Options trading is a complex way of managing a portfolio, and one that comes with increased risk. Despite the complexity of actually employing this technique, it can be fairly easy to understand if you look at it in small examples to start with. By the end of this blog my hope is that you will have gained an understanding of how options trading works, and are able to have a meaningful discussion about their usage.
What is an Option?
In the simplest of terms, an option contract is a form of insurance in the stock market. Just like insurance as you know it, there is a buyer and a seller of the insurance. By definition the buyer has the option to force the seller into fulfilling the contract if they so choose. The seller naturally has the obligation to hold up their side of the deal if the buyer demands it. Every option contract is for 100 shares of stock, so if you sell 10 options then you will have an obligation for 1,000 shares of the stock. Every option contract has a “strike price” which is the price that the contract will be executed at if the buyer so chooses. Every option also has an expiration date, and these typically are in 1 week increments.
What are the Types of Options?
There are 2 types of options. A “call option” is one that gives the buyer the right to force the seller into selling them a stock at a designated price. For example, if stock A is currently $10, the buyer may buy the call option with a strike price of $15. In this example, if the price of stock A skyrockets to $30, then the buyer of the option can force the seller to sell them 100 shares of stock A for $15, and thus the buyer of the option will profit $15 per share.
A “put option” is the opposite of a call because the put option gives the buyer the right to force the seller to buy the stock from the buyer if they so choose. For example, if stock A is currently $20, then the put option strike price may be $15. Then if stock A plummets to $5, the buyer of the option can force the seller to purchase 100 shares of stock A from the buyer for $15 per share. In this example the buyer of the option will profit $10 per share.
On the other side of the contract there is the seller. As I mentioned earlier, the seller is on the hook to fulfill the contract if the buyer chooses, so what is in it for them? When the buyer purchases the option, they must pay the seller money to keep them on the hook. If the option never gets exercised then the seller simply keeps the money that they received in the beginning and moves on. Back to our example from before, let’s say the put option is sold with a strike price of $15 and the current stock price is $20. The buyer may have to pay the seller $300 to be able to have this option contract with an expiration in 1 month. If 1 month later the stock price is $25, of course the buyer is not going to exercise the contract because they would be selling a $25 stock for just $15. So the option will expire worthless, and the seller keeps the $300 that they received in the beginning.
Options trading is a very complex practice that can be difficult to understand. Hopefully this blog helped clear up some of the questions that may be out there, and allows you to have a better understanding of how options trading works. Options trading can be very risky, and is certainly not for everyone. Prior to engaging in options trading of your own, I strongly recommend that you do further research and speak with a financial advisor to ensure you understand all of the risks involved.