I remember when I first looked into how to trade stock options years ago, I found it incredibly confusing at first. It took me quite a while to get my head around how they work. In this article I will try and write it in a way that I feel would have helped me to understand when I got started.
A stock options contract lets you buy or sell a stock for any price you choose at a specified point in the future. The main bonus with options is that you are never obliged to buy or sell the stock when the contract expires. If the price moves against you, you can just let the contract expire.
For example if the Exxon Mobil stock was currently priced at $50 and you thought the price was going to increase, you could buy an options contract for 3 months in the future. As I mentioned above, you can choose the stock price you buy at.
Calls and puts
A call option gives the owner of the contract the option to buy the stock on expiry. A put is the reverse, offering the option to sell the stock on expiry.
This is the price that the owner of the contract can buy or sell the stock at on expiry.
At The Money
At the money refers to the strike price being equal (or very close to) the current price of the stock.
Out Of The Money
This is where a call option has a strike price higher than the current stock price. A put option is out of the money if the strike price is lower than current stock price.
In The Money
This is the opposite of out of the money.
A call option is in the money if it has a strike price lower than the current stock price. A put option is in the money if the strike price is higher than the current market price.
All options contract have a premium to pay. The premium will always be high if a options contract is in the money rather than at the money or out of the money.
I hope you are not too confused so far. Let’s look at a live example of a stock options trade.
Let’s say we think the Google stock is going to go up significantly over the next year. The google stock price at the time of writing this article is $600.
We will to buy an at the money call option with an expiry of one year from now.
For this stock, 1 contract is equal to 100 shares. We will just buy the one contract in this example. This would mean I am buying $60,000 worth of google stock (100*$600)
My broker informs me that is options contract will cost me $7,100.
I need to pay this $7,100 up front. This is the most I can lose on this particular options contract.
We will now look at 2 scenarios:
If in one years time, google had a bad year and the stock price fell by 50% you would lose the $7,100 you paid for the premium. You can see here how options can protect you if a company’s stock drops significantly.
However, if they continue to grow and their stock reaches $800 after a year your profit would be substantial.
The $60,000 investment would have grown to $80,000. A profit of $20,000. The only cost would still only be the premium of $7,100, resulting in a net profit of $12,900.
Broker for Stock Options Trading
Most of the popular stock brokers let you trade options. The cost is under $1 per contract for most discount stock brokers.