so rosy trading options. If the stock had fallen $20 instead, the call option would likely have little or no value at all. In such a scenario, the buy-and-hold investor could hold the stock in the hopes that one day it would return back to $100 at some point in the future. But the call option purchaser doesn’t have the luxury of time on his/her side. When the expiration date is reached, the call option expires worthless and 100% of the $5 investment is lost.
The keen observer will note that even though the call option purchaser lost 100% of the $5 investment, it is still a lot less than the $20 the stock purchaser lost. So, even when stocks fall and options lose money there is still some merit to selecting options.
WHICH OPTIONS BROKERS SHOULD YOU CHOOSE?
To begin trading options, you will need to answer screening questions from your options broker. Online options brokers compete aggressively on pricing so you will be spoiled for choice when comparing commissions costs, and the best online options brokers have knowledgeable support staff and powerful trading platforms to meet your needs.
The hurdle to opening a brokerage account to buy and sell stocks is low. With sufficient funds to meet any account balance minimums, you can get started quickly. But options brokers impose a slightly steeper hurdle before permitting you to trade options. You will be asked some screening questions and must have sufficient funds in your brokerage account to meet their minimum account balance and margin requirements.
The best options brokers understand the risks and rewards of simple and complex options strategies, support you with knowledgeable staff, competitive commissions costs, and powerful platforms. Each of the options trading platforms below, tastyworks, and thinkorswim, serves options traders well in each of these dimensions.
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