Options trading is an uncommon financial instrument that lately gained great momentum. Options trading can be actively traded and, in these days, when many investors are choosing to use a more active investment style in order to try and make more immediate returns, Options have proved to be a great solution and a way to turn relatively small amounts of capital into significant profits.
With many financial instruments, such as stocks, the only way to take advantage of leverage is to borrow funds to take a position and this isn’t always possible for everyone. With some instruments, though, leverage is possible in other ways. One of the biggest benefits of trading options is that options contracts themselves are a leverage tool, and they allow you to greatly multiply the power of your starting capital.
# What is Options Trading?
Options trading is basically buying or selling contracts on the public exchanges. An option is a contract between a buyer (who Bid for the contract) and a seller (who Ask for a certain price for the contract). Buying an options contract is in practice no different from buying stock. You are basically taking a long position on that option, expecting it to go up in value. If your options do go up in value, then you can either sell them or exercise your option depending on what suits you best.
If you were expecting an underlying asset to go up in value, then you would buy call options, which gives you the right to buy the underlying asset at a fixed price. If you were expecting an underlying asset to go down in value, then you would buy put options, which gives you the right to sell the underlying asset at a fixed price. This is just one example of the flexibility on these contracts; there are several more.
Traders can use options to speculate on the price movement of individual stocks, indices, foreign currencies, and commodities among other things and this obviously presents far more opportunities for potential profits.
# Types of Options
There are two main types of options: Calls and Puts.
Calls give the buyer the right to buy the underlying asset, while Puts give the buyer the right to sell the underlying asset.
Call options are contracts that give the owner the right to buy the underlying asset in the future at an agreed price. You would buy a call if you believed that the underlying asset was likely to increase in price over a given period. Calls have an expiration date and, depending on the terms of the contract, the underlying asset can be bought any time prior to the expiration date or on the expiration date.
Put options are essentially the opposite of calls. The owner of a put has the right to sell the underlying asset in the future at a pre-determined price. Therefore, you would buy a put if you were expecting the underlying asset to fall in value. As with calls, there is an expiration date in the contact.
# How an Option Works – A Detailed Example
For example, let’s examine a Call Option: A call option is a financial contract between two parties; the holder and the writer. If you’re the holder of the call, you are the owner of the contract; this means you have purchased the right to buy the underlying security. The seller of the call is called the writer, and they sell the contract for a price that is paid by the holder. The contract would contain terms for the strike price, the underlying security, and the expiration date.
The underlying security is the asset on which the contract is based. For example, if you bought a call based on shares in Company X, then you would be buying the right to purchase shares in that company. The strike price stipulates the price at which you have the option of purchasing the underlying security. The expiration date is, quite simply, the date on which the contract expires.
# In the Money or Out of the Money?
There are three distinct stages that the holder of a call contract can experience – in the money, at the money, or out of the money.
In the money is when the underlying security is at a higher price than the strike price.
At the money is when the security is equal to the strike price.
Out of the money is when the security is worth less than the strike price.
The obvious time for the holder of a call to exercise their option, or sell it, is when it is in the money.
# Real-life Examples
The examples below highlight how calls can be used as an alternative to actually investing in stocks. These examples are somewhat simplified, but they at least give you an idea of some of the advantages. For the sake of these examples, we are ignoring commissions and fees incurred for buying and selling stocks and options contracts.
Buying Tesla Stocks
Tesla (TSLA) is currently trading at $990 per share (actually $991, but for simplicity). You think it’s a good price and you decide to purchase one share of Tesla. If Tesla stock goes up to $1,100 per share, your profit will be $110, which will give you a yield of ~11% only ($110/$990).
Buying Tesla Options
Tesla Call Option, which expires 9 days after the day you bought it and has a strike price of $1,000, costs $33.5. We know that one option grants you 100 stocks. This means that the option actually costs you $3,350 ($33.5 * 100).
You decide to buy the option for the price of $3,350 and you want to know what would be your yield if Tesla stock’s price goes up to $1,100.
At expiration, assuming that the price did get to $1,100, you’ll get 100 stocks of Tesla at the strike price promised: $1,000. You sell the shares right away and receive immediately $10,000 [(1,100 – 1,000) * 100 shares]. If we take into consideration the price you paid for the option ($3,350), you’ll end up with $6,650, which is a 98.5% yield on the money you invested! [($6,650 / $3,350) – 1].
It’s worth pointing out, however, that there are some disadvantages to owning calls too. There is always the risk of an options contract expiring with no value if the stock trades below the strike price until the expiration date. Also, if you are investing in stock options rather than stocks themselves then you don’t receive a dividend if one is paid out to stockholders.
- Options Contracts are financial contracts between two parties that represent a future transaction on a specified asset at a specified price.
- The buyer of the contract has the right, but not the obligation, to initiate that specified transaction. The seller of the contract has the related obligation to carry out the transaction should the holder choose to initiate it.
- there are basically two main types of Options; call options which give the holder the right to buy the underlying asset at the strike price and put options which give the holder the right to sell the underlying asset at the strike price.
- Trading Options is a great way to take advantage of the price movements of various assets without having to actually own those assets.
- Options Contracts are good leverage tools that can potentially provide big profits relative to the amount risked.
- The main drivers of the price of an Option are; the current stock price, intrinsic value, time to expiration or time value, and volatility.