Stock Options have proven to be one of the most versatile and profitable investment vehicles available. Options can provide investors with a means to hedge risk, earn income, speculate on price movements, and even store value. However, options are also one of the most complex financial instruments to trade, which is why they are often misunderstood and misused.
In this article, we will take a close look at what options are, how they work, and some of the most popular option strategies that beginners can use.
Let’s jump right into it.
What Are Options?
Stock Options are contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price within a certain time frame. There are two types of options: call options and put options.
Call Options
A call option is a contract that gives the holder the right to buy an underlying asset at a specified price within a certain time frame. For example, let’s say you buy a call option on ABC stock with a strike price of $50 and an expiration date of December 21st. This means that you have the right to buy ABC stock for $50 on or before December 21st. If the stock price is above $50 on December 21st, you will exercise your option and purchase the stock for $50. You can then sell it immediately at the current market price and pocket the difference. If the stock price is below $50 on December 21st, you will not exercise your option and you will lose the money you paid for the option.
We just covered buying a call option which is also known as a Long Call. Long means you are buying and hoping the stock price goes up.
A Short Call is the opposite of a Long Call. It is when you sell a call option in hopes that the stock moves down in price.
Put Options
A put option is a contract that gives the holder the right to sell an underlying asset at a specified price within a certain time frame. For example, let’s say you buy a put option on XYZ stock with a strike price of $40 and an expiration date of December 21st. This means that you have the right to sell XYZ stock for $40 on or before December 21st. If the stock price is below $40 on December 21st, you will exercise your option and sell the stock for $40. You can then buy it back immediately at the current market price and pocket the difference. If the stock price is above $40 on December 21st, you will not exercise your option and you will lose the money you paid for the option.
We just covered buying a put option which is also known as a Long Put. Long means you are buying and hoping the stock price goes down.
A Short Put is the opposite of a Long Put. It is when you sell a put option in hopes that the stock moves up in price.
Expiration Date
The expiration date is the date when the option contract expires and can no longer be exercised. For both call and put options, the expiration date is the third Friday of the month in which the option contract expires.
The expiration date is important because it determines whether or not an option is in the money or out of the money. An option is in the money if it has intrinsic value, which means the underlying asset’s price is above the strike price for a call option or below the strike price for a put option. An option is out of the money if it has no intrinsic value, which means the underlying asset’s price is below the strike price for a call option or above the strike price for a put option.
Intrinsic Value
The intrinsic value is the difference between the underlying asset’s price and the strike price. For example, let’s say the stock price of XYZ is $50 and the strike price of your XYZ put option is $40. The intrinsic value of your put option is $10 because it allows you to sell XYZ stock for $10 above its current market price.
Time Value
The time value is the difference between the option’s premium and its intrinsic value. The premium is the price you pay for the option contract. The time value is important because it represents the chance that the underlying asset’s price will move in your favor before the expiration date. The longer the time frame, the greater the chance that the underlying asset’s price will move in your favor and the higher the time value will be.
For example, let’s say the stock price of XYZ is $50 and the strike price of your XYZ put option is $40. The intrinsic value of your put option is $10 and the premium is $15. This means that the time value of your option is $5 because it represents the chance that the stock price will fall below $40 before the expiration date.
As a general rule, the closer you get to the expiration date, the less time value an option will have. This is because there is less time for the underlying asset’s price to move in your favor.
Volatility
Volatility is a measure of how much the price of an asset fluctuates. A volatile asset experiences price swings, while a less volatile asset experiences smaller price swings.
Volatility is important because it affects the time value of an option. The more volatile an asset is, the greater the chance that its price will move in your favor before the expiration date and the higher the time value will be.
For example, let’s say you buy a call option on XYZ stock with a strike price of $50 and an expiration date of December 21st. XYZ stock is very volatile and its price moves up and down a lot. This means that there is a greater chance that its price will be above $50 on December 21st and you will make a profit.
However, if XYZ stock is not very volatile and its price doesn’t move much, there is a lower chance that its price will be above $50 on December 21st and you will make a profit.
Seller’s of option premium are looking for high volatility so they can sell options with high time value. Buyers of option premium are looking for low volatility so they can buy options with low time value.
At-The-Money
At-the-money options are options with a strike price that is equal to the underlying asset’s current market price. For example, let’s say the stock price of XYZ is $50 and you buy a call option with a strike price of $50. This option is at-the-money because the strike price is equal to the stock price.
At-the-money options have the highest time value because they have the greatest chance of making a profit. This is because the underlying asset’s price only has to move in your favor by a small amount for you to make a profit.
Out-Of-The-Money
Out-of-the-money options are options with a strike price that is higher than the underlying asset’s current market price for call options or lower than the underlying asset’s current market price for put options. For example, let’s say the stock price of XYZ is $50 and you buy a call option with a strike price of $60. This option is out-of-the-money because the strike price is higher than the stock price.
Out-of-the-money options have the lowest time value because they have the lowest chance of making a profit. This is because the underlying asset’s price has to move a long way in your favor for you to make a profit.
In-The-Money
In-the-money options are options with a strike price that is lower than the underlying asset’s current market price for call options or higher than the underlying asset’s current market price for put options. For example, let’s say the stock price of XYZ is $50 and you buy a call option with a strike price of $40. This option is in-the-money because the strike price is lower than the stock price.
In-the-money options have intrinsic value because they are already in a profit position. They also have time value because there is still a chance that the underlying asset’s price will move further in your favor before the expiration date.
The Bottom Line
Options are often used as a hedging tool to protect against losses in the underlying asset. They can also be used to speculate on the future price movements of an asset. As a beginner, it is best to start with simple call or put options and then move on to more complex strategies such as straddles, strangles, and spreads.
Always do your research and consider your investment goals before you begin trading stock options. For more stock and financial information, please check out our other resources at OptionsFinanceProfits.com.
