Trading options is very different from trading stocks because options have distinct characteristics from stocks. It's important for investors to take the time to understand the terminology and concepts involved with options before trading them.
Options are financial derivatives, meaning that they derive their value from the underlying security or stock. Options give the buyer the right, but not the obligation, to buy or sell the underlying stock at a pre-determined price.
- Options give a buyer the right, but not the obligation, to buy (call) or sell (put) the underlying stock at a pre-set price called the strike price.
- Options have a cost associated with them, called a premium, and an expiration date.
- A call option is profitable when the strike price is below the stock's market price since the trader can buy the stock at a lower price.
- A put option is profitable when the strike is higher than the stock's market price since the trader can sell the stock at a higher price.
Trading stocks can be compared to gambling in a casino: You're betting against the house, so if all the customers have an incredible string of luck, they could all win.
Trading options is more like betting on horses at the racetrack: Each person bets against all the other people there. The track simply takes a small cut for providing the facilities. So trading options, like betting at the horse track, is a zero-sum game. The option buyer's gain is the option seller's loss and vice versa.
One important difference between stocks and options is that stocks give you a small piece of ownership in a company, while options are just contracts that give you the right to buy or sell the stock at a specific price by a specific date.
It's important to remember that there are always two sides for every option transaction: a buyer and a seller. In other words, for every option purchased, there's always someone else selling it.
Types of Options
The two types of options are calls and puts. When you buy a call option, you have the right, but not the obligation, to purchase a stock at a set price, called the strike price, any time before the option expires. When you buy a put option, you have the right, but not the obligation, to sell a stock at the strike price any time before the expiration date.
When individuals sell options, they effectively create a security that didn't exist before. This is known as writing an option, and it explains one of the main sources of options since neither the associated company nor the options exchange issues the options.
When you write a call, you may be obligated to sell shares at the strike price any time before the expiration date. When you write a put, you may be obligated to buy shares at the strike price any time before expiration.
There are also two basic styles of options: American and European. An American-style option can be exercised at any time between the date of purchase and the expiration date. A European-style option can only be exercised on the expiration date. Most exchange traded options are American style, and all stock options are American style. Many index options are European style.
The price of an option is called the premium. The buyer of an option can't lose more than the initial premium paid for the contract, no matter what happens to the underlying security. So the risk to the buyer is never more than the amount paid for the option. The profit potential, on the other hand, is theoretically unlimited.
In return for the premium received from the buyer, the seller of an option assumes the risk of having to deliver (if a call option) or taking delivery (if a put option) of the shares of the stock. Unless that option is covered by another option or a position in the underlying stock, the seller's loss can be open-ended, meaning the seller can lose much more than the original premium received.
Please note that options are not available at just any price. Stock options are generally traded with strike prices in intervals of $0.50 or $1, but can also be in intervals of $2.50 and $5 for higher-priced stocks. Also, only strike prices within a reasonable range around the current stock price are generally traded. Far in- or out-of-the-money options might not be available.
When the strike price of a call option is above the current price of the stock, the call is not profitable or out-of-the-money. In other words, an investor is not going to buy a stock at a higher price (the strike) than the current market price of the stock. When the call option strike price is below the stock's price, it's considered in-the-money since the investor can buy the stock for a lower price than in the current market.
Put options are the exact opposite. They're considered out-of-the-money when the strike price is below the stock price since an investor wouldn't sell the stock at a lower price (the strike) than in the market. Put options are in-the-money when the strike price is above the stock price since investors can sell the stock at the higher (strike) price than the market price of the stock.
All stock options expire on a certain date, called the expiration date. For normal listed options, this can be up to nine months from the date the options are first listed for trading. Longer-term option contracts, called long-term equity anticipation securities (LEAPS), are also available on many stocks. These can have expiration dates up to three years from the listing date.
Options expire at market close on Friday, unless it falls on a market holiday, in which case expiration is moved back one business day. Monthly options expire on the third Friday of the expiration month, while weekly options expire on each of the other Fridays in a month.
Unlike shares of stock, which have a three-day settlement period, options settle the next day. In order to settle on the expiration date, you have to exercise or trade the option by the end of the day on Friday.