If you spend much time investing, you’ve undoubtedly heard about options.
It’s a way to profit from stocks, whether they rise or fall. Best of all, it doesn’t require a long-term commitment of a large amount of capital, the way traditional stock market investing does.
It’s a very specialized investment method, and not for the faint of heart.
If you’re interested in stepping into it, below we offer a high altitude view of the basics of options trading.
If you do decide to go ahead, be sure to take advantage of virtual trading accounts, which are offered by many large investment brokers.
They’ll give you a chance to learn the ropes before committing real money.
First, What Are Options?
Though options are tied to the price of a security, they don’t actually represent ownership of it.
That means it will be possible to profit from either the gain or loss in the value of the underlying security, without actually holding the position in your portfolio.
Options are contracts to buy or sell stocks at a certain price, and within a specific timeframe.
For example, you might purchase an option to buy stock in ABC Corporation at $50 per share, by July 31.
Should the stock rise in price to $60 within that time, you can purchase the stock at $50, and realize an immediate gain of $10 per share. If you purchased an option to buy 100 shares, you’ll realize a gain of $1,000 (100 shares X the $10 price gain), less the cost of the option trade.
If however the share price never reaches $50, you can simply let the option expire, and your only loss will be the trading fees you paid to purchase the option. That’s because the buyer of the option has the right, but not the obligation, to exercise the option.
Conversely, if you purchase the right to sell stock ABC Corporation at $50, and the price drops to $40, you’ll realize a gain of $10 per share. Once again if the option was for 100 shares, you have a total gain of $1,000, less the cost of the option trade.
And just as is the case with an option to buy, if the price of the stock never falls below $50, you can simply let the option expire, and your loss will be limited to the cost of the option trade.
Defining the Types of Options
The universe of options has its own language, so we’ll start with some basic definitions of important terms.
Option writer. This is the term for the seller in an option contract.
Option holder. This is the term for the buyer in an option contract.
Puts. This is the right to sell a security within the option contract at a price specified in the contract. Basically, a put is a way to gain from the decline of the underlying security.
Calls. This is the right to buy a security within the option contract at a price specified in the contract. A call is a way to profit from an increase in the price of the underlying security.
Strike price. This is the price within an options contract to either buy or sell the specific security. That price must be exercised within the date listed in the contract. As the option holder (buyer, making a call), you’ll be looking for the price of the security to rise above the strike price. However, as the option writer (seller, making a put), you’ll be wanting the market price of the security to fall below the listed strike price.
Option expiration. Each option contract has a specific period of time within which the option to either buy or sell must be exercised. If an option to purchase 100 shares of a stock has an expiration date of October 15, the option must be completed no later than that date. If it doesn’t, the option will expire and become worthless.
Options contract. The agreement that spells out the specific terms of the option, including the strike price and expiration date. A contract is composed of 100 shares of stock in a given company. If you want an option for 1,000 shares, you’ll purchase 10 contracts.
Bull vs. Bear Options Trading Strategies
There are actually several strategies used with options, as it’s generally a trading activity used by more sophisticated investors.
But two of the most common strategies are bull strategies and bear strategies.
Either strategy describes the basic process we covered the very beginning, but here we’ll also discuss the advantages of each over other strategies to either gain from the rise or decline of a stock price.
This is the general strategy you will use if you believe the price of a certain stock will rise.
In this case, you’ll purchase a call option. That may give you the option to purchase 200 shares of a company stock at $100 per share.
If the price of the share then rises to $120 within the option expiration, you can exercise your option to buy it at $100 per share. You can then immediately sell it for a profit of $20 per share.
Since the option is for 100 shares, your profit will be $2,000.
If you paid $200 to purchase the option, your net profit will be reduced to $1,800. That will enable you to earn a very quick profit without having to tie up a large corner of your portfolio holding the stock until the price rises.
In effect, it’s a way to leverage control over a large amount of stock, but doing so without the need or cost of margin financing.
This is a major reason why options trading has become so popular in recent years, particularly with the advent of online, discount brokerage firms.
We’ll discuss the fees associated with options trading when we list recommended options trading platforms. Fees vary from one platform to another, so it’s difficult to generalize.
This is the exact opposite of the bull strategy.
With the bear strategy, your expectation is that the price of the stock will decline.
In this case, you would use a put option enabling you to sell the stock at $100 per share.
If the option is for 100 shares of stock, and the stock price falls to $80, you’ll get a $2,000 gain. Once again, if the cost of the trade is $200, your net profit will be $1,800.
This strategy is generally safer than shorting the same stock, which is another strategy to gain on the decline in a stock price.
The basic problem with shorting is that while your gain is limited to 100% – assuming the unlikely event the stock goes all the way to zero – but your potential loss could even be greater than 100%.
That’s because there’s no limit on how high a stock can go. If you bet against a stock with a short, and the stock price takes off, your position could be completely wiped out.
Using the bear strategy, you’ll enjoy the gain if the value of the stock falls, but you won’t have any of the risk if it rises.
After all, if the stock price rises above the strike price before the option expires, you can just let the option expire, and your only loss will be the $200 you paid for the option fee.
Recommended Brokers for Options Trading
There are dozens of brokerage firms, but not all are appropriate for options trading.
It’s a very specialized form of investing, and you’ll need to choose a broker that has the right combination of low fees and options trading tools.
For that reason, don’t focus solely or mainly on price. Many platforms have resources and trading tools that will help you be a better, more profitable options trader.
Recommended brokers include (in no special order):
Ally Invest. Ally offers a robust options trading platform, with no minimum balance required. Their fees are $4.95 per trade, plus $0.65 per contract. But if you make at least 30 trades per quarter, it drops to $3.95 per trade, plus $0.50 per contract. 20 contracts will be $13.95.
TD Ameritrade. TD Ameritrade offers their thinkorswim trading platform, one of the most comprehensive in the industry. There is no account minimum, and fees are $6.95 per trade, plus $0.75 per contract. 20 contracts will be $21.95.
E*TRADE. E*Trade sports no account minimum balance required, and pricing at $6.95 per trade, plus $0.75 per contract. The cost of 20 contracts will be $21.95.
Charles Schwab. Schwab acquired optionsXpress, one of the top options trading platforms in the industry, and folded it into their own options platform. Like Fidelity, the base fee is $4.95 per trade, plus $0.65 per contract. If you purchase 20 contracts, the cost will be $17.95. There is no minimum account balance required.
Interactive Brokers. This brokerage comes with their OptionTrader platform specifically for options. There is no account minimum, and a fee of just $0.01 per trade, plus $0.70 per contract. 20 contracts will be $14.01.
Fidelity Investments. They offer their Active Trader Pro for options trading. The fee is $4.95 per trade, plus $0.65 per contract. If you purchase 20 contracts, the cost will be $17.95. There is no minimum account balance required.
Robinhood. This is not one of the more advanced trading platforms. However there is no account minimum, and no fees for stocks or options. In other words, if free trades are all that matters, this is your go-to platform.
Options trading is becoming increasingly popular. But before you decide to dive in yourself, be sure to take it slow.
Take advantage of any virtual trading accounts offered by large brokers.
And unless you’re an experienced options trader, be sure to work with a broker that has all the tools and resources you’ll need to master the art.