This article was last updated on December 27
Over the last 10 years I have traded all sorts of financial instruments. One that I have found particularly useful in volatile times like we have now, are options. Options provide a way to make money from both rises or falls in stock prices. It is also allows you to implement risk management strategies to protect existing holdings.
But Option trading is a high-risk, high reward trading strategy and I do not recommend you get into it without spending the time and effort to understand the topic because they magnify losses just like they do the gains. Before you start on option trading make sure you follow the market for a while, feel comfortable with investing and trade with funds that you can afford to loose.
This post covers 30 useful things to know about how options work, and is based on tips from my own real life trading experience. Hopefully it will help those new to options who just want to understand how they work and perhaps to start trading them. I have also tried to simplify the jargon where possible, but feel free to leave a comment on this post if you want more clarification.
- The most common options are “calls” and “puts”. An option is called a derivative trading instrument because it “derives” its value from another underlying asset – in this case a stock.
- Buying a Call Option – You are betting that a stock will go up.
- Buying a Put Option – You are betting that a stock will go down.
- You can create all sorts of option trading strategies by buying combinations of the underlying stock and the call and put options related to it.
- One option’s contract controls 100 shares of stock. Option prices are quoted on a per share basis, and because the minimum you can buy is 100, make sure you do the math. E.g., An AAPL $100 December call option costs $1.80. To buy this contract you would need a minimum of $180 to purchase 1 contract (100 x $1.80 = $180)
- Three important components that affect the price of an option.
– Strike Price = the price at which you are allowed to buy (call) or sell (put) the stock
– Term = The time remaining before the option expires
– Current Stock Price of the underlying asset (stock)
- A call option is classified as “in-the-money” when the strike price is less than the current stock price. It is “out-of-the-money” when the strike price is greater than the current stock price. The reverse is the case for put options. Out-of-the-money does not mean the option is worthless because there is a time value component as well. In fact out of the money options valuation is completely based on the time (value) to expiry and probability that the option will get back into-the-money before the term expires.
- The value of an option is basically determined by the price of the stock, the time until the option expires, and the strike price. There are many more variables and complex models (like Black-Scholes) to determine option pricing, but for basic trading its best to keep to simple and focus on the main variables. From my trading experience, the time to expiry and current stock price are the key factors in determining the value of an option.
- Everything else being equal, as time runs down, the option will lose value. This is known as option time-decay and means that option trading is definitely not a viable form of long term investing.
- The other attribute that affects the option value is volatility. The faster the stock price moves up or down, the higher the option’s value. Why? A volatile stock has a better chance of hitting the strike price than a stock that moves 5 cents a day. But, keep in mind that this attribute is already built-into the price of option. You only benefit if the stock becomes more volatile than expected during the options period (term).
- Remember, you can bet that a stock goes up or down, so you can make money in any environment that isn’t a straight line (which is a rarity for long periods of time).
- Biggest advantage of options: Leverage. You control a lot of stock with minimal money. For example, if you purchase five options contracts for $1,000 (5 contracts x 100 shares x $2.00 per option = $1,000) you are controlling 500 shares. Say those shares trade at a stock price of $20. In order to purchase 500 shares of the stock, you would need $10,000.
- Disadvantage of options: The value of an option value can go to zero, very quickly. As time runs down on the option’s term, the value of the option drops if it is “out-of-the money”. If the stock price has not moved much during the term, the value of the option drops. The most popular options have a term of 2 to 6 months, so you need something to happen fairly quickly or your investment disappears.
- If the strike price is above the stock price, the option is considered “in the money”. There is nothing wrong with buying “in the money” options, but keep in mind that you will be paying a premium for them – the amount between the stock price and the strike price plus an option premium.
- If the option’s strike price is to far “out of the money” and time is running out, even a big move in the stock will not likely increase the option value significantly. This makes having discipline when buying and selling options critical.
- It is probably best to buy options that have a term of at least three months and are no more than 10 to 20% “out of the money”. Example: Stock price = $100, Strike price = $120, therefore the option’s strike price is 20% “out of the money”)
This concludes Part 1, covering what options are how they are valued. Part 2 discusses how to effectively trade options and what signs to watch for before buying/selling. You can find that article here.