Understanding options trading basics can be a difficult topic to understand for investors who have not been exposed to this type of investing. Many people can easily pick up the basics of stock analysis and how they are traded. Share price, volume, buy and sell are just a few of the important concepts to understand when you trade stocks.
Stock option traders, however must learn several additional concepts in order to be successful. Learning the options trading basics is the first place to start, provided the investor has a clear understanding of how the stock market works in general.
Stock Options Trading Basics
Here are 6 options trading basics that are critical to understand.
1. Strike Price
The strike price of an option (also known as the exercise price) is a fixed value that never changes for the length of the contract. For call options, the strike price is the amount per share the underlying stock can be purchased for, on or before the expiration date. If an investor owns a call contract with a strike price of $50, then they have the option to purchase the underlying stock at that price even if the stock trades well above that amount.
Investors who are bearish on a stock can opt for a put option where the strike price is the amount per share that the underlying stock can be sold for. An investor who owns a $55 put has the right (but not obligation) to sell the underlying stock at the strike price. Even if the stock trades well below the this amount, the owner of the option can exercise their right to make a profit from the large gap between strike price and share price.
2. Expiration Date
Another important options trading basic that should be fully understood by investors is the expiration date. Each option has an expiration date which defines the day the contract is no longer valid, unless it has been previously exercised. An American option can be exercised on or before the expiration date.
It is important to note that options traded in the United States usually expire on the third Friday of each month. Unless this day falls on a holiday, this is almost always the expiration date of an option.
3. Intrinsic Value
The total value of an options contract is based on two different pieces. One of the parts is referred to as the intrinsic value, which is the difference between the underlying stock price and the strike price. In the case of a call option, if the strike price is $25 and the share price is $30, the intrinsic value is considered to be $5. Anytime the share price falls on or below the strike price for a call, the intrinsic value is $0.
For a put, anytime the strike price is above the current share price, then there will be an intrinsic value. For example, a put option with a strike price of $45 that has an underlying stock trading at $47.50 would have an intrinsic value equal to $2.50. Anytime the stock price rises above the strike price, the option is considered to have no intrinsic value.
4. Time Value
The other piece that makes up the value of an option is known as time value. Time value is important to an option, especially when it has no intrinsic value. Go and look at any option that has no intrinsic value and you will see how it still has some value, even as low as $.05. This phenomenon is known as time. An option that has several months to expire will have more time on its side and have the potential to eventually build up an intrinsic value depending on how the underlying stock preforms.
The next time you look at an options contract that has several months till it expires, see if you can calculate its time value. It is everything left over after the intrinsic value. In many cases, options only have a time value because of where the stocks price is trading in relation to the strike price.
5. In the Money
When a stock option is considered in the money, it means that it can be exercised and is actually worth money. An in the money call option is one where the strike price is below the current share price of the stock. For example, say you purchased a call with a strike price of $25. This option will be considered in the money as long as the stock trades at $25.01 or above.
Put options can also be considered in the money when the share price of the underlying stock is above the strike price. For example, if you owned a put option with a strike price of $30, it would be considered in the money as long as the stock did not trade above $29.99.
6 . Out of the Money
An option that is out of the money would technically be worthless as soon as the expiration date has passed. A call option that is out of the money has a exercise price that is above the current share price. A call with a strike price of $30 is considered out of the money when the share price trades at $29.99 or below.
A put option on the other hand is out of the money when the share price exceeds the strike price. A put with a $25 strike price is out of the money as soon as the share price trades at $25.01 or above.
It is important to note that a stock option with a strike price around the current share price can move in and out of the money on a given trading day. This is why concepts like time value are important to understand and help to make an out of the money option still hold some monetary value up until the expiration date.
There are many important concepts to learn as an options trader, regardless the type of options trading strategy that is implemented. The strike price and expiration date are both critical pieces of information that never change for the lifetime of the option. The relationship between the strike price and expiration date in relation to the underlying stock help make up the total value of an option which has two parts – time value and intrinsic. All of these factors help define if an option is then considered to be trading in the money or out of the money.
Understanding these options trading basics will help investors build on their knowledge into more complex and lucrative strategies.
What options trading basics do you consider to be the most crucial to comprehend to be a successful investor?
Photo credit: Alex E. Proimos