Options investing opens up exciting new opportunities for traders, but getting started can seem daunting. I won’t pretend otherwise – there is a learning curve. But with the right foundation, you can demystify options and utilize them effectively in your portfolio. This first part of the introductory guide aims to provide a base of knowledge to begin trading options.
On our introductory guide on options investing! you’ll learn exactly what options are, the different types, and how they work. We’ll go over options trading mechanics – how to buy and sell them and factors that influence pricing. You’ll get actionable tips on choosing a brokerage and key strategies to implement. And we’ll have an honest discussion about risks and how to manage them.
Even experienced investors can benefit from a refresher on the fundamentals. So whether you’re a total novice or looking to expand your skillset, read on to become a savvier options trader.
What Are Options? A Comprehensive Overview
Now that we’ve set the stage, let’s dive into the nitty-gritty of what options actually are.
Defining an Option in the Investment World
An option is a contractual agreement that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specified date. The underlying asset could be a stock, ETF, commodity, or index.
- The predetermined price is known as the strike price. This is the price at which the buyer can exercise their option.
- The expiration date is the last day the option contract is valid. After this date, the option expires and ceases to exist.
- Options come in two main varieties: calls and puts. We’ll cover those shortly.
In summary – an option is a derivative that represents a contingent claim on an underlying investment for a limited period of time. Its value is based on the price fluctuations of that underlying asset (stock, ETF, commodity, or index).
Options vs. Stocks: Key Differences
While options are derived from stocks, they have some key advantages that make them different from stocks:
- Leverage: One of the biggest advantages of options is the leverage they provide. When you purchase an option, you pay a fraction of the cost of buying the underlying stock outright, yet you get the same exposure to the upside (for calls) or downside (for puts). This allows you to control large numbers of shares while only putting a small amount of capital at risk. Stocks do not provide the same inherent leverage.
- Defined risk: With options, you know your maximum loss potential ahead of time – it is limited to the premium paid to buy the option. The most you can lose is 100% of your investment. Stocks carry unlimited downside risk – share prices can keep falling without limit. Options define your risk upfront.
- Higher risk/reward ratio: The leveraged nature of options allows for very high-profit potential compared to the initial capital outlay. However, they also carry a higher percentage likelihood of expiring worthless. So, options tend to have a higher risk/reward ratio compared to stocks – higher potential rewards but also a higher risk of losing the entire investment.
- Shorting ease: It is much easier to take a short position with options than with stocks. To short a stock, you have to borrow shares that you don’t own, sell them, and hope the price drops so you can buy them back later at a lower price to return to the lender. This involves paying interest and dividends.
With options, you simply buy puts, which gives you the right to sell shares at the strike price. You don’t actually have to borrow and sell short shares to benefit from a bearish outlook. Going short with puts does not require locating and borrowing shares.
In both cases, shorting involves selling something you don’t actually own yet. With stocks, you have to borrow the actual shares before you can short them. With options, you don’t have to borrow the underlying shares – you simply buy puts which provide the same bearish exposure. The key difference is that puts allow you to short synthetically without borrowing shares. - Wider variety: Options have many different types of contracts – calls, puts, spreads, combinations – providing a wide array of strategies. Stocks just have one instrument. This variety allows tremendous flexibility and nuance in trading options.
- Asset agnostic: You can trade options on all kinds of underlying assets – stocks, indices, commodities, currencies. This provides great flexibility in tailoring options trading to your market outlook and goals. Stocks lock you into a single asset.
Options differ greatly from stocks in their inherent leverage, defined and limited risk, ease of shorting, variety of contracts, and flexibility. This makes them very useful tools for managing risk and enhancing returns if used correctly. But both options and stocks have their place in your portfolio for different investing goals.
Types of Options: Understanding Calls and Puts
Now that we’ve defined what options are, let’s explore the two main types – calls and puts. Getting a solid grasp of each will provide a strong foundation as you begin trading options.
Call Options: The Right to Buy
A call option gives the holder the right, but not the obligation, to purchase shares of the underlying asset at the strike price on or before the expiration date.
Calls are powerful instruments because they allow traders to benefit from an upward move in the underlying asset. Here’s a detailed example:
- Let’s say you have a bullish outlook on XYZ stock, which is currently trading at $50 per share.
- You purchase a call option contract on XYZ with a strike price of $55 expiring in 6 months. This gives you the right to buy shares at $55 anytime in the next 6 months.
- If XYZ rises to $60 during that time, you can exercise your call option to buy shares at the lower locked-in price of $55, and immediately sell them at the market price of $60. This nets you a profit of $5 per share minus the initial premium paid.
- However, if XYZ stays below $55 and the call option expires worthless, the most you can lose is the amount you paid for the initial premium. Your risk is capped.
- Calls allow you to benefit from an upward move without needing to buy the stock upfront. They provide upside exposure with defined, limited downside risk.
In summary, call options are very useful tools that allow traders to profit from a bullish outlook with managed risk. Calls shine when you expect the underlying asset price to rise. They provide great upside profit potential in that scenario.
Put Options: The Right to Sell
A put option gives the holder the right, but not the obligation, to sell shares of the underlying asset at the strike price on or before the expiration date. Puts are powerful tools because they allow traders to profit from a bearish outlook on a stock. Here’s a detailed example to illustrate how they work:
- Let’s say you think XYZ stock is overvalued and the price will decline soon. XYZ is currently trading at $50 per share.
- You purchase a put option contract on XYZ with a strike price of $50 expiring in 3 months. This gives you the right to sell shares of XYZ at $50 anytime in the next 3 months.
- If XYZ falls to $40/share during that time, you can exercise your put option, buy shares at the market price of $40, and immediately sell them at the higher $50 strike price guaranteed by the put. This nets you a profit of $10 per share minus the premium paid.
- However, if XYZ stays above $50 and your put option expires out of the money, the most you can lose is what you paid for the initial put premium. Your downside risk is defined and limited.
- Puts allow you to profit from a bearish view without needing to short actual shares. They provide downside exposure with capped risk.
Put options are very versatile tools that let traders take short positions with defined, managed risk. Puts shine when you expect the underlying asset price to decline. They provide a great mechanism to potentially profit from falling prices.
Comparing Calls and Puts
While calls provide the right to buy the underlying asset, puts provide the right to sell it. Here is a more in-depth comparison:
- Profit potential: Call options allow you to profit from a rise in the underlying asset price, while put options allow you to profit from a fall in the underlying price.
- Risk: The maximum risk for both calls and puts is the premium paid for the option contract. Unlike stocks, options have defined and capped downside.
- Strike price selection: For calls, you want to choose a strike below the current market price so you can capitalize if the asset rises above the strike. For puts, you want a strike price above market value to profit if the price falls below the strike.
- Time decay: Both calls and puts lose value as they approach expiration due to time decay. Managing time decay is an important consideration for all options traders.
- Volatility: Implied volatility increases the premiums of both calls and puts. Historic volatility also impacts pricing.
- Market outlook: You would buy calls when you have a bullish outlook and expect prices to rise. You would buy puts when your view is bearish and you forecast prices falling.
- Break-even: For calls, the underlying price must rise above strike + premium to be profitable. Puts break even when the price falls below strike – premium.
- Assignment: Call buyers may be assigned stock if exercised. Put buyers may be assigned short stock positions if exercised.
While calls and puts have some similarities, their difference in directionality makes them suited to opposite market views. Together, they provide flexibility for a range of trading strategies.
Mastering the Basics of Options Investing
And that concludes the first part of our introductory guide on options investing! In this article, we covered the basics – defining what options are, the two main types of options contracts, and how calls and puts work.
You now have a solid grounding in these core concepts. But options trading involves much more, from mechanics of buying and selling to risks and strategies. Luckily, there is a second part to this guide where we dive into those topics in more depth.
The goal so far was to provide the foundation needed before moving onto practical steps and tactics. Consider this Part 1 in our options investing series. Be sure to check out Part 2 where we explore options trading mechanics, risk management, and actionable tips to start trading options yourself.
The journey has only just begun! With the basics now understood, you’re ready to take the next step in becoming a savvy options trader. Stay tuned for more.
