How Does Options Trading Work

How does options trading work

Since I routinely post about stock options trading, investing, hedging and income generation and get the occasional question, “How do Stock Options Work?” or “How to Trade Stock Options“, I figured I’d do a series on the various types of stock options strategies out there (they are numerous!) by starting with the most basic stock option strategies: Trading put and call options.

I’ll start with some definitions and then get into some real-life examples.

Stock Option Trading Basics:

  • A Stock Options Contract is a contract between a buyer and a seller whereby a CALL buyer can buy a stock at a given price called the strike price and a PUT buyer can sell a stock at the strike price.
  • 1 Stock Option contract represents 100 shares of the underlying stock
  • Think of a CALL and a PUT as opposites.
  • You can be a CALL Buyer OR Seller
  • You can be a PUT Buyer OR Seller
  • Given Puts/Calls and Buyer/Seller status, there are 4 main types of transactions we’ll cover today – Put Buyer, Put Seller, Call Buyer and Call Seller
  • If you are an option buyer, you pay the listed “premium” for the option; conversely, as a seller of an option contract, you derive income equivalent to the “premium”

Key Options Terms are the following:

  • Strike Price: This is the key price that drives the transaction.

    Options Trading for Beginners

    For a Call option, if the underlying share price is BELOW the strike price, the option is “out of the money” and if so at expiry, it will expire worthless. For a Put option, if the underlying share price is ABOVE the strike price, the option is “out of the money” and if so at expiry, it will expire worthless.

  • Expiration: This is the last date the option can be traded or exercised, after which it expires.

    Generally, there are options traded for each month and if they go out years, they are referred to as LEAPS. The same concepts hold for LEAPS as the stock options contracts we’re discussing here.

  • Premium: This is just another word for the price of the option contract.
  • Underlying Security: For our purposes, we will be discussing stock options.

    How do Stock Options Work? Trade Calls and Puts – Part 1

    If you’re holding a contract on Microsoft, you have the right (but not the obligation) to exercise 100 shares of MSFT.

  • Buyer or Seller Status: If you are the buyer, you have control of the transaction.

    You purchased the option contract and can execute the transaction or close it out or you can choose to allow the options contract to expire (usually only in the case where it is worthless).

    If you are a seller of an options contract, you are at the mercy of the buyer and must rely on the holder at the other end of the contract. There is the opportunity to “close out” the position

Stock Options Trading Example #1 – Call Buyer:

People trade stock options for myriad reasons.

Often times, it is purely for speculative reasons.

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For example, if you believe that the Swine Flu pandemic is going to become particularly troublesome and a stock with a vested interest in supplying vaccines in large quantities would stand to benefit from such a scenario, then perhaps you purchase an out of the money call option on Novavax. If shares are at $4.28 today and you think they could rocket past $10 on a massive epidemic, then perhaps you buy the January (expiry) 10 (strike) Call option. The cost (premium) is .70. The .70 is “per share” so .70*100=$70.

How does options trading work

This means it’s going to cost $70 to buy a single option contract, plus whatever trading commissions exist. Since you paid .7 or $70 and the strike price is $10 per share, by January expiry (the third Friday of every month), NVAX shares would need to be at $10.70 in order for you to break even.

How does options trading work

In order to have made money (in lieu of commissions), shares would need to exceed $10.70. If, for example, shares rocket to $20.00 at expiry and you sell the options back to close it out just prior to expiry, you’d pocket the difference between $20 and $10 and reap (10*100shares) = $1000.

Given your initial $70 investment, even though shares only went up about 5-fold from $4.28 to $20, the option returned over 14-times the initial investment ($1000/$70). As you can see, utilizing these leveraged instruments can lead to big gains quickly. However, most options actually expire worthless – about 2/3 by most conventional estimates. There’s no free ride. For everyone looking for a speculative home run, there’s a seller on the other side deriving income from a speculative buyer thinking that the stock WILL NOT reach the strike price they sold at, so they’ll get to keep that .7 at the end of the expiry in January.

Note that at the other end is a Call Seller which is often someone engaging in covered call option writing strategies – this can be a lucrative option strategy worth checking out as well.

Stock Option Trading Example #2 – Put Buyer:

When wondering if anyone actually made money during the economic collapse, the answer is a resounding YES!

Opening an options trading account

People who were holding puts on Financial and Real Estate stocks especially, made large returns on investment given the precipitous declines in shares of those companies. If for example, you feel we’re in for another economic calamity due to commercial mortgages collapsing next, and all Financials are going to fall, you could buy a Put option on the Financials ETF XLF, which is representative of the Financial sector at large.

How does options trading work

With a share price of $13.34, let’s say you buy a Dec09 expiry Put with a strike price of $10. That means that you expect the XLF ETF to drop well below $10 per share by December. The premium (or your cash outlay) for such a play is .25, or $25 per contract. That’s relatively cheap.

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But keep in mind that you’re talking about a 40% drop to just break even. If the XLF collapses and returns to its March lows of around $6 per share, your put would be worth about $4 at expriy (10-6).

That represents a 16x return on investment. Imagine the players that had the foresight to buy out of the money puts in 2007 and 2008?

How to Trade Stock Options?

There are various online brokerage outfits that allow you to trade stock options.

How Does Options Trading Work?

For most outfits, you can buy options without any special requirements. If you’re looking to sell options, because your risk is much greater (or unlimited for selling naked/uncovered calls), you generally need to sign up for a margin account and agree to risk notifications.

Here are the top online options trading brokerages based on reviews and costing:

1.

optionsXpress – Awesome $100 Signup Bonus Running Now.

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Plus, $12.95 for 1,5, or 10 contracts – flat fee if hitting 35 traders/quarter. Otherwise $14.95/trade.

How does options trading work

A good price for newer/smaller options traders. Stocks are $9.95 per trade if greater than 8 trades per quarter or $14.95 for 8 or less trades.

2.

Zecco – Another incredible pricing scenario –

Get 10 free stock trades every month with $25,000 balance or 25 trades each month $4.50 otherwise

3.

Consider the core elements in an options trade

tradeMONSTER – $7.50 Stock Trades across the board. $12.50 Options Trades for up to 20 contracts.

4.

How does options trading work

OptionsHouse.com – An incredible $2.95 Stock Trading Price and $9.95 Options Contract Pricing.

5. Tradeking is widely knows as best in class for service and cost.

Essential Options Trading Guide

I endorse TradeKing and I have an account myself. $4.95 stock trades and competitive on everything from Options to Margin. Check it out!

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Tagged as: How do options work, Trade Stock Options