If you’re into investing, then you’ve likely heard of a strategy called options trading. While it may seem like a mysterious technique used only by an inner circle of elite traders, options trading can be done by even beginners. Join us for a breakdown of what exactly options trading is and how it works.
What Is Options Trading?
Options trading at its most basic is actually a fairly simple concept. An option is a contract that gives the holder the right to buy or sell something at a certain price (known as the strike price) by a certain date. There are two different types of options you should be aware of:
- Call Options- Calls give the owner the right (but not obligation) to buy a specified number of shares for a specific price by a specific date.
- Put Options- Puts give the owner the right (but not obligation) to sell a specified number of shares for a specific price by a specific date.
Options can be purchased to cover a variety of different time periods, ranging from days to years. Investors purchase options for a variety of reasons, such as to protect their portfolios or even to generate a profit.
How Does Options Trading Work?
An easy way to think of a call option is sort of like a coupon. The main difference is that while coupons tend to be free, you have to pay what’s known as a premium to purchase a call option. Be aware that premiums are non-refundable, whether you end up using or selling the option or not. That said, in certain circumstances, it can be worth it.
Say that you see a company called ABC Inc. that’s been trending upward and is currently priced at $28/share. You read in an article that ABC Inc. is about to release a new product next week and you think it’s going to be a game-changer. So you purchase a call option that gives you the right to buy 100 shares of ABC Inc. at a strike price of $30 at any time throughout the next month. Sure enough, the product is a hit and a week later ABC Inc. is suddenly trading at $50 a share. At this point, you can either pull out your “call coupon” and buy the shares at a discount, wait to see if the price goes even higher, or sell your “call coupon” for a profit to someone who is interested in using it to make a purchase.
Put options, on the other hand, are basically a form of insurance. Say that a company known as XYZ Inc. is trading for around $75 per share. You got in on the game early and even own 100 shares yourself. While the company has been doing well, it’s obviously being oversold and you fear the price is due for a downward correction soon. Rather than cash out, you can buy a put option that gives you the right to sell your shares for a strike price of $71.25 each within the next month. Even if things take a turn for the worst and XYZ plummets to $50 a share, you can still exercise your option to sell your shares for $71.25 each at any time before the expiration date.
What Is the Difference Between Stocks and Options?
The main difference between stocks and options is that stocks are shares of ownership in a company, whereas options are contracts that give you the right (but not the obligation) to buy or sell a specified number of shares at a certain price by a certain time.
When it comes to stocks, you pretty much either own them or you don’t. When stock traders believe a company’s shares are going to go up in value, they’ll usually purchase some and ride the price up before selling them for a profit.
Options traders, on the other hand, might simply buy a call option, giving them the right to purchase a certain number of shares at a specified strike price. Until they actually exercise their option, however, they don’t actually own the shares. The perk of this approach is that they have until the call’s expiration date to see if the purchase is worth it. If the stock price rises above the strike price in their call option, they can buy the shares for an instant profit. The downside is that if the price drops, the option is worthless.
How Are Options Priced?
Options can be priced in different ways, but their prices generally revolve around two key factors. The first is called intrinsic value, which refers to how much potential for profit the option offers.
The price will be affected by whether the option is in-the-money (ITM) or out-of-the-money (OTM). ITM options mean that the holder can currently buy or sell the specified shares for a profit. An OTM option is one that doesn’t currently have the ability to be exercised for a profit, but might before its expiration date.
Option prices are also affected by time value, which has to do with how much time the stock has left to rise or fall before the expiration date. Time value takes into account things like volatility and the difference between the option’s strike price and the price at which the stock is currently valued.
Best Options Trading Platforms
If you already have a brokerage account, it’s highly likely that it will give you the option to trade futures. If you’re looking to open an account with a new brokerage, however, here are some of our favorite options trading platforms:
- Best no-commission options platform: Webull
- Best overall options trading platform: tastyworks
- Best for beginners: Schwab
- Best for advanced traders: Interactive Brokers
Be sure to do your research and make sure you select a broker that offers low fees and the tools you need to get started.
Why Is Options Trading so Risky?
Much like trading stocks, the level of risk you subject yourself to by trading options goes somewhat hand in hand with your level of knowledge. Just as an experienced stock trader with a thorough knowledge of fundamentals and chart reading is going to do better than an inexperienced trader, options trading often comes down to knowing the rules and how to play by them.
So does that mean that experienced options traders always make a profit? Not necessarily. The more you learn about options, the more you’ll understand which options are riskier than others and why.
Gaining a thorough knowledge of options is less about guaranteeing that you’ll always make lower-risk choices and more about guaranteeing that you’ll always understand the level of risk you’ll be undertaking with each trade.