Options trading can be very complicated, especially for beginners. Words like premium, delta, puts, and calls may scare you away. If you are looking to dip your toes into the options market, you should first learn the basics.
What Is an Option?
An option is a contract that gives the buyer (the holder or owner of the option) the right to buy or sell an asset at a pre-determined price (strike price) by a specified date (expiration date). Buyers pay a premium for the option and may lose that initial investment if the stock doesn’t perform well.
If you buy an option, you are buying the right to buy or sell a security or asset at a specified strike price and in a certain time-frame. The seller must allow you to exercise that option.
For instance, say the premium on an option is $5 for 100 shares, so $500. Assuming that it’s a call option, it gives you the right to buy stock (not sell it), at the contract’s strike price of $90 and the maturity date is a month later. If your options go up in value on or before the maturity date, say $100—meaning you are up to $10 per share ($100-90)—your options are “in-the-money” by $10. If you multiply that by 100 shares, then you will get $1,000. Subtract your initial investment of $500 and you’ve got a tidy $500 (excluding commission and fees).
If the value of those shares had decreased, however, you would be out $500. Your options would expire “out-of-the-money” and become worthless. That’s one of the risks of trading options.
A call option, which is used for buying (not selling), gives you the right to buy the underlying security at a set price any time up to your option’s expiration date. You would usually buy call options if you expect the value of the underlying asset to increase within a certain time frame.
A put option gives you the right to sell (not buy) security in a certain time-frame. You would usually buy put options if you expect the value of an underlying asset to go down. If your speculation pans out, you can sell the stock at a price higher than its current value. This is one way of “short selling” the stock, or betting that the stock’s value will decrease.
How to Trade Options
Options are traded on major exchanges and they are regulated by the Securities and Exchange Commission (SEC). To trade options, you will need to work with a brokerage firm that supports options. If you enter the options market as an individual investor, you will be required to submit an application first. This is because trading options come with very serious financial risks and regulators don’t want ordinary investors getting in too deep.
Options trading is not for everyone. It’s not ideal for an average person with a busy life and no investing experience or expertise. However, if you have some extra money and you really want to trade options, go ahead. Just make sure you do your homework.