While trading stocks is a familiar concept to many, the more complex world of options trading exists in some obscurity to the average person. Given that it is a good way to hedge a portfolio, more and more investors want to learn about options trading. The following is an introduction to the process that covers everything from common terminology to the basics of options trading.
What is an Option?
An option is a contract that involves a bundle of shares, as opposed to individual shares. Options typically involve 100 shares of stock. When you enter into an option contract, you commit to either buy or sell the shares of the stock at a predetermined amount by a certain date.
As a contract, an option allows you more flexibility than purchasing individual assets. In addition to buying or shorting the shares of the stock, you can also sell the contract to another investor or just let the contract and your financial obligation to the contract expire.
Why Trade Options?
Investors turn to options trading for a number of reasons. One is that options trading offers a way to hedge against risks in the rest of a portfolio. In other words, trading an option on a company that you already have stock in can protect against any short-term volatility in that stock. Trading options also require a smaller initial investment and give you time to see how a company will perform in the longer term.
The Terminology of Option Trading
Options trading has its own language. Getting to know the terms is an important first step before you attempt any trading. One of the central concepts in options trading is what is known as the “strike price”, or the price per share at which the contract executes a buy or a sell. You sometimes hear this referred to as an “exercise price”.
Options traders also refer to their options as either in-the-money or out-of-the-money. Respectively, these mean that an options contract is either showing a profit or not showing a profit. Finally, you need to know that a call option involves buying the shares, while a put option involves selling or shorting the shares.
The Central Components of an Options Trade
An options trade involves three central components: the direction a stock will move, how much that stock will move, and over what timeframe that will happen. When you enter into an options trade, you need to consider each of these carefully. If there is a company you have had your eye on, consider how dynamic it has been in the past and how long it has taken in the past to show dynamic movement. Expiration dates on an options trade can be as short as days but also run into the months or years.
Understanding Option Prices
Since option trades involve price over time, the value of an option is not a static sum. It involves two components: an intrinsic value and a time value. The intrinsic value of an option relates to how close the underlying stock price is to the exercise price. If you believe a stock is going to rise from $100 to $120 and you buy a call option, as an example, the intrinsic value of your options increase as the stock rises towards that $120. The time value of the option involves everything else related to price, including volatility, time until the option expiration, and interest rates, to name a few.
Finding a Broker
Given its complexity, options trading requires more screening than stock trading, so you need to have a clear picture of your financials before proceeding. Once you have a basic understanding of options trading, you need to reach out to a broker. The process for opening an options trading account at a brokerage is quite complex. When you reach out to brokers, you will need to answer some detailed questions about your investment history, your financial status, and your experience with trading. The broker then assigns you a number between 1 and 5 that defines the level at which you can trade options. With a basic understanding of the process and a bit of luck, you can begin expanding your portfolio with this unique approach to the stock market.