How Do Options Work

People are growing increasingly interested in attempting to make money with options since various investing applications make it easier to learn about and trade them. A wise rule of thumb for any investment, though, is to learn the essentials first.

So, how do options work? This article will explain what options are, how to trade them, and whether or not this is a good financial strategy for you.

About Options

You can buy or sell an asset for a defined price if you execute the transaction by a particular date under the terms of an option contract. When you purchase or sell an option, you’re actually trading a contract, not the actual asset. This is a crucial distinction to be aware of while learning how to invest money.

Options are derivatives, and it’s crucial to know this. There are a number of advantages to trading contracts rather than assets, such as stocks or commodities. Individual stocks, stock indexes, ETFs, bonds, commodities, and foreign currencies are among the most common underlying assets for options.

If you exercise your option before it expires, you will be able to buy the underlying asset for a fixed price. It is possible to acquire an option contract for $50 per share that permits you to buy shares of a stock before the contract’s expiration date, for example. The Saturday after the third Friday of the month is the most common expiration date for options contracts, however some contracts specify a different day.

It’s also important to keep an eye out for the option’s premium, which is stated in its contract. A $1.50 premium on an options contract means that you’ll have to spend $150 up front only to acquire the options contract, regardless of how many shares of stock you really own.

Finally, there are two main types of options:

  • The ability to purchase shares at a certain price is known as a “call option.” As an option holder, you are entitled to the shares at the contract price if you exercise your right to purchase them.
  • As an alternative, a put option allows buyers of underlying assets to sell those assets at an agreed upon price. You’re simply buying the right to sell, which might be a bit perplexing at first.

There are several types of options, but remember that when you buy an option, you are purchasing a contract to make a transaction before the expiration date with certain restrictions. You have three options: sell the contract to a third party (preferably at a higher price than you paid for it), execute the contract and proceed in accordance with its conditions, or let the option expire and do nothing.

How are options calculated?

You must first grasp how options are presented before you can comprehend how options operate. A typical stock option is a nice illustration of this. You may see: if you look at the choice.

XYZ May 50 Call $1.50

Why do you think this is? Here’s how to put it into words:

  • The ticker symbol for XYZ’s stock is XYZ. In the options contract, this is the stock on which the options are based.
  • When the option expires in May, it will no longer be available.
  • The price at which the underlying stock can be bought or sold is shown by the number 50. An example of this would be a stock with a $50 “strike price.”
  • This is a call option, as indicated by the call sign. In this situation, if you buy the option, you’ll be able to buy the shares at issue. It would be possible to sell the shares at $50 if this option were a put option.
  • You’ll pay $1.50 per share for the privilege of participating. So, if you want to buy 100 shares of an option, you’ll have to pay a $150 upfront and non-refundable fee.

If you’re looking to purchase or sell options, you have four main choices: buy calls, sell calls, buy puts, or sell puts. Contracts are what you’re purchasing and selling when you trade options. As a result, you have the option of purchasing or selling call contracts or put contracts.

Both ways, the goal is to sell options for more than you purchased for them. You should be able to finish the options contract and obtain a better price than what the underlying asset is now selling for.

In-the-money vs out-of-the-money

When it comes to options, knowing if you’re in or out of the money is crucial (or, sometimes, at-the-money). The most important consideration in options is the strike price, which is the predetermined price at which the underlying asset can be bought or sold.

A call option is worthless if the strike price is higher than the stock price. With a $50 strike price, you’re in-the-money if you bought an XYZ option and the stock market price of XYZ is over $50. A $75 per share price increase is possible for XYZ stock. If you pay $50 for 100 shares of stock, you are entitled to do so. If the stock is being sold at a discount to the market price, this indicates you’re making money.

As a result, when the asset’s value drops below the strike price, you’ll lose money. This means you’ll have to pay extra for your shares if XYZ’s share price falls below $40 before you can fulfill your contract, even if you opt to do so at $50.

It’s the opposite way around with a put, which is a right to sell an asset if an option is in the money or not. If the stock’s price goes below the striking price, you’ll make money; otherwise, you’ll lose money if you can sell the shares for more on the open market than what’s specified in the options contract.

When a call option is at-the-money, there is no difference between its strike price and the market value of its underlying asset.

Pros

  • You can use it to protect other assets you possess against a decline in value.
  • The initial outlay is frequently less than the actual purchase price of the underlying asset.
  • You’ll be able to take advantage of leverage and increase your profits.
  • Allows you to make more complex trading decisions than just buying or selling an item.

Cons

  • Short-term swings in the asset’s price must be accurately predicted.
  • Both for and against you, leverage may be used. Expanding one’s alternatives by taking on debt may result in greater losses.
  • As a result, many options contracts are worthless after the option holder has already paid the premium.
  • Short-term capital gains taxes, which are levied at a greater rate than long-term gains, are likely to be paid on your profits in many circumstances.

Why do investors choose to invest in options?

People select options because they believe they have the potential to help them make money, just like they do with most other sorts of investing and trading.

Options may assist investors control downside risk, which is one of the reasons they’re popular among certain investors. If an underlying asset loses value, put options can provide a safety net. As an example, let’s imagine that you acquire $15 worth of stock. You’d like to be able to sell them in the event that the price falls below your expectations. That’s why you buy a put option on that stock for $12, which gives you a six-month option to sell at that strike price.

This option is worthless as long as the stock price doesn’t move over $15 a share by the expiration date. However, what if the stock price decreases to $9 per share within that time period? You may now sell your shares for $12 each by exercising your put option. Rather than losing $6 per share, you now only have a $3 loss. At least your losses aren’t too bad.

Options for speculation, on the other hand, appeal to a larger audience. If a stock call option is in-the-money when you buy it, the concept is that you can resell it for a profit. You may be able to boost your gains by selling your options to someone else for a higher price than you paid, which gives you access to a bigger number of shares. Making money rapidly with little sums of money is an attractive prospect for some traders.

Put option traders might use this method in the other direction. It’s possible to profit if you’re right about the price of an asset falling by purchasing put options. When the value of the underlying asset plummets, you may recoup the cost of the put option by selling it to someone who intends to use it to sell the underlying asset for a profit. Basically, you can sell the contract at a price that permits you to profit from the difference in the strike price and the market price.

If you’re mistaken about the direction of the price of the underlying asset or fail to locate a buyer, you might wind up losing considerably more than intended. To be successful in options trading, you must have the ability to accurately predict short-term price changes and market events that might affect those prices.

Because price changes over a short period of time can decide whether you’re in-the-money or out-of-the-money on an options transaction, timing your entry and exit points is critical during periods of extreme volatility.

Are Options appropriate for you?

People with a high risk tolerance and a little amount of “fun money” at their disposal are typically the best candidates for options trading. Using leverage to buy options on margin increases the risk of losing more money than you invest, so you should be aware of this while trading options.

Many typical brokerage accounts allow option purchases. Buying and selling alternatives may also be done using internet platforms and applications, which make it easier. Trading options has never been easier because of platforms like Gatsby, Robinhood, and Webull.

However, despite the fact that these applications might make option trading easier, you should still take the time to learn how they function and how they fit into your overall portfolio. As a result, many novice traders wind up losing more money than they intended because they lack a thorough understanding of the options trading process.

Check out our selection of the finest investment apps if you’re interested in long-term wealth building. While some of them can help you get started with very little capital, others can do the bulk of the work for you automatically. Options trading may not be the greatest solution for people looking to develop long-term wealth, especially those with a limited tolerance for risk.

About the author: David Krug is the CEO & President of bankovia. He’s a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he’s not reading about cryptocurrencies, he’s researching the latest personal finance software.