Last updated on April 21st, 2022 , 01:55 pm
Ever wondered what stock options are, and what the benefits of trading options are as opposed to simply trading stock?
Keep reading to learn options trading basics and why people trade them. You’ll learn each concept with visualizations to help you understand options logically.
TAKEAWAYS
- Options are leveraged securities, which means profits and losses are magnified.
- Options typically have less principle risk than stocks.
- Options can be combined to profit from any market direction, including markets that go nowhere.
- All options have a 1.) Strike Price 2.) Expiration Date and 3.) Contract Multiplier (typically 100×1)
- Call options profit in bullish, or rising markets.
- Put options profit in bearish, or falling markets.
- Just like stocks, options can be both bought and sold.
What is Options Trading?
Options trading is the act of buying/selling a stock’s option contracts in an attempt to profit from the stock’s future price movements. Traders can use options to profit from:
1.) Stock price increases (bullish trades)
2.) Stock price decreases (bearish trades)
3.) When a stock’s price remains in a specific range over time (neutral trades).
Option Trading Benefits
The benefits of option’s trading are innumerable. Here are a few of the more important benefits.
- Leverage
With options, traders can leverage return potential, which means significant gains can be made with relatively small amounts of money.
For example, an options trader can risk $500 and make $500 (100% return on investment) if their stock price prediction is correct. When buying shares of stock, the stock price must increase 100% for you to double your investment.
However, there’s also the potential to lose more money compared to trading shares of stock. Leverage can work for or against you, but when used carefully it can increase returns on investment immensely.
- Reduce Risk
Another huge benefit of trading options is that the strategies used can sometimes have significantly less loss potential compared to buying/shorting shares of stock. This does not apply to all option’s strategies, but certain strategies do indeed reduce risk when compared to stock trading.
- Custom-Tailored
As mentioned earlier, options can be used to profit from virtually any stock price movement (or lack of) in the future. They can even profit when the stock does not move at all!
Unique Option Characteristics
Before getting to the specific details related to options, we need to first cover the 3 unique characteristics of option contracts:
1.) Expiration Date
All options have expiration dates, which is the date the option’s final value is determined and can no longer be traded.
Stocks typically have options with expiration dates ranging from a few days to two years away.
Longer-term option’s are referred to as “long-term anticipation securities”s or simply LEAPs.
2.) Strike Price
An option’s strike price is the price at which shares will be bought/sold if an option is exercised. We’ll talk more about this in a moment.
3.) Contract Multiplier
The number of shares an option contract can be converted into. Typically, equity options like AAPL options have a contract multiplier of 100 (each option can be converted into 100 shares of stock). Index options are NOT settled via delivery of stock, but cash.
Options and Leverage (Trade Example)
Our first trade example will demonstrate how options can leverage returns compared to simply buying shares of stock.
Trade Example: Stock Trade vs. Option Trade
Stock Trade ➜ Buy 4 Shares for $150. Sell 30 Days Later for $160.
Profit ➜ +$40 (6.7% Return: $40 Profit / $600 Investment).
Option Trade ➜ Buy the 30-Day 150 Call for $5. Sell for $10 in 30 Days (Stock at $160).
Profit ➜ +$500 (100% Return: $500 Profit / $500 Investment).
As we can see, the option trade resulted in a much more significant return relative to the money invested. However, if the stock price remained at $150 over the 30-day period, the stock trader would not have lost any money, while the options trader would have lost the entire $500 investment.
If you’re wondering, buying a $5 option costs $500 because of the option contract multiplier of 100. The $5 option price is on a per-share basis, which means the actual cost of the option is 100x more than the option’s displayed price.
The Two Option Types
Now that you’ve seen the power of options, let’s get into the two option types.
The first option type is a call option:
Call Option: This type of option gives buyers the right to buy 100 shares of stock (per contract) at the option’s strike price before the option expires. Here are some examples of what this means:
| Strike Price | Meaning |
|---|---|
|
$100 |
Call buyer has the right to buy 100 shares of stock for $100/share before the option expires. |
|
$120 |
Call buyer has the right to buy 100 shares of stock for $120/share before the option expires. |
Since there’s more value in having the ability to buy shares of stock at lower prices, call options with lower strike prices cost more money:
| Strike Price | Hypothetical Option Price |
|---|---|
|
$100 |
$3.50 |
|
$120 |
$0.06 |
Additionally, call options at lower strike prices have a higher probability of being valuable at expiration, as call options only have value at expiration if the stock price is above the call’s strike price at the time of the expiration date.
Call Option Example
To make sure call options make complete sense to you, let’s look at a hypothetical trade example to demonstrate the profit/loss potential when buying a call option.
Call Trade Example
Stock Price ➜ $50
Trader’s Prediction ➜ Share price will increase to $60 in two months.
Option Trade ➜ Buy the 50 call that expires in 60 days for $5.00.
| Stock Price in 60 Days | P/L of Call Option | P/L (+100 Shares) |
|---|---|---|
|
$0 |
-$500 (Call Worthless) |
-$5,000 |
|
$50 |
-$500 (Call Worthless) |
$0 (Call Worth $5) |
|
$55 |
$0 (Call Worth $5) |
+$500 |
|
$60 |
+$500 (Call Worth $10) |
+$1,000 |
|
$65 |
+$1,000 (Call Worth $15) |
+$1,500 |
At $50 or less (at or below the call’s strike price), the option will be worthless at expiration because there’s no value in being able to buy shares of stock at $50 with the call option when the stock price is at or below $50.
At $55, the call option is worth $5 at expiration because the ability to buy shares of stock $5 below the current share price is worth $5/share.
At $60, the call option is worth $10 at expiration because the ability to buy shares of stock $10 below the current share price is worth $10/share.
At $65, the call option is worth $15 at expiration because the ability to buy shares of stock $15 below the current share price is worth $15/share.
Compared to buying shares of stock, buying call options can have significantly less loss potential when the stock price falls substantially. However, for the call option to break even or profit, the stock price must increase.
Selling Call Options
Just like shares of stock, call options can also be sold as an opening trade. For instance, let’s say a stock is trading for $100 and we sell the 110 call for $5.00:
When selling call options, as long as the stock price is below the call’s strike price at expiration the position will be profitable. However, if the stock price rises substantially, the loss potential on a short call position is theoretically unlimited.
Here’s how this particular short call position would perform based on various stock prices at expiration:
For instance, if the stock price rose to $200 by the call’s expiration date, the loss would be $8,500 per call that was sold.
With the stock at $200, the 110 call would be worth $90 because the ability to buy shares $90 below the current share price is worth $90/share. Since the call was sold for $5, the loss would be $85 on the option, which represents an $8,500 loss per contract due to the option contract multiplier of 100.
At $115, the call would be worth $5 and there would be no profits or losses.
At $110 or lower, the 110 call would expire worthless and the call seller would keep the $500 collected when initially selling the call.
Because of the risk outlined above, it’s not advised to sell call options without protection in the form of long stock or another call option purchased against the short call.
The Second Option Type: Puts
Put Options give buyers the right to sell 100 shares of stock (per contract) at the option’s strike price before the option expires. Here are some examples of what this means:
| Strike Price | Meaning |
|---|---|
|
$80 |
Put buyer has the right to sell 100 shares of stock for $80/share before the option expires. |
|
$90 |
Put buyer has the right to sell 100 shares of stock for $90/share before the option expires. |
Since there’s more value in having the ability to sell shares of stock at higher prices, put options with higher strike prices cost more money:
| Strike Price | Hypothetical Option Price |
|---|---|
|
$80 |
$0.49 |
|
$90 |
$3.50 |
Additionally, put options at higher strike prices have a higher probability of being valuable at expiration, as put options only have value at expiration if the stock price is below the put’s strike price at the time of the expiration date.
Like we did with calls, let’s go through a hypothetical put option trade example:
Trade Example: Put Option
Stock Price ➜ $200
Trader’s Prediction ➜ Share price will fall to $190 sometime over the next 30 days.
Option Trade ➜ Buy the 30-Day 200 Put for $6.50
| Stock Price in 30 Days | P/L of Put Option | P/L (-100 Shares) |
|---|---|---|
|
$250 |
-$650 (Put Worthless) |
-$5,000 |
|
$200 |
-$650 (Put Worthless) |
$0 |
|
$195 |
-$150 (Put Worth $5) |
+$500 |
|
$190 |
+$350 (Put Worth $10) |
+$1,000 |
|
$175 |
$1,850 (Put Worth $25) |
+$2,500 |
At $200 or higher (at or above the put’s strike price), the option will be worthless at expiration because there’s no value in being able to sell shares of stock at $200 with the put option when the stock price is at or above $200.
At $195, the put option is worth $5 at expiration because the ability to sell shares of stock $5 above the current share price is worth $5/share.
At $190, the put option is worth $10 at expiration because the ability to sell shares of stock $10 above the current share price is worth $10/share.
At $175, the put option is worth $25 at expiration because the ability to sell shares of stock $25 above the current share price is worth $25/share.
Compared to shorting shares of stock, buying put options can have significantly less loss potential when the stock price increases substantially. However, for the put option to break even or profit, the stock price must fall.
Selling Put Options
Just like calls, put options can also be sold. For instance, here’s how selling a put would work out if we sold a 170 put for $7 on a stock that was trading for $190:
As long as the stock price is above the put’s strike price at expiration, the position will realize a full profit and 100% of the option premium collected when selling the put will be kept. The reason for that is the put will be worthless because there’s no value in the ability to sell shares at a price below the current share price.
However, if the share price falls, selling put options can result in significant loss potential:
For example, if the stock price fell to $150 by expiration, the 170 put would be worth $20 because there’s a $20-per-share value in being able to sell shares $20 above the current stock price.
Since the put was sold for $7, an increase to $20 would represent a $1,300 loss per put contract that was sold. The worst-case scenario when selling puts is that the stock price falls to $0 (the company goes out of business) before the option expires.
Final Word
Trading options has its benefits over trading shares of stock, but, as you’ve learned, there are also some massive risks related to trading options. Hopefully, you’ve learned the basics of how options work and are prepared to keep learning.
Want to go in-depth on options trading? Read our complete guide here!
NOTE! In order to trade options, you must first be approved for options trading by your broker.
