An “option” in the finance world entitles the holder of the option to buy or sell an asset at a pre-determined price, on or before a certain date. The buyer pays a premium for the option, and may lose that initial investment depending on how the stock performs. If that sounds confusing, fear not. We’ll break it down for you in our guide to options.
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What Are Options?
If you buy an option, you’re purchasing the right to buy or sell an asset (usually a stock) at a certain price and in a certain time-frame. The seller must let you exercise that option. The buyer of an option pays a premium for the privilege of having the option to buy or sell at a predetermined “strike price” on or before a certain date.
The investor’s initial outlay is that premium multiplied by the number of shares at stake. Let’s take a slightly simplified example. Say the premium on an option is $4 for 100 shares, so $400. Assume we’re talking about a call option, which entitles the purchaser to buy stock, not sell it. The strike price in the contract is $80, and the maturity date is a month later. At some point on or before that date the stock is trading higher, at say $90, meaning the investor is up $10 per share ($90-80). The options are “in-the-money” by $10. Multiply that by 100 shares and you’ve got $1,000. Subtract the initial investment of $400 and you’ve got a tidy $600 (not including commission and fees).
Nice, right? But if those shares had decreased in value, our hypothetical investor would be out $400. The options would expire “out-of-the-money” and be worthless. That’s the risk you run when you dabble in options.
The most common form of option, and the one described above, is a call option. A call option is an option used for buying, not selling. The buyer of the option is hoping that, at the time he or she “calls” the option, the price of the stock will have risen beyond the strike price. That way, the agreed-upon price the buyer pays will be lower than what the stock is worth. When you bet that a stock will increasing in value you’re “going long” on that stock. You can then a) exercise your option to buy the stock and either hold it or turn around and sell it on the open market, or b) close out with the entity that sold you the options. When you close out (also known as “trading out”) you perform what’s called an offsetting trade by selling the option you originally bought. You never actually own the underlying asset.
A put option is an option that gives the buyer the right to sell (not buy) an asset in a certain time-frame. It’s the counterpart to a call option. As you might expect, the buyer of a put option is hoping that the stock price will have decreased since the original options contract date. If it has, the buyer of the option can sell the stock for a higher price than the stock is now worth. This is one way of “shorting” the stock – i.e. betting that its value will drop.
How to Trade Options
Options are traded on major exchanges and the options market is regulated by the Securities and Exchange Commission (SEC). You’re likely better off trading regulated options as opposed to trading over-the-counter (OTC) unregulated options or gambling on binary options. To enter the regulated options market, though, you’ll need to go through a brokerage firm. The broker will handle your options contract. You can check options tables online to find out how you’re doing.
Ready to go try your luck on some options contracts? Not so fast. If you want to enter the options world as an individual (“retail”) investor you’ll be required to submit an application first. Why? Because options carry very serious financial risks and regulators don’t want ordinary people getting in too deep. In your application, you’ll need to answer questions about your investing experience and knowledge.
Dabbling in options is not for everyone. Conventional wisdom states that the average person with a busy life and not a lot of investing expertise would likely be best served by the un-glamorous investing route of buying and holding some low-cost index funds. But if you have some extra money and your heart is set on options trading as recreation, fair enough. Just make sure you do your homework.
It’s a good idea not to commit to a broker without checking SEC and Financial Industry Regulating Authority (FINRA) records for the broker’s licensing and any history of disciplinary action. Read through the broker’s application closely and answer honestly. And it’s also a good idea not to bet the house on an options contract. Any money you spend on options should be “fun money,” not the down payment, the bill-paying money, the emergency fund, the college fund or the retirement savings. Seriously.
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