So you’ve got a brokerage account, and you’ve made a few trades in the stock market. You feel good about your investments. You have done your research and you have a diversified portfolio.
Last year you turned a good profit, but it wasn’t without its losses. Such is the stock market. Lately, the market isn’t trending in the right direction.
You bump into a friend. He explains that he didn’t lose any money when his stock went down. You wonder, “how could that be?”
He begins talking and you stop him dead. “Wait! What is option trading?” You ask.
What Is Option Trading?
An option is a contract. It gives a buyer the right, but not the obligation to buy or sell a stock or other asset. They’re purchased at a predetermined price, for a predetermined time.
Options trading is like buying insurance for an investor.
The Story of Joe the Investor
Let’s say Joe the investor buys 100 shares of Disney for $120 per share. He has invested $12,000 in Disney.
However, Joe feels a little nervous about the volatility of the market. He decides to buy an option as insurance. After all, $12,000 is a lot of money.
Joe buys a put option for $500. In the next 30 days, the price of Disney’s stock plummets. The prices of Disney’s stock has gone from $120 down to $85.
If Joe was any normal investor, he would have two options:
- Keep the stock and pray it goes back up
- Cut his losses
BUT… Joe isn’t your average investor. Joe knows he could be waiting a while for Disney’s stock to go back up. He doesn’t want to wait on for a return-on-investment. After all, there are other stocks out there making money.
Joe exercises his right to sell his $500 put option, and even though the price has dropped $40 per share. He hasn’t lost any money except for his initial payout for the option, $500.
Joe has just saved himself from a $4,300 loss! Now that’s insurance.
Options aren’t just insurance, though. You don’t need to own stock to buy an option. They can be bought and sold just like stocks, and if done right, it can make you a LOT of money!
How Does Option Trading Work?
Now that you know that options can be used as insurance for an investor, it’s time to understand how options are traded to make a profit.
Believe it or not, most of the companies you support every day like Google, Netflix, Apple, and more have options that you can buy. Better still, you can purchase these right from your computer, laptop, phone, or tablet.
Calls and Puts Explained
You can think of trading options like betting on the price of a stock. You either bet that the stock will go up or go down.
There are two ways you can invest in your favorite companies with options trading. There are two types of options. They are calls and puts.
What Is a Call Option
If you purchase a call option, you want the stock price to go up. Maybe you have been watching Nike’s stock for some time and following its trends.
You notice the stock price is unusually low according to your research. You also know that Nike is set to release a new Air Jordan sneaker that sneakerheads won’t stop blogging about.
You purchase a call option because you feel confident that the price of the stock will go up in the next month or two based on your research.
What Is a Put Option
If you purchase a put option, you want to stock price to go down.
Let’s go back to the Nike analogy. Let’s say you bought your put option a month ago, and just like you thought, the stock price went up. Good for you!
With the release of the new Air Jordan shoe behind Nike, you feel the stock is set to come back down to earth in the next month or two, so you buy a put option.
Now instead of betting on the price to go up, you’re betting on the price to go down.
Because of the volatility of the market, you notice the price of Nike is inflated. This is most likely due to the release of their new Air Jordan sneaker.
You notice the sneakerheads have moved on. They’re talking about different brands, and you notice the stock price is an anomaly when you research the three and six-month trends.
Two months later, just as you figured the price of Nike has come down. You sell your put option for a profit!
Understanding Option Prices
Option prices are based on three factors: time to expiration, stock price, and volatility. These three factors drive the price of options up or down and factor in how much profit you make from an option trade.
Time to Expiration
All options have an expiration date. These dates may be set out 30 – 60 days. The longer you hold an option, the more expensive the option becomes. For instance, a 30-day option may cost $250, while a 60-day option may cost $500.
As time passes, an option’s value will decay. This is what is known as time decay. An option’s time value is always decaying, meaning once you buy an option its value begins to decay, limiting your profit. Most stocks have expirations that are weekly, monthly, or even quarterly.
Options are bought at a certain stock price. This stock price is known as the strike price. The strike price is the predetermined price you would use if you want to exercise your option.
Let’s say you buy Verizon for the strike price of $60. Consider the option like an over-under bet.
If you purchase a call option, you are betting the stock price will go over the strike price. If you purchase a put option you are betting the stock price will go under the strike price.
The difference in price, above or below the strike price, determines the profit.
The price of an option also depends on the volatility of the stock. The more volatility, the more risk, the higher the price. The lower the volatility, the lower the risk, the lower the price.
Volatility is an important factor when thinking about purchasing options. This factor alone is the backbone of some investors’ options trading strategy.
Success Starts With Massive Action
Being an investor always involves risk. How you assess that risk, either as a stock trader, or an options trader is up to you. By now, you should no longer be asking yourself: what is option trading?
Done right, options trading can help you ride the market up or down to great profits.