Stock Option Trading
The basics of stock option trading using simple and clear examples.
Stocks, bonds, CDs, and mutual funds are all common words these days. In fact, even the most inexperienced investor can give a pretty good description of each one of these financial tools. Yet, in our “financial tool box” is one that has yet to become widely used. Often misunderstood and usually reserved for the experts, it has been at the center of very successful financial plans as well as a number of disastrous ones.
With the explosion of online investing and the increased interest in all such financial topics, one question seems to be on a lot of minds lately: What is options trading?
Options trading should not be undertaken casually. It is a very risky and speculative financial tool that can offer great rewards in certain cases, but can just as well be very detrimental to anyone’s portfolio if it is abused. Option trading is, however, a rather simple financial tool. Yet, the outcome can vary substantially depending on the way options are used.
An option contract is often defined as “the right to buy or sell a security at a certain price, at a certain time.” Indeed, if an investor acquires a call option on XYZ at $62, for example, he/she has the right to buy stock XYZ at the price of $62. A “Put option on XYZ at $62” is just the opposite. It gives the investor the right to sell stock XYZ at $62. It must be noted that options trading occurs in units of 100 shares, meaning that one option gives you the right to buy or sell 100 shares of XYZ. Therefore, if an investor buys three June $62 puts of XYZ , he/she will have the right to sell 300 shares of stock XYZ at the end of June (at the expiration date of the option).
Option contracts do not need to be exercised. In other words, if the option turns out to be a mistake, the investor can simply choose not to use it. He/she will, of course, incur the loss of the premium paid for the option contract because it then becomes worthless, but no other loss will incur.
Let’s use a simple example: I buy a July $110 call on ORCL. The option costs me $75. When the July expiration time comes, ORCL is trading at $85, so it makes no sense for me to buy the stock at $110. I, therefore, do not exercise my option to buy. My contract becomes worthless, and I have incurred a loss of $75. On the other hand, if ORCL is trading at $150 at the end of July, I will go ahead an exercise my option contract and buy 100 shares of ORCL at $110, therefore creating an instant profit since ORCL is really worth $150 and I bought it for $110 + $75 option cost.
The net profit on this contract is $325 (cost $1175 – current value $1500). Great return considering that I only invested $75. And those profits could be substantially higher if I had bought 3 or 4 option contracts compared to a maximum loss of $75.
It should now be obvious that the main advantage of trading options is the ability to control a large number of shares with a minimum investment. Indeed, buying 100 shares of ORCL at $110 would cost $1100 versus the $75 needed for an option contract giving you the control of those same 100 shares! So whether you are trying to limit your initial investment, speculating, or simply hedging your portfolio to limit losses, options offer a lot of advantages provided that they are used very carefully and in small amounts. Furthermore, option contracts, just like other securities, do fluctuate in value and can be bought and sold just like stocks.
Finally, it is important to differentiate between a European option contract and an American option contract. European options can only be exercised at the expiration date of the contract. On the other hand, American options can be exercised at any time before or on the expiration date.
Option trading can be a very complex financial task, and this article has only addressed the basics. It is advisable for anyone interested in trading options to learn as much as possible before using this very speculative, yet possibly very rewarding, financial tool.