A Simple Tutorial on What Options Are and Trading Methods
What if an investor feels that stock ABC will go from 10 dollars to 20 dollars per share in the next six months? He would no doubt want a contract that would allow him to purchase stock ABC during that time period.
What if a trader felt that stock ABC would drop from 10 dollars to 8 dollars in the next month? Then he would benefit from a contract that would allow him to sell shares of ABC at an agreed upon price, but cover them or replace the shares at future prices, which he hopes will be considerably less.
The bullish type of options contract where profits are realized when the stock rises, is named a Call. The hawkish options contract that profits when a stock drops is dubbed a Put. Each contract is equivalent to one hundred shares of the underlying securities. One can never lose more than what has been paid for the contract when purchasing options. The investor is purchasing rights, but not obligations, to trade.
Components of a Stock Option Contract
There are three major components to a stock options contract: time until expiration, whether it is a Put or a Call option, and the strike price.
- Time until expiry: the longer an investor wishes to hold onto an options contract, the more it will cost. The price paid for the contract is called a premium. The amount of value lost daily from time decay is represented by the Greek letter Theta. The decay is quickest in the final month of an options life.
- Put or Call option: As stated earlier, a Put contract gives the investor the right to short shares at a certain price and buy back at current prices. A Call option contract allows the investor purchase shares at the strike price, and sell at the current share price.
- Strike Price: This is the value associated with the options contract that allows the trader to buy or sell shares at this threshold. This value will greatly affect premiums.
Although there are many other factors such as interest rates, historical and implied volatility of a stock, the previous three are the major ones that are most transparent.
Trading Google With Stock Options
To illustrate, imagine that Google is trading at 600 dollars. A certain trader feels it will go up significantly in the near future. What option could he buy?
First he needs to decide on how much time he needs. If he is unsure he can purchase up to a couple of years worth of option time, but this gets very expensive. Most judicious traders will choose a few months to balance time and cost.
Next he needs to consider at what price he would like to purchase shares at. If he wants to purchase shares at 400 dollars when the stock is currently trading at 600 dollars, he would need to pay 200 dollars of intrinsic value for the contract plus any extrinsic value. This contract is termed ‘in the money’ since the strike price is below current share price on the Call options contract. Although the probability that he will be able to exercise the contract is high, his leverage is greatly reduced which lowers profitability.
Should he want the strike price, which is the price he can purchase shares at, to be 800 dollars per share, this contract would be dirt cheap. But the likelihood that Google will rise 33% in a few months may be unlikely. This contract is called ‘out of the money’, since the strike price is above the current share price on the Call options contract.
Simple Rules to Follow When Purchasing Options
For the investor that wishes to employ the simple strategy of purchasing options for increased leverage, these rules may be helpful.
- Purchase options three to six months away until expiration. This will allow enough time for the stock to move in price, yet short enough to keep options premiums down.
- To maximize leverage with acceptable risk, purchase ‘at the money’ options where the strike price is roughly equivalent to share price. Slightly ‘out of the money’ is fine too.
- Buy and sell based on technical analysis performed on the underlying shares.
Balancing the Good and Bad with Stock Options
Buying Call and Put options can often return ten times the profits that the underlying share does. However, it also has some caveats associated with it. Time is working against the options contract shareholder. Because close to 80% of options contracts expire worthless, it is evident that some options traders are poor at options selection. Proper options selection can be a sound strategy when used with the portion of capital designated for moderate to high risk. Future articles will be dedicated to researching a wide variety of stock option strategies with lower risk and wider applications.
