Options Trading: How Does It Work?

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by Advice Chaser
by Advice Chaser
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When you’re looking into investments, the number of technical terms can be overwhelming. To make things worse, they are often explained using equally obscure terms! If options trading is one of the topics that remains opaque to you, you won’t want to miss our webinar on July 22.

What Is Options Trading?

When you purchase an option, you are purchasing the right—but not the obligation—to buy or sell a particular underlying asset at a particular price and a particular time. 

Let’s break that down a little more.

Options are part of an investment class known as “derivatives” because they derive their value from an underlying asset. In most cases the underlying asset is stocks, but you can buy options in real estate, currency, etc. 

Options have an expiry date, which can be weeks or years in the future depending on the underlying asset. “European style” options can only be exercised on the expiry date, whereas “US style” options can be exercised at any point up to the expiry date. Note that these names don’t necessarily reflect what kinds of options will be available in your area. 

Options also have a strike price, or exercise price, which is the price at which you buy or sell the underlying asset when you exercise the option. Below are examples of buying and selling respectively.

Call option

When you purchase a call option, you have the right to purchase the underlying asset at your strike price. For example, your option allows you to buy 100 shares of a given stock for $10 each. Later, the price of that stock rises to $20 a share. You can exercise your option to buy the stocks for $10 and then immediately turn around and sell them for the market value of $20, netting a tidy profit. (Minus your options premium.) 

Put option

A put option is essentially the opposite of a call option. Let’s say you buy the right to sell 100 stocks for $20 apiece. Later, the price falls to $10 per share. You can scoop up 100 stocks at $10 each and then immediately exercise your option and sell them for $20 apiece. 

Some people will use put options as insurance on stocks they already own rather than using them for speculation as in the example above. 

In general, a call option is going to have more potential for gains than a put option, because the price of the underlying asset could rise indefinitely, whereas it’s not going to drop lower than $0. 

What Affects the Price of Options?

There are many different things that affect an option’s value other than the intrinsic value of the underlying asset. Financial experts refer to these factors by a series of Greek letters and collectively as “Greeks.” We’ll cover only a few of these factors here:

  • In, at, or out of the money: An option is “in the money” if exercising it would lead to a profit, “at the money” if it would lead to breaking even, and “out of the money” if it would lead to a loss. Options that are already in the money are worth more than ones that are not. 
  • Time: An option that has more time left before its expiry commands a higher premium because there’s more time for its profitability to increase.
  • Volatility: Options command higher premiums in more volatile markets because there’s a greater potential for high profits. (Though of course there’s also greater potential for serious losses when trading options.)

Should You Invest in Options?

Options trading is appealing because you can leverage a small amount of money into big profits compared to simply buying and selling stock outright. You can also profit from a market where prices are dropping (via put options), unlike standard stock trading. 

However, options trading does carry considerable risks. As with many other types of investments, you could simply have bad luck and end up losing money as a result. Moreover, when trading options you’re competing with professional hedge fund managers, who have significantly more experience and resources to put into analyzing the market and making the best trades. 

If you do invest in options, keep them to a small slice of your portfolio just as you would with any high-risk investment. 

Sign Up for Our Options Trading Webinar

When you first dip your toes in investing, it can seem like a whole new world with its own language. A financial advisor is a vital resource. To learn more about trading options, sign up for our webinar on July 22. At noon Eastern time, Howard Holmes will walk us through all the basics. Bring any questions you have!

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