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I have to admit for the longest time I’ve been meaning to learn options trading. Not only because it is a great way to hedge your risk, but it seems like all the top traders utilize options in some form or another.
We’ve already covered the effect options expiration can have on the overall market, but lets learn a little bit more about this form of trading.
All examples exclude commissions unless otherwise stated.
What is options trading?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. The “specific price” is referred to as the strike price, and the “certain date” is known as the expiration date. The “underlying asset” is usually the corresponding stock. The total cost of an option is called the premium.
Lets look at quick example of the idea behind options trading…
The value of a house costs $300,000, but you can’t afford to pay for it right now. So you negotiate a deal with the owner to buy the house in 2 months for the same price of $300,000. For this contract, you must pay a price (or premium) of $4,000.
Flash forward 2 months and consider the 2 possible scenarios that could arise.
1. A major company shifts its headquarters in the regional area of the house causing its value to rise to $500,000. Due to the contract aka option, the owner is still required to sell you the house for $300,000. Thus, you have made a profit of $196,000 ($500k – 300k – 4,000).
2. The house undergoes an inspection and finds mold, a bad roof, and structural damage. You prove the house to be worthless; however, since you bought an option, you are not required to go through with the sale, although you still lose the $4,000 (cost of contract).
While this is a farily simple example, this showcases some important points of options trading.
- When you buy an option, you have the right but not an obligation to do something.
- Options derive their value based on something else. In most cases, this is a stock.
Should you choose to let the option expire you lose 100% of the investment it took to purchase the option contract, which can make options trading very risky if you are clueless.
There two types of options: calls and puts…
A call gives the holder the right to buy an asset at a certain price within a specific period of time. Think of calls like “long positions” on a stock. Buyers of calls believe the stock price will increase before the option expires.
A put gives the holder the right to sell an asset at a certain price within a specific time period. Think of puts like a “short position” on a stock. Buyers of puts believe the stock price will decrease before the option expires.
Why use options
With options, traders can make money in both up and down markets. Options also allow you to leverage your capital because one contract represents 100 shares.
While this type of trading can be risky, the main perk of options trading is the ability to actually hedge your risk. Options can be used as an insurance policy to protect your investment against a downturn.
Lets look at an example of using options to hedge your risk…
Today is January 1 and you purchase 200 shares of ABC at $10/share and two February $9 puts for $0.25 ($25 per contract).
Let’s consider whether this position makes for a good trade.
Excluding commissions, your total cash investment is $2,050 ($2,000 for stocks and $50 for option contracts). If the stock moves above $10.25, you are now in a profit position on paper and won’t have to consider the put option because it will expire worthless. If, however, ABC plummets to $6 a share, then the value of the insurance quickly becomes apparent. If you were faced with a stock value of $6 at the February expiry, you would be looking at a loss of $250 (200 X [10.25-9.00]). Contrast this with the loss you would have incurred without the married put strategy: $800 (200 X [10.00-6.00]).
This type of hedge is known as married puts. For a put to be considered “married,” the put and the stock must be bought on the same day, and you must instruct your broker that the stock you have just purchased will be delivered if the put is exercised.
How to use options
Now that we pretty much know what options are and how they work, how can we trade them?
Lets first look at an example of options trading…
On June 1, the stock price of Company ABC is $57 and the premium is $2.25 for an August 60 Call, which indicates that the expiration is the third Friday of August with a strike price of $60. The total price of the contract is $225 ($2.25 X 100) because each stock option contract is the option to buy 100 shares.
The strike price of $60 means that the stock must rise above $60 before the call option is worth anything. Because the contract is $2.25 per share, the break-even price would be $62.25. If the stock price stays below $60, then the option is worthless and your down $225.
5 weeks later the stock price is at $68. The options contract has increased along with the stock price and is now worth $7.50 per share, which increase your total value to $750. You now stand at a profit of $525 (($7.50 – 2.25) x 100), and you can close your position or wait till expiration if you feel the price will continue to head higher.
Closing out position means that holders sell their options in the market, and writers buy their positions back to close. According to the CBOE, about 10% of options are exercised, 60% are traded out, and 30% expire worthless.
An option contract decreases in price as the odds become greater. For example. if the current stock price sits at $60, then a call option will be cheaper with a strike price of $68 than $62. For a put option, the price of a contract will be cheaper at $62 than $68.
You can see the contract prices through an option table either through your broker or a financial site such as Yahoo Finance. See a complete list of broker commissions for options.
See the example of a December options table for Cisco below…
When this image was taken, the current price of Cisco (CSCO) stood at $24.02. If we believed that Cisco would be greater than $26 before December 19, 2009, then we would purchase a call option contract with a strike price of $26.
This contract costs $0.11 per share, so our initial investment would be $11 (0.11 x 100). Obviously, you could buy more if you wanted.
As per our example, if the stock was to rise to $27 and the contract price was now $0.60, then our profit is now $49 (($0.60 -0.11) x 100).
Some things to note about the options table: Volume (VOL) refers to the total number of contracts traded for the day. Option Interest (Op Int) indicates the number of option contracts that are open; these are contracts that have neither expired nor been exercised.
Conclusion
As you can see, options trading is really not so difficult; however, there is a higher level of risk involved than buying and selling stocks. For more, in-depth option trading strategies and methods, check out The Definitive Source for Information About the Options Trading.
Any advice or tips on options trading?