In short, it’s a contract. An option gives its holder the right – but not the obligation – to buy or sell 100 shares of stock on a designated date.
Every option is linked to a specific stock. So whenever you place an options trade, its price will be affected by the movement of its underlying stock.
Options come in two standard varieties: calls and puts. And options trade in lots of 100 shares (called contracts).
A call option gives you the right – but not the obligation – to buy 100 shares of a particular underlying stock at a specific price (the exercise price or strike price) before a specified date in the future (the expiration date).
The opposite of a call is a put. A put option conveys the right – but again, not the obligation – to sell 100 shares of a stock at the strike price by the time the put option expires.
All options have expiration dates. It could be a matter of weeks, months or, in the case of certain options called LEAPS (Long-Term Equity Anticipation Securities), up to three years. If you don’t exercise your right within that given time, the option expires and is worthless.
Most options trade on the Chicago Board Options Exchange, American Stock Exchange and, of course, the New York Stock Exchange. There are other options markets, but that isn’t something you need to worry about. When you place a trade with your brokerage firm, it will search the exchanges for the best price.
The important thing for you to understand is that options are traded just like stocks in the sense that they have a symbol and their price fluctuates along with their underlying asset or security…
An option is directly linked to its underlying security – be it a stock, index, commodities future, etc.
For example, you could choose to simply buy 500 shares in Company XYZ, which is currently trading for $10 a share.
Excluding commissions (which are increasingly becoming a thing of the past), that would cost you $5,000. However, you might not want to buy 500 shares at the same time, or you might think the price for that is a little too steep.
So rather than buy the stock outright, you can buy options on it – which are significantly cheaper per share. This gives you the right to buy or sell those same 500 shares at a certain price at a certain time.
The key question you need to ask yourself is whether you think Company XYZ is going to go up or down.
If you think it’s going to rise, you buy calls. If you think it’s headed for a decline, you buy puts. You then need to decide on a strike price (your target price).
Next, you need to pick a time frame for your scenario to play out – the end of which is known as an expiration date. This can be anything from weeks to months to years out from the day you bought the option.
Options prices vary depending on their expiration date and the strike price as well as the volatility of the market or industry and company in question. More on options pricing later.
Anyway, once you’ve done all that, you’re ready to buy.
Options trade in lots of 100 shares. These lots are known as contracts. When you buy an options contract, be it a call or a put, it gives you the right to buy or sell your 100 shares before a specified date in the future – hopefully when the underlying stock hits your strike price.
When you buy an option, it is as though someone is saying, “I will allow you to buy or sell 100 shares of this company’s stock at a specified price per share at any time between now and the expiration date.”
And it’s further understood that for this right, they expect you to pay a fee.
That fee is called the premium, which will vary considerably depending on the exercise price and time until expiration as well as the stock’s volatility…
Selling, or “writing,” options is just as simple as buying them, but it works completely differently. When you write an options contract, you’re selling the right to buy or sell 100 shares of a stock at a given price and on a certain date.
In exchange for selling that right, you collect the options premium upfront. And from there, the play will shake out differently depending on the type of options writing you’re doing…
Writing a naked option means you’re selling the right to buy or sell shares that you don’t own yourself. This can be a good way to make a quick buck – you sell the options, collect the premium and, as long as the option expires worthless, you walk home with your money.
However, if the market goes against you and the options buyer exercises their right, you’re on the hook for hundreds – or potentially thousands – of shares. Naked call writing can backfire on you quickly and in spectacular fashion. But there is a far safer way to write options…
Covered options writing is when you write options contracts for shares you have. For example, if you own 1,000 shares of Coca-Cola (NYSE: KO), you could sell 10 calls against it – one for every 100 shares of Coca-Cola that you have.
With covered options, if the buyer exercises their right, then you lose your shares but you won’t have to scramble to buy hundreds of shares at once on the market, spending your premium and then some. However, if the options contract expires worthless, you also get to keep the shares.
So if you hold a stable blue chip, like Coca-Cola, selling calls can be a great way to leverage it for some short-term cash.
An option has two sources of value. The cost (or premium) of any given option is based on its intrinsic value and its time value.
Intrinsic value refers to the portion of the option premium that is in the money. Any additional value beyond that is considered time value. For example…
A call option has a current premium of $3 ($300 per contract) and a strike price of $45. At the time you buy the call, if the underlying stock’s market value is $46 per share, we say the following about its intrinsic value as well as its time value:
Even if the stock’s value stays the same – leaving the intrinsic value at $1 – as the stock approaches expiration, its time value shrinks, leading to a decrease in the total amount of the premium.
At expiration, the time value will equal zero, leaving the premium value equal to the intrinsic value (in this case, $1).
All options act the same when it comes to intrinsic value. All options that are in the money (i.e., the strike price of the option is less than the stock’s current value) will reflect that value.
If an option is in the money by $5 (e.g., the option is at a $35 strike and the current price is $40), then the option premium will be at least five points. If the option moves $10 into the money, then the option premium will reflect at least 10 points of value.
Conversely, if the stock declines and the option moves out of the money (for example, the strike price is at $45 and the stock is at $44), then the intrinsic value goes to zero and the premium would reflect only the time value.
With all that in mind, let’s take a look at an option listing and put all this together.
This one is for Apple (Nasdaq: AAPL), obviously. This is a monthly option, so it would expire on the third Friday in April. On the expiration date, the options become worthless and you are left holding the bag.
The number next to the expiration date is the strike price. That’s essentially the price you’re betting on the underlying stock exceeding or falling below.
This is a call, so we buy it anticipating a rise in share price. So in our example, we think that Apple’s shares will exceed $105 per share. The higher the share price goes over the strike price, the more money we make.
Here’s an example of how an options play works in practice…
Say we want to buy stock in a company trading for $10 per share. This company has great fundamentals and huge sales growth. In short, it’s going places.
We think we can leverage this by buying the company’s call options, which expire in about two months and have a strike price of $12. They’re trading for a premium of $0.50.
That’s the price per share. Remember, an options contract represents 100 shares, so the full entry price of this trade would be $50, or $0.50 multiplied by 100.
We’re betting that the company’s share price will exceed $12 two months from now. To break even on this trade, the underlying share price of our options would have to exceed our per-share premium plus the strike price, or $12.50.
Let’s say, over the month after we entered our position, the company’s share price shot up 40% to $14. With one month to go, our call has gone up to $2 per share, or $200 for the whole contract.
Now, $2 might not sound like much, but it’s a 300% gain from our $0.50-per-share buy-in.
An investment of just $500 would have become $2,000 in a single month.
Buying a put would work the opposite way.
Say we’re watching another company that trades at $10. We think its shares are very overbought, and we expect it to fall. We believe the price will drop by at least 20%. So we buy $8 puts on it that expire one month from now for $1.
Remember, because an options contract represents 100 shares, each put option would cost $100.
The share price would have to drop to $7 for us to break even. Every amount less than $7 would be pure profit.
That company begins to sell off after an exceptionally bad earnings report. Its share price plummets to $4.
We sell our puts at $300 and again book a 200% gain.
Had you shorted the $500 worth of stock, you would have borrowed 50 shares at $10.
You would have then bought back those same $10 shares at $4, pocketing a gain of $6 per share. That’s a profit of $300 based on 50 shares. That’s a tidy 60% gain. But it’s far less than the 200% gain on the options.
As you can see, options are an exceptionally good way of leveraging short-term movements in the market.
That’s really the benefit of options. They work best when paired with stock picks, giving you leverage on the markets to help you in maximizing your gains.
With that in mind, let’s talk about how the market buys and sells options.
Each options contract has a bid price and an ask price. They’re also known as the bid and offer. It’s a two-way price quotation that illustrates the best price the option can be bought or sold for at any given time.
The bid price represents the maximum price that a buyer is willing to pay for an options contract.
The ask price, or offer price, represents the minimum amount a seller is willing to take for the same options contract.
A trade can occur only after the buyer and seller agree on a price for the option, which is between the bid and the ask.
The difference between the bid and the ask is called the spread. The smaller the spread, the more liquid the option and the easier it is to trade.
To the average investor, the bid-ask spread is an implied cost of trading.
For example, if you’re looking at an option that reads $1/$1.05, someone looking to buy the option would pay $1.05, while the person selling it would receive $1.
The $0.05 difference is pocketed by the market maker. That doesn’t sound like much, but remember that each contract represents 100 shares – so $0.05 a share comes out to $5 per contract.
But before you can actually buy any options, you need to set up your account to trade them…
Thanks to mobile investing apps, like Robinhood and Webull, it’s easier than ever to trade options. Because of them, none of the big brokers charge commissions on trades anymore.
Regardless of which broker you use, you’ll need to get approved to trade options. You simply have to answer a few questions from your broker and you should be approved in no time.
Now, there are several levels of accounts when it comes to trading options. Level 1 allows you to sell covered calls and cash-secured puts. Cash-secured means the trader has the cash on hand to buy the shares at the strike price to deliver the shares should the options holder exercise.
Level 2 allows you to buy long options, standard calls and standard puts. Most brokers limit access to Level 2 and higher because of the higher risks involved. If, for example, the puts or calls expire worthless, the buyer is out the premium they paid.
Account Level 3 allows you to set up trading spreads and buy on margin – that is, to create positions whose value exceeds that of their current account. Options spreads are far more complicated than other option strategies.
Finally, Level 4 accounts let you sell naked calls and puts. These use the riskiest trading strategy, as the upside is limited to the premium and the potential downside is considerably greater than you would get for selling the naked options.
I wouldn’t worry too much about Level 3 and Level 4, as the most common types of plays can be done with a Level 2 account… And setting up your account to trade options at Level 2 shouldn’t take more than a few minutes.
However, the process will vary between brokers. If you have any trouble, reach out to your broker’s customer service department.
It might take some time to familiarize yourself with all the intricacies of options trading, but setting up an account to trade can be done in as little as five minutes.
Once your broker approves you, you’re all set. Trading options is not that different from trading stocks.
Now, buying stock is simple. You just log in to your brokerage account, search by the company’s symbol or name, select the number of shares you want, and click “Buy.”
Buying options is just as easy. It has a couple of extra steps though. Start by looking up the options available for the stock you want.
Once you’re looking at the list, find the one that matches the expiration date and strike price you want.
When you find the option you want, select the number of contracts you want to purchase and click “Buy to Open.” To sell, select “Sell to Close.”
It’s that easy. Armed with this guide, you’re all set to take your first steps into the world of options trading.
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April 2022.
