Brace yourself when you first enter the world of options because the first step will be to master new terminology that sounds more like the name of a college fraternity than a method of managing risk and speculating in the market.
Terms like theta, gamma, and vega are common in options trading and initially seem intimidating but fear not because once you come to terms with the jargon you will discover effective ways to manage portfolio risk, lower cost basis and speculate more cost effectively.
Table of Contents
What Is An Option?
Options are powerful instruments that allow traders to lower cost basis, generate income, limit risk, protect principal, and profit from volatility. Options are contracts that can be bought and sold, and exist for fixed time periods before they expire. Options come in two forms: calls and puts. Calls and puts can be both bought and sold to allow you to take a view on the markets that they will rise or fall, or even stay flat.
Options allow traders to take a view on the market and profit when that view is realized. Just as you can purchase stock and make money when it rises in value or short stock and make money when it falls in value, so too can you trade options and make money when your view turns out to be right.
The big difference between stocks and options is that options expire at a specific point in time. You can hold a stock theoretically forever but an option exists only for a limited time period, and after that point in time it expires.
BENEFITS OF OPTIONS
Options are powerful trading instruments used by successful and sophisticated investors, such as Warren Buffett. They can be used for a wide variety of purposes, including to lower cost basis, generate income, limit risk, and profit from volatility.
- allow traders to bet on a stock rising for a fixed time period at a lower cost than buying a stock outright;
- can systematically lower the risk of holding a stock over time;
- can act as insurance policies for specific time periods, protecting stocks held when markets correct lower; and
- options can be used both to limit losses and profit from large stock movements during periods of high market uncertainty.
WHAT IS AN OPTION?
An option is a contract to buy or sell stock at a pre-agreed price and by a specific date. Unlike stocks which are traded in shares, options are traded in contracts where 1 contract generally corresponds to 100 shares of the underlying stock.
An option is a contract that:
- gives you the right to buy or sell a stock; or
- obligates you to buy or sell a stock.
Depending on which option you buy or sell, you will be betting on a move up or down in the underlying stock – and sometimes you can make money even if the price movement of the stock is fairly flat and doesn’t move much at all.
TYPES OF OPTIONS: CALLS AND PUTS
A call option is a contract that gives the buyer the right to buy the underlying stock at a fixed price by a certain date. Buying calls is a bullish bet that the underlying stock will rise.
A put option is a contract that gives the buyer the right to sell the underlying stock at a fixed price by a certain date. Purchasing puts is a bearish bet that the underlying stock will fall.
But you are not limited to simply buying options, you can sell them too. When you sell a call or a put option, you take the other side of the trade to the purchaser. So, if the buyer of a call option is expecting the underlying stock to rise, then by selling a call option your expectation is the stock will not rise. If the stock price stays somewhat flat or falls lower, that is a good outcome for you.
And if you sell a put option, you are taking the other side of the trade to a put purchaser. So if the put purchaser is hoping the underlying stock will fall in order to make money, then you, as the put seller, are hoping for the stock to not fall, but instead to remain just about where it is or to rise in value to make money.
The terminology used by stock market traders to signal a rising or falling stock is called bullish and bearish respectively. Buying calls and selling puts are considered bullish options strategies because money is made when the underlying stocks rise while buying puts and selling calls are considered bearish options strategies because money is made when the underlying stocks fall in value.
OPTIONS: RIGHTS AND OBLIGATIONS
If you buy an option, you have the right to exercise that option. For example, if you buy a call option you can exercise your right to buy the underlying stock at any time. You don’t have to buy the stock, you simply have the right to buy it if you wish.
If you sell an option, you have an obligation to buy or sell a stock. For example, if you sell a call option, you have an obligation to sell stock if the call option buyer exercises their right to buy the underlying stock. And if you sell a put option, you have an obligation to buy stock if the put buyer exercises their right to sell the underlying stock.
The simplest way to understand rights and obligations is to keep in mind that buying options gives you rights while obligations are incurred when you sell options.
Buying options ⇔ Rights
Selling options ⇔ Obligations
Best Options Brokers
The best online options brokers have reasonable commissions costs, fast and accurate order execution, powerful screening and back-testing tools, and knowledgeable customer support staff who understand simple and complex options strategies.
Catering to options traders is not every brokerage firm’s cup of tea. To get started trading options, you will want to choose a broker who has a deep understanding of options strategies, and both TastyWorks and thinkorswim, featured below meet that high hurdle.
Just as thinkorswim won accolades and a huge fan base for delivering to options traders a world class trading platform with powerful screeners, back-testing strategy tools and analyzers, along with fast order execution of even complex options strategies, so too does TastyWorks deliver in every respect.
Plus, TastyWorks offers $0 commissions costs to close out options contracts, a competitive cost structure that will please fee-savvy options traders.
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How To Generate Income Trading Options
Selling call options on stock you own is similar to renting out a property you own to a tenant because in both cases income can be generated and money can be made without requiring the underlying asset to appreciate in value.
Imagine a property owner who decides to make a long-term investment by purchasing a property to rent out for passive income. If you discovered the property had been purchased but the owner decided not to rent it out, you would quickly spot the lost opportunity to generate income from a tenant paying rent.
Without a tenant in place, the only way the property owner can make money is when the property appreciates in value. But if the property were rented out to a tenant, the property owner could make money even if the property never appreciated in value, simply by pocketing the rental income.
Just as a property owner can generate income by renting the property to a tenant, so too can the owner of stock generate income on a regular basis. The way a stock owner generates regular income is by selling call options against their stock holding.
Most stock investors don’t realize that holding a stock and not generating income from options is akin to buying a property and not renting it out to generate rental income. The way to generate regular income when holding a stock is to sell call options against the stock. For every 100 shares of stock held, 1 call option contract can be sold.
For example, if you own 100 shares of stock trading a $50 per share and sell one call option at a fixed price of say $55 for $1 per contract, that means you will receive $100 (because 1 contract generally corresponds to 100 shares of stock so $1/contract x 100 shares per contract = $100). By selling a call option against your stock holding, you are obligated to sell the stock at $55 per share if the stock rises to that level or above it.
Even if the stock never reaches $55 per share, you are technically still obligated to sell it at $55 if the owner of the call option exercises their right to buy the underlying stock at any time. But in practice, the owner of the call option will almost never choose to exercise their right to buy the stock at $55 if the share price is lower – otherwise they would be unnecessarily paying a higher price for the stock compared to the price at which it is trading in the market.
As the call seller, the bottom line is that the only time you are ever likely to have to sell your stock is when the price rises above the pre-agreed strike price, which is $55 in this case.
How To Limit Risk Trading Options
Buying put options on stocks you own can protect your principal when stocks decline in value. The cost of buying the insurance that comes along with put option purchases can be high if you buy put options regularly so, although it’s a powerful strategy to limit risk every so often, it’s an expensive strategy to use regularly.
When you own a home or a car you generally buy insurance in case something bad happens. But few people buy insurance on stocks they own. A benefit of options is that you can buy insurance on a stock even after something bad has happened to the stock. In contrast, it’s virtually impossible to buy insurance on a home after say an earthquake has destroyed it or on a car after it has crashed. But if a stock you own has fallen in price and you think it may fall further, you can still buy insurance to protect against further losses.
The way to purchase insurance for a fixed time period on a stock you own is to buy a put option for that stock which gives you the right to sell the stock at a pre-agreed price, called the strike price, for a fixed period of time. For example, if you were worried that a stock might fall between now and some time in the future, you could purchase a put option on that stock in order to limit the risk of holding the stock for that duration. If the stock moves lower, the put option gives you the right to sell the stock at pre-agreed price over a certain time period.
Perhaps your concern stems from a stock specific event, such as an earnings announcement, or a risk related to the stock market or the economy. If you own a pharmaceutical stock, perhaps you are concerned about an upcoming FDA adjudication on a drug that may cause the stock to plummet if the decision goes the wrong way for the company. Regardless of the reason, you may wish to limit the risk of holding stock without insurance protection for a specific period of time. And the way to do that is to purchase a put option against your stock ownership position. For every 100 shares of stock owned, 1 put option contract could be purchased – which provides the insurance desired.
If the stock was trading in the market at $52 per share and you wanted to limit your risk exposure in case the stock moved lower, you could purchase a put option at a pre-agreed strike price, say $50. This means if the stock moved below $50 per share, you would still have the right to sell the stock for $50 per share. Even if the stock dropped all the way to $20 per share, you still would have the right to sell the stock for $50!
There is a cost to buying the insurance that comes along with buying puts so it’s generally not a strategy to be followed on a continual basis. If you did purchase put options on an ongoing basis, the sum of the premium costs could continually erode your portfolio value. However, from time to time, purchasing put options against stock you own can be a very valuable strategy to protect your portfolio from losses.