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Updated on Tuesday, November 27, 2018
Options trading can become quite complex, but at their heart, options are all based on a basic formula. An option is a right to buy or sell a security at some future date at some specific price. Those specifics are governed by the option contract. Investors find options interesting because of the potential to earn huge returns, though that comes at the cost of risking a significant loss.
If you’re looking to get started in the world of trading options, here’s what you need to know about them.
What is an option?
An option is a contract between a buyer and seller that entitles the option buyer to purchase or sell a security, usually a stock, at a given price — the strike price — by a certain time.
Options are essentially a bet on which way a stock will move. Buyers pay the seller a fee, called a premium, and if the “underlying” stock finishes above or below the strike price (depending on the option type) when the option expires, it’s worth money.
There are generally two outcomes for an option:
- If the underlying stock doesn’t make the buyer’s anticipated move, the option expires worthless. When this happens, the buyer loses the premium and the seller keeps it. The seller’s profit is the buyer’s loss.
- If the underlying stock does make the anticipated move, the option is “in the money.” The option’s profit is the difference between the strike price and the stock price. In this case, as the option nears expiration, the buyer typically exercises the option — either putting up cash to buy the stock or selling it at the strike price, depending on the type of option — and records a profit. The buyer’s profit is the seller’s loss.
One option is called a contract, and each contract represents 100 shares of the stock. For example, if you buy or sell three contracts, your options position tracks the movement of 300 shares of stock.
Options allow investors to capture a stock’s movement while paying a much smaller upfront cost, the premium. This means that options can allow investors to enjoy the full upside of a stock’s move without paying the stock’s full price — that’s the real attraction of options trading.
In other words, options magnify the returns, both on the upside and on the downside. While an investor can earn virtually unlimited upside, he or she also can suffer a complete loss of the premium paid.
Types of options: calls and puts
There are two broad types of options — call options and put options — and they entitle buyers and sellers to different things. Here’s a quick way to keep calls and puts straight: Calls become more valuable when the stock rises, while puts become more valuable when the stock falls.
A call option specifies the price at which a stock can be purchased by some future date, and this option increases in value as the stock rises.
- A call buyer expects the stock to go up, making the option more valuable. A call buyer profits when the option’s premium costs less than the difference between the stock price and the strike price at expiration.
- A call seller (or writer) expects the stock to fall or stay flat, making the option less valuable. A call writer profits when the option’s premium costs more than the difference between the stock price and the strike price at expiration.
- A put option specifies the price at which a stock can be sold by some future date, and this option increases in value as the stock falls.
- A put buyer expects the stock to go down, making the option more valuable. A put buyer profits when the option’s premium costs less than the difference between the stock price and the strike price at expiration.
- A put seller (or writer) expects the stock to rise or stay flat, making the put less valuable. A put seller profits when the option’s premium costs more than the difference between the stock price and the strike price at expiration.
One thing to note on employee stock options: Sometimes companies grant employees stock options as a perk of employment. These options entitle employees to buy the company’s stock at a specified price by a certain time, usually much longer than options that are found on the exchanges.
Employee stock options are always call options — no management team would want to allow its employees to wager on the company’s decline. These stock options usually will expire worthless if the employee does not exercise them, and they do not trade on an exchange.
How options trade
While it’s most common to talk about options with stock as the deliverable, there can be options on almost anything — even, perhaps most famously, on movie scripts. Regular options on an exchange can be written on stocks, exchange-traded funds and major indexes such as the S&P 500 and the Dow Jones Industrial Average.
Still, stocks are the most common deliverable, though not all stocks have options. A highly liquid options market — having lots of buyers and sellers — exists on primarily the largest and most liquid stocks. The market’s smallest stocks may not have much (or any) options activity, or the market may not even exist for them.
Stocks with options on them usually have one option expiring each month, on the third Friday of the month. However, higher-volume stocks may have options that expire on a weekly basis.
The most liquid options markets have another feature not available in less liquid markets: long-term options called long-term equity anticipation securities (LEAPS). That’s a clunky name for options with expirations that go out as far as two years or so. In other respects, they function like standard options. LEAPS give traders more for their bet to be right.
Are options risky?
Yes and no. Any financial security can be risky if investors don’t know what they’re doing, and so it is with options. Because options magnify the upside and downside of an investment, they can be risky in some situations. But in other situations, investors actually can use options to reduce risk. The key thing to understand is how options expose the investor to gains and losses.
Two important points in this regard:
- An option buyer can never lose more money than he or she invests. A buyer’s loss is capped at the total amount of the investment. In exchange, the buyer could earn nearly upcapped gains.
- Conversely, an option seller can lose more than he or she receives in premium income. A seller can lose many times the value of the premium received and may even have to send more money to the brokerage to cover the loss. The loss can be uncapped.
It’s important to re-emphasize that an option buyer can lose the entire premium if the stock does not make the expected move in share price by expiration. So, not only must the investor predict where the stock will move, but he or she must get the timing right too. If not, the seller pockets the premium.
What are some basic options strategies?
Based on these principles, some options strategies have limited risk (and some are even used by risk-averse retirees).
- Call buying: potentially unlimited upside at the cost of the premium
- Put buying: very high upside at the cost of the premium
- Covered calls: selling a call when you already own the underlying stock, a retiree favorite
Meanwhile, other options strategies can have significant risk.
- Naked calls: Writing a call when you don’t own the underlying stock exposes you to potentially unlimited loss if the stock rises.
- Put writing: Expect a sizable loss if the stock falls markedly.
However, used in moderation and with lower-risk strategies, options can increase an investor’s total return.
Is options trading right for you?
Options trading typically works best for investors who want to be actively involved in the market. You won’t need to trade every day or even every week, but you have to pay attention to the market, where stock prices are heading and what might move them. That requires a significant time commitment.
So, if you’re unwilling or unable to make this kind of commitment, trading options probably isn’t for you. That’s fine because many studies have shown that passive investors — those who buy a fund and simply hold — tend to do better than active investors.
But if you’re still interested in giving options a go, you’ll want to understand your own risk tolerance and temperament. Like investing in stock, options investing is best for those with an even temperament and those who are able to emotionally handle the fact that they’re trading the possibility of major downside with the chance for significant upside.