Understanding option trading could take up several textbooks on the nuances and strategies needed to trade these. I will help you understand the basics of option trading to see if it fits in with your overall investment strategy.
What is an Option?
When you buy a stock, you are buying a piece of that company. You own something that you can sell and should retain some level of value (outside of the company filing for bankruptcy). An option is a contract to either buy or sell a stock at a certain price within a given timeframe. By itself, an option is not ownership of a stock but rather the right to buy/sell that stock. It may help to think of options as stock insurance. If you had a large amount of a stock (Ex: you own $100k worth of a stock) you could buy an option as a safety net. Someone could agree to buy that $100k worth of stock from you for $80k any time in the next 2 years. In exchange for this “option”, you agree to pay them a premium of $10k. How does anyone make money in this example? Well the person who offered to buy your stocks for $80k just made $10k from you and they hope that the stocks never drop below that price, so they got $10k for free. Let’s say the company has a terrible year and the stock price drops where that stock is only worth $20k now. You can exercise your option and force the sale of the stock at the agreed-upon $80k which would minimize your losses substantially.
There are a couple of components to know about regarding options. You can either buy or sell the option to purchase stock at a certain price, or you can buy/sell an option to sell a stock at a certain price. These are “calls” and “puts”. Every option has a “strike” price (the amount the contract would be exercised for) and an expiration date (the date the contract will come to an end). It is also important to note that every options contract is for 100 shares of whichever stock it is associated with. It doesn’t matter if that stock trades for $10 or $1,000, all options are good for 100 shares.
What are the Advantages of Options vs. Trading Regular Stocks?
Trading options allow you to bet on whether you think a stock price will go up or down. In traditional stock trading, if I think a stock will increase in value, I buy as much of that stock as I can. If I spend $10k buying stocks and it goes up 10%, I just made $1,000. In that same example though, if I had spent that $10k on an option for that same stock and it went up 10%, I could make 10’s of thousands of dollars depending on the option and price of the stock. Think of it like a casino. I could spend millions of dollars and open a casino and make a nice return every year of 10% OR I could take those same millions and bet it all on black at the roulette table. If I bet right, I will make a ton more money but I’m also taking a much bigger risk at the same time because if my bet is wrong, I lose all my money. If I spent that money on building a casino and it didn’t succeed, I could probably still sell the casino and make back a decent portion of my investment.
What Makes an Option Price Go Up or Down in Value?
When looking at the “strike” price of an option, the further “in the money” you are, the more expensive it will be. The money refers to the strike price being better than the price the stock currently trades at. You also must look at the likelihood of the stock price going up or down within the timeframe it’s set for. Going past earnings dates will naturally increase the value of an option as those can cause stocks to drop or gain significantly. Typically, the longer an option has until it expires, the more valuable it will be. Options that are coming close to their expiration date and “out of the money” will likely decrease in value quickly as they are unlikely to be exercised and therefore not worth anything. To simplify things, you must look at how likely is the option to be exercised and how far “in the money” is it/ will it be when exercised to get a good idea of its value.
Are Options Worth Trading?
Just like any investment strategy, option trading has its pros and cons. It is a higher-risk strategy because you are essentially “betting” if a stock will go up or down within a certain timeframe. The main difference with options is that you can’t just hold them forever and hope their value will go up. They will typically lose value over time if they are not close to the strike price. Option prices can also drop or increase in value much quicker than a stock can. Depending on the option, a stock may only drop 10% but the option attached to that stock could drop over 90% in value. Of course, the opposite is true and a stock that increased 10% in value could raise an option attached to over 100%. As always, never invest more in an option than you would be willing to lose, and set a stop loss to avoid losing your entire investment.
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