Stock options trading explained simply
One option contract is good for shares of that underlying stock. The contract will also enforce a time frame to make that trade.
An option will expire at the close of the third Friday of the stated expiration month. In addition, the contract will specify a strike price. This is referring to the price of the underlying stock not the option itself. Call vs Put But wait, there is something we're still missing. You may be asking yourself, well so what? That's where another very important characteristic comes into play and that is Call vs Put. So which one do you choose? That depends on your personal belief on how IBM stock will behave.
Remember that an option contract has an expiration date. In our example, it is May 15, Well then you want to buy a Put Option.
To summarize, a Call Option gives you the right to buy low while a Put Option gives you the right to sell high. Remember that buying the option contract gives you that right. Which means the person selling you the contract is actually giving you that right. In both scenarios you are buying low and selling high! Now when I say you are buying and selling shares, it's not exactly correct. That's called an Option Assignment. And your brokerage firm will charge you a small fee for handling the nitty gritty transactions in the back end.
Option Premium The one thing we didn't talk about so far is how much does it cost to buy an option contract? That depends on two factors. How close the current market price is to the strike price and how much time is left before the option expires.
These two concepts are called Intrinsic Value and Time Value. A Call Option is said to have intrinsic value if the current market price is above the strike price. The rest of the option price is the Time Value. A quick side note about how option premiums are stated. When you see an option price quote, you will typically see the price divided by It's stated that way because one option controls shares.
Don't be confused or mislead and buy more options than you can handle! For a Put Option, obviously the Intrinsic Value would be based on how much lower the market price is relative to the strike price.
Time Decay An important factor to consider is the decay of time. The Intrinsic Value doesn't decay, just the Time Value. Buying and Selling Options All this discussion was assuming the fact that you would keep the option contract until expiration. But the fact is you may not want to. In reality many people do not buy and hold the option that long. If they see an increase in the option they bought they will most likely sell the option and take their profit.
Now you know that as time proceeds the decay in Time Value will decrease the value of your option. So the only way to make money is to hope that the underlying stock moves in your favour. But if IBM's market price increases as well, the decay in time value may be offset. You can probably guess by now that the closer the market price is to the strike price, the more the option is worth.
Now you can wait and see what happens on May 15th, but if you just wanted to take advantage of a short term price swing you can take your profits right now and run.
This section about reading options chains has been out dated, but it is still worthwhile to read through because you may still encounter these in various other websites. Click here to find out the latest method of reading options chains. Now that you know so much about options, lets talk about how to find them and how to interpret what you see. You can look at the diagram below or go directly to Yahoo by opening another browser page and entering the URL http: As you can see there is a table like the one below: The red circle indicates this is for May The first column shows all the available strike prices.
The green circle shows a weird looking symbol. It's certainly not the symbol for IBM, but it looks similar. There is a standard for listing option quotes which you can see by going to the cheat sheet see link on the right hand navigation. We provide more information on selling and exercising options later. One of the big advantages of options contracts is that you can buy them in situations when you expect the underlying asset to go up in value and also in situations when you expect the underlying asset to go down.
If you were expecting an underlying asset to go up in value, then you would buy call options, which gives you the right to buy the underlying asset at a fixed price. If you were expecting an underlying asset to go down in value, then you would buy put options, which gives you the right to sell the underlying asset at a fixed price. This is just one example of the flexibility on these contracts; there are several more. If you have previously opened a short position on options contracts by writing them, then you can also buy those contracts back to close that position.
To close a position by buying contracts you would place a buy to close order with your broker. There are basically two ways in which you can sell options contracts.
First, if you have previously bought contracts and wish to realize your profits, or cut your losses, then you would sell them by placing a sell to close order. The order is named as such because you are closing your position by selling options contracts. You would usually use that order if the options you owned had gone up in value and you wanted to take your profits at that point, or if the options you owned had fallen in value and you wanted to exit your position before incurring any other losses.
The other way you can sell options is by opening a short position and short selling them. This is also known as writing options, because the process actually involves you writing new contracts to be sold in the market. When you do this you are taking on the obligation in the contract i.
Writing options is done by using the sell to open order, and you would receive a payment at the time of placing such an order. This is generally riskier than trading through buying and then selling, but there are profits to be made if you know what you are doing. You would usually place such an order if you believed the relevant underlying security would not move in such a way that the holder would be able to exercise their option for a profit.
For example, if you believed that a particular stock was going to either remain static or fall in value, then you could choose to write and sell call options based on that stock.
You would be liable to potential losses if the stock did go up in value, but if it failed to do so by the time the options expired you would keep the payment you received for writing them. Options traders tend to make their profits through the buying, selling, and writing of options rather than ever actually exercising them. However, depending on the strategies you are using and the reasons you have bought certain contracts, there may be occasions when you choose to exercise your options to buy or sell the underlying security.
The simple fact that you can potentially make money out of exercising as well as buying and selling them further serves to illustrate just how much flexibility and versatility this form of trading offers. What really makes trading options such an interesting way to invest is the ability to create options spreads. You can certainly make money trading by buying options and then selling them if you make a profit, but it's the spreads that are the seriously powerful tools in trading. A spread is quite simply when you enter a position on two or more options contracts based on the same underlying security; for example, buying options on a specific stock and also writing contracts on the same stock.
There are many different types of spreads that you can create, and they can be used for many different reasons. Most commonly, they are used to either limit the risk involved with taking a position or reducing the financial outlay required with taking a position.
Most options trading strategies involve the use of spreads. Some strategies can be very complicated, but there are also a number of fairly basic strategies that are easy to understand. You can read more about all the different types of spreads here.
There are actually a number of benefits this form of trading offers, plus the versatility that we have referred to above. It's continuing to grow in popularity, not just with professional traders but also with more casual traders as well.
To find out just what it is that makes it so appealing, please read the next page in this section — Why Trade Options? What is Options Trading? Section Contents Quick Links.