An option is a derivative of a stock, future, index or exchange traded fund which means that their value depends on the price of the underlying trading instruments as mentioned earlier. Every option has a strike price that is a certain price of the stock. The value of the options change relative to how close the strike price is to the current price of the underlying trading instrument. Every option has a limited life as well; it depends on it's expiration date. Once it is passed, the option will no longer exist.
There are basically two types of options: the call option and the put option. Options trading is all about these two types of options. When you buy call options, it means that you are bullish about the price of the underlying instrument and if you buy put options, it means that you are bearish about the price of the underlying instrument.
When you buy call options, you reserve the right to buy a stock at the strike price. When you sell call options, you are obliged to sell the stock at the strike price. Let's take a look at an example:
Andy purchases 3 call option contracts (the right to purchase 300 shares, 1 option contract is equivalent to 100 shares) with strike price of $30 for XYZ stock (Note that for every option buyer, there is a seller. However, they do not deal in options trading with each other directly as their stock trading companies or brokerages do so through an exchange) when the XYZ was trading at $28. If the share price of XYZ soars to $40 by the expiration date, Andy can still purchase 300 shares of XYZ stock at the strike price of $30 (Take note, that's a profit of $10 x 300 = $3000 already!) if he chooses to exercise his call options.
Now, the profits from the above options trading transaction may not seem very lucrative in absolute terms. The good thing is that he does not need to pay the price of the 300 shares of XYZ stock for the 3 contracts in the first place. For example, if Andy purchased the contracts when the price of XYZ stock was $28, he might only have to pay for the time value for the life of the option, which might have only been $7 for 6 months to expiration date. This means that he only paid $7 x 3 x 100 = $2100 for the 3 call contracts. Further calculations can allow us to conclude that Andy made a percentage profit of 142.3% for 6 months of work as compared to 35.7% if he had purchased the shares and held onto them for 6 months. See the difference between the two rates of returns in options trading and share trading?
Let's discuss about put options in options trading next. When you buy put options, you reserve the right to sell the shares of the underlying instrument for a certain strike price. When you sell options, you are obliged to sell the shares of the underlying instrument for a certain strike price. Let's follow this up with another example:
Andy now believes that the share price of XYZ is going to fall after reviewing it's price performance. Rather than short selling the shares (which carries a high risk as there is technically no ceiling to how high the share price can rise), he decides to engage in options trading of purchasing 3 put contracts with strike price of $38 and a expiration of 6 months at the cost of $6.50 with the current share price of $40.
Shortly after Andy's purchase, the share price of XYZ starts to tank on alleged accounting issues and incorrect reporting of it's previous quarterly results. Eventually, the share price of XYZ falls to $22 after 5 months and Andy decides to sell his option contracts. He makes a profit of $16 x 3 x 100 = $4800 which is a percentage profit of 246.2% as compared to 40% for short selling 300 XYZ shares and buying it back later. Again, we can see the huge difference in the returns from options trading and stock trading.
What happens when the current share price of XYZ is below the strike price of the option? For call options, it will be practically worthless as there is no intrinsic value (calculated by subtracting the strike price from the current share price) and the time value has dropped to zero (since the option as reached the expiration date). For put options, there will be an intrinsic value (calculated by subtracting the current share price from the strike price) and although the time value has dropped to zero, Andy's stock trading company or brokerage firm will exercise his contract and arrange for the sale of his shares at the strike price. If he does not possess the shares, his stock trading company or brokerage firm will buy from the open market and sell at the strike price. This is basically how options trading works.
A word of caution here! While options trading can amplify one's returns from the stock market, it can also amplify one's losses as well if not used properly. Hence, it is strongly advised that one should not start to engage in options trading unless one has mastered stock trading at the intermediate level; this means that you have to at least be making some money consistently by stock trading.
Another form of options trading which is much more dangerous than buying options is selling them. Although it is a strategy used by some good traders to make money consistently in the stock market, it can be very dangerous especially if the seller is selling call options naked, which means that he or she does not own the shares he or she is obliged to sell to the buyer. If the option is exercised, the seller will have to buy the shares from the open market at the current share price and sell it to the buyer of the option at the strike price.
That's all for the introduction to options trading for now. In the future, I will be posting on this topic of options again to explain the uses and how it can be safer than stock trading if used properly.
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