If you’re looking to build up an investment portfolio there are a number of securities you can choose to invest in, everything from stocks and bonds to mutual funds. But one of the most popular securities are stock options. But what exactly are stock options and how do they work? In this article we’re going to cover a few stock options basics, these are the things you need to know before trading options.
Speak the Lingo
Before you begin trading options you need to understand the lingo. Option traders have developed their own language over the years. To help you understand what they’re talking about we’ll cover a few of the most common phrases here;
Call Options: Known as a call, you purchase these in the hope that the price will rise before expiry.
Put Options: Known as a put, you purchase puts in the hope that the price will fall before expiry.
Strike Price: The price at which the option is executed, it differs from the spot price which is quotation only.
Option Premium: The income received by an investor who sells an option contract to another party.
Option Expiration: The option expiry is the time or date at which the option expires. At this point you have to decide whether to execute the option or not.
Options Moneyness: Moneyness is the intrinsic value of an option in its current state. Is the option profitable or running at a loss? Should you keep the option open or cut it short?
Margin requirements: The amount an investor needs to deposit before he can trade on margin. Margin requirements are determined by the Federal Reserve Board.
Iron Condor: The iron condor is an advanced option trading strategy utilizing two vertical spreads – a put spread and a call spread with the same expiration and four different strikes.
Long Straddle: The long straddle is a non-directional options trading strategy that involves simultaneously buying a put and a call of the same underlying asset.
Short Straddle: The short straddle is a non-directional options trading strategy that involves simultaneously selling a put and a call of the same underlying asset.
Long Butterfly: The long butterfly is long position that will make profit even if the future volatility is lower than the implied volatility.
Short Butterfly: The short butterfly is the same as a long butterfly but taking a short position.
Long Strangle: The long strangle is a trading strategy that involves buying both a call option and a put option of the same underlying security.
Short Strangle: The short strangle is a trading strategy that involves selling both a call and put option of the same underlying security.
Covered Put: The covered put is a put option that’s sold by an investor which is backed by a corresponding number of long shares in the underlying security.
Covered Call: A covered call is a call option which is bought by an investor which is backed by a corresponding number of short shares in the underlying asset.
Bull Put Spread: A bull put spread is a type of options strategy that’s used when the investor expects a rise in the price of the underlying asset.
Bear Put Spread: A bear put spread is a type of options strategy that’s used when the investor expects a fall in the price of an underlying asset.
Bull Call Spread: An options strategy that involves purchasing call options at a specific strike price whilst also selling the same number of calls of the same asset and expiration date but at a higher strike price.
Bear Call Spread: A type of options strategy, it’s achieved by selling call options at a specific strike price while also buying the same number of calls, but at a higher strike price.
Bull Calendar Spread: Is a bull options strategy that involves purchasing options in the same underlying asset but with different expiration’s.
Bear Calendar Spread: The same as a bull calendar spread but used in a bear market.
Protective Put: A risk-management strategy that investors can use to guard against the loss of unrealized gains.
Protective Call: The same as a protective put but uses call options instead.
VIX Options: A type of non-equity option that uses the CBOE Volatility Index as the underlying asset.
Naked Puts: A put option where the option writer does not have a position in the underlying market.
Index Options: A security that uses one of the indices as the underlying market. The S&P 500 is a good example of an index option.
Credit Spreads: An options strategy where a high premium option is sold and a low premium option is bought on the same underlying security.
Volatility Smile: A popular charting pattern that results from plotting the strike price and implied volatility of a group of options with the same expiration date.
What are Stock Options?
An option is the right, but not the obligation to buy an underlying asset at a specified price on or before a predetermined date. They’re a binding contract with very specific rules to prevent people from reneging on them.
Still confused? Let’s look at an everyday example. Let’s say you have a love of fast food and want to buy 2000 shares in McDonald’s, you agree a price of $100.50 per share, which means you’ll have to hand over $200,100 in total. But you can’t afford to pay for them just now so you agree with the seller to hold the shares for one week, until you can cover the cost.
The options seller agrees that he’ll hold the shares for you at $100.50 for one week. He charges you $300 for doing so. After one week you have the option to either buy the shares at $100.50 or cancel the contract, in which case you would forfeit your $300 options fee. In the above example you would be the options buyer.
Now two things can happen, the price of McDonald’s could rise above $100.50 to $101.80 due to the launch of a new happy meal, complete with Shrek character. In which case your original shares would now be worth $203,600, giving you a profit of $2300 after you’ve paid the option fee.
Or the price of beef could rise weighing down the price of McDonald’s to around $100, 00. This would mean your investment was worth $200,000, if this happens you don’t have to take up the option but you would still have to pay the option fee, in which case you would lose $300.
Hopefully this little example show’s you in simple terms how options work. They can be a little confusing to get your head around at first, but once you’ve carried out a few test trades you’ll soon get the hang of them. The most important thing to remember is that you’re under no obligation to buy the underlying stock, you’re simply trading the option to buy the stock at the desired price.
If you want to start trading options there are a number of basic stock options strategies that all traders should know. All these strategies are tried and tested and used by professional options traders everyday. So if want to be successful at trading options, start by testing a few of these strategies in your virtual trading account, before you risk any real capital.