So you've heard a lot about options trading, but with all the jargon flying around, you're probably a little confused. Condors, butterflies and bull call spreads, oh my! We aren’t in Kansas anymore, Toto.
The truth is that options are a little more complicated than stocks, but not much. And they are very flexible tools once you master the basics, so you've come to the right place to learn options trading. We'll walk you through the key concepts, and once you've mastered that, we'll teach you about the more sophisticated concepts and strategies you can use.
What Is A Stock Option?
Stock options are simply contracts that give the owner the right to buy (e.g., call option) or sell (e.g., a put option) a stock at a specific price at some time in the future. That price is called the strike price. The period of time could be as short as a day or as long as a couple years, depending on the option. The cool thing about buying an option is you have the right, but not the obligation, to buy or sell that stock.
And for every options buyer there is a seller, who has to take the opposite side of the trade. Unlike the buyer, the seller has the obligation to sell or buy that stock if the buyer exercises his option.
Remember, there are only two types of options: calls and puts. But you can combine them to create dozens of different strategies.
Options are quoted with a bid (what someone is willing to pay) and ask (what
someone is willing to sell for) the option. Options may be bought, or sold,
using either market orders or limit orders. Since options typically have lower
volumes and have wider bid-ask spreads, it's often a good idea to use limit
orders when placing a trade to get an execution price in-line with what you
are willing to pay.
A single equity option contract represents an option on 100 shares of the underlying stock. Quotes for equity options are multiplied times 100 to yield a total cost for the position.
Strike prices are the stated price per share for which the underlying security may be bought or sold. Equity option strike prices are listed in increments of 1, 2½, 5, or 10 points, depending on their price level.
If a stock option is purchased it is considered to be a debit trade (premium paid). If a stock option is sold, it is considered to be a credit trade (premium collected).
Understanding an Option's Profit Potential
One of the most useful things you'll learn in trading options is how to read a "profit curve", which visually shows the profit potential of your trade.*
In this chart, you are looking at the value of a call option at expiration depending on where the price of the underlying stock ends up on that day. Let's break it down:
- When you purchase an option, you pay the "option premium" for the right buy that stock. So unless the stock moves up by expiration day, you're simply out that money.
- If the price of the stock moves up past the "strike price", then you start making that money back. And if it moves up enough, you've turned a profit! As you can see on the chart, the profit potential of a call option is in theory limitless. As long as the underlying stock price continues to increase, the value of your option will continue to increase. And since a single option contract controls 100 share of stock, the value of your option moves up 100 times as fast as a single share of that stock.
- If the price of the option goes down, you're simply out the option premium. You can never lose more than the premium paid (plus any commissions you paid).
So as you see from the chart, a call option has limited downside equal to the premium paid and theoretically limitless upside. Pretty nifty, right?
Options Premium and the Profit Curve Before Expiration
When you buy an option, the profit and loss curve looks a bit different than it will on option expiration day*. That's because the value includes the "option premium". In other words, when you buy an option you could possibly turn around and sell it and recoup most or all the premium you just paid.
The premium is determined by a variety of factors:
- The "intrinsic value" of the stock option, which is just the value of that option at expiration.
- The "time value" of the stock option. That's pretty logical... the more time you have before an option's expiration date the higher the chance that it could hit or exceed the strike price. So as you get closer to expiration day, the "time value" decays away.
- The volatility of the underlying stock. Again, that's pretty logical. If a
stock has been bouncing all over the place recently, then the chance that it
will make a big move in your favor is usually higher. If you bought an option
whose volatility was pretty low and all of a sudden the underlying stock starts
bouncing around more, then your option is usually going to be worth more.
- The difference between the underlying stock price and the option strike price. The closer the stock price is to the strike price, the higher chance the option will expire in the money.
- Interest rates on free capital.
So how does this play out? As we said, at any point prior to expiration, your option is usually going to be worth more than the intrinsic value. Below is a typical call option profit curves prior to expiration day:
The math behind these curves is actually really complicated. But never fear, the stock options analytics tools on Zecco.com will draw them for you instantly. Just pick an option, add it to the P&L calculator, and use the sliders to play with changes in expiration date and volatility.
More on Stock Option Volatility
There are actually two kinds of volatility - historic and implied. In theory, the historic volatility of an underlying security should affect the stock price in a very specific amount. But if you look at any given option, there is often a difference between the historic volatility and the "implied" volatility that is priced into the stock. Maybe there is a big earning announcement coming up that could cause a big move one way or the other. Regardless, if you believe that the marketplace is an efficient mechanism for processing information, you might want to focus on implied volatility. That is volatility "implied" by the marketplace.
Some people compare historic and implied volatility in search of under-priced options, but others adhere to the idea that the marketplace is inherently efficient and there is no such thing as "underpriced options". Remember, though, that while implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Expiration
An option will automatically exercise if it is worth more than $0.01 at the expiration date of the option. There is no commission charged if an option is automatically exercised -- although lack of buying power in an account will potentially result in delivered shares being sold immediately on the open market at a prevailing market price. Most options traders manage option positions carefully -- especially in the days leading into the option expiration. In fact, most options traders sell (or close) their positions prior to expiration to cash out and avoid dealing with acquiring (or providing) the underlying stock.
Dividends and Voting Rights
Option holders do not enjoy the rights due stockholders including voting rights or receipt of dividends.
LEAPS
A LEAP option (Long Term Equity AnticiPation Security) has an expiration date that extends out two years. They are available on about 450 stocks. LEAPS always expire in January.
Benefits and Risks
One of the biggest advantages of an option, over holding a stock position, is investment leverage. The amount of buying power required to put on an option position is usually substantially less than the amount of buying power required to purchase underlying stock shares. Thus, percentage gains can be high relative to the amount of money put at risk.
But losses from holding an option can be equally dramatic. In general, options are considered to be a speculative investment.
Options are short-term investments where gains and losses occur within a 12-month period of time. They are often subject to rules governing short-term capital gains.
*These examples omit the costs associated with trading options, and you'll need to figure that into your overall returns. At Zecco Trading, options commissions are just $4.50 per trade and $0.50 per contract.