Most people invest in the stock market at some point in their lives. Usually, they invest their money into equities, and few look into options trading. The latter form of trading is becoming more popular, but can be risky and result in substantial losses if not understood.
When trading options, one purchases an options contract. There are two forms of these contracts: calls and puts. A call option gives the holder the right, but not the obligation, to purchase a security at a given price. A put option takes the opposite position, giving the holder the right, but not the obligation, to sell a security.
Investors purchase calls when they think that the security will increase in value and buy puts when they believe it will fall. This seems simple, but there are many factors at play in these contracts.
Before purchasing an options contract, an investor should do thorough research on a company and predict whether the stock will rise or fall. Then, the investor needs to view available contracts for the stock and know that they are written for 100 shares, unless otherwise specified in the contract.
The options first appear in an options chain, which is a list of available contracts. The chains can be overwhelming, but are actually quite simple. An investor will need to decide to buy a call or a put and then choose a desired expiration date.
The expiration date is the date when the options contract is no longer valid, but the investor can exercise or sell the contract any time before that date. Options with an expiration date further in the future will be more expensive but give more time for the stock to reach the strike price.
The strike price is the price at which investors will purchase a security if they have a call, or sell a security if they have a put. For example, a call option with a $3 strike price and a January 2024 expiration date will give the investor the right to buy 100 shares of the stock for $3 per share anytime before January 2024.
If an options contract has a strike price of $3 and the stock is trading at $5, then this contract is "in the money." This means the security is trading at a price higher than the strike price, so if an investor exercises the contract, that investor will profit from the difference in prices. Buying contracts already "in the money" will be expensive because they will most likely also be "in the money" when exercised, but these contracts are not as risky.
Once investors have selected a desired strike price and expiration date, they must look at the price of the option. It is important to consider that sometimes it is cheaper to purchase equity in place of options. If a call option is priced at $0.50, then the contract will cost $50 because the $0.50 premium must be multiplied by the number of shares the contract represents, usually 100.
Options can also be used to leverage stocks. With each contract written for 100 shares, the price of a contract is almost always less than that of 100 shares of equity. If an options contract is purchased for a $0.50 premium when the stock is trading at $1, the rights to 100 shares are leveraged for half the current price.
To help understand these terms, consider this example: A call option is purchased at $0.50 in 2022 with an expiration date of Jan. 20, 2024, and a $3 strike price. When an investor purchased the call, the stock was trading at $1 per share, but is trading at $5 in 2023. When the investor exercises the contract, she receives 100 shares of the stock for $300 and is then able to sell them for $500. After the purchase price and premium are subtracted, the investor profits $150 while risking only the $50 paid for the contract. If she had purchased 100 shares she would have paid $100 and profited $400, but could have lost her entire investment.
If investors select the right options, they can make greater profits than from trading equities.
Employing strategy other than selecting a strike price and expiration date is an important component of options trading. One popular strategy is called a “straddle,” which is when a call and a put are purchased at the same strike price and expiration date for the same underlying security, which covers an investor in the case of the stock rising or falling.
Another strategy is a covered call, in which investors write call options for the same number of shares they possess. This earns the writers a premium and allows them to sell at the desired price if the security expires "in the money."
Options trading gives investors a chance to predict how the stock market will perform in the future while profiting from doing so. There are risks, however, and if a contract expires “out of the money,” then the premium paid is lost, but this loss is usually less than what would have been incurred with an investment in equity.