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Stock Options Defined

 

 

Options trading involves a distinct process that’s different from stock trading. Before you dive into options trading, it’s important to understand the terminology and the factors involved. If you’re curious about what stock options can do for your financial freedom, this guide will cover everything you need to know.

  • Stock options are contracts that give traders the right, but not the obligation, to buy and sell an underlying asset or security.
  • Stock options can pose certain risks to traders, and it’s important to understand the terminology and processes of options trading before active trading.
  • Trading stock options comes with several highly advantageous benefits, but it also comes with some drawbacks.
  • You can use options trading simulators and tools to better understand the processes of trading options before actively trading.

What Are Stock Options?

Image via Pixabay by Mohamed Hassan

So what is a stock option? In simple terms, it’s when investors have the right to buy or sell securities at a certain price and by a set date. Options are financial derivatives that gain value from the underlying asset. This means that options traders have the choice, but not the obligation to buy or sell securities. If the trader feels it isn’t in their best interest to exercise the option, they can let it expire.

One of the biggest differences between trading stocks and trading stock options is that stocks enable you to own a small share in a company while stock options are contracts that give you the ability to buy or sell securities. Ultimately, there are always two sides to every stock option transaction: selling and buying. This means that whenever you purchase a stock option, you’re purchasing it from another trader. Stock trading, on the other hand, involves buying stocks from the market or through a specific index, not another trader.

Understanding How Stock Options Work

Trading options can come with some complexities, so you should gain a deeper understanding of the process before getting started. When you sell an option, you’re creating an asset or security that didn’t exist before you sold it. This is known as writing an option. Options traders are typically the main source of options since associated companies and exchanges aren’t the ones issuing the stock options.

Here are some more important characteristics of options trading that you should know:

Puts and Calls

Stock options are broken into two distinct types: call options and put options. Purchasing a call option gives you the right (but not an obligation) to buy a certain stock or security at a specific price. This predetermined price is called the strike price. You can buy a call any time before it expires. Buying a put option gives you the right to sell the stock at the strike price at any time before the option’s expiration date. You’re also not under any obligation to sell the option under a call.

Calls and puts make up the main types of options contracts you trade with. When you write a call, you may be obligated to sell options at their strike price before the actual expiration date. Writing a put, on the other hand, could potentially obligate you to purchase the options at their strike price prior to the expiration date.

American and European Options

There are two distinct styles of options trading: American and European. When trading American options, you can write calls and puts during any time period between the purchase date and the expiration date. European options are less common, and you can only purchase and sell European options on their expiration dates.

Options Contracts

Options contracts are the number of stock options you’re looking to purchase. Typically, one option contract equals 100 shares of the underlying asset or stock. If you decide to purchase three call options on the expectation that each underlying asset will rise above the strike price by the expiration date, you can either sell or buy more shares at your predetermined strike price, no matter the current value of the stock. If the expiration date closes and the shares are worth less than your purchase price, you could lose the whole amount you spend to buy the options.

Option Expiration Dates

When you trade stock options, you have the right to bet on an underlying asset or stock as it rises or falls. You also have the right to choose a specific date in the future for when you expect the value of the stock to rise or fall. This is the expiration date, and it’s important because it helps traders outline a price value of the puts and calls they write. The process of setting the price value on the expiration date is known as the time value, and this value is important for outlining option pricing models.

Strike Prices and Premiums

Options trading uses strike prices and premiums to dictate transactions. The strike price represents the value that you would expect an option to either rise above or fall below by the time the expiration date rolls around. The strike price is what you’ll use to determine whether you should exercise an option or not.

The premium is what you pay when you purchase a stock option. You take the price of a call and multiply it by the number of contracts you buy, then multiply this result by 100.

Advantages of Trading Stock Options

There are quite a few advantages of getting into options trading. Firstly, stock options give you some considerable leverage. If you want to bet against stocks, you can buy put options that can limit any potential losses up to 100%. If you’re short selling, you can potentially leverage that 100% loss rate into a limitless amount of loss.

By purchasing options rather than the actual stock, you can theoretically create the same value in profits over time with a smaller initial investment.

Second, options trading can give you the ability to set up volatility and time-sensitive trades whereas stocks just give you the choice to buy or sell. With options, you can buy and sell a range of combined puts and calls, all at various strike prices and expirations dates, giving you a diversified way to trade.

Another excellent advantage of options trading is that it requires low capital. This means you can take a position with a lot less than the stock market. You can go far with $500 in the options market compared with $500 in the stock market.

There are also unique trading strategies you can learn and use with options trading, which can help you make the most of your investments.

Disadvantages of Trading Stock Options

There are also some drawbacks to options trading. For one, time plays an important role in options trading. Stock options have a time value that’s always decaying, meaning you’re losing value the closer to the expiration date you get. You have to be completely on top of your value predictions by the time the expiration date comes in order to make a profit. Many options tend to expire with no value at all, while stocks rarely fall to zero.

Taxes can also present a drawback, especially since profits from options are frequently taxed at the top rate for short-term capital gains. Commissions can also frequently be higher for options, especially on quick options, like weekly options. And while leverage can be an advantage of trading options, it also presents a downside. If you happen to be wrong about the strike price when the expiration date arrives, you can stand to take a large hit to your portfolio.

If you’re experienced with stock trading and want to try options trading, you can develop your understanding further by using options trading simulators and other resources to help you gain more exposure to the process.