Trading Stock Options
If you want to make money in the stock market no matter which direction it is going, up, down or sideways, you can do it by trading stock options.
Options trading is a very fast way to either make money hands over fist, or go broke in a hurry if you are careless and do not know what you are doing. This kind of “playing” the stock market is very risky and takes a lot of guts, especially for beginners, and/or if you do not have the money that you can afford to lose. It takes time and experience to get a good feel for options trading. Once you are knowledgeable and have a feel (some experience) for it, trading options can be a great way to make money.
In its simplest explanation, an OPTION to buy or sell a certain stock is bought or sold, rather than the stock itself. It allows someone to buy or sell the stock, within a certain period of time, at a certain price, called the “strike price.”
The advantages of trading stock options are cost and volume. Options are much cheaper than the associated stock. For example, an option for a stock selling for, lets say $10.00 a share, may be only .20 a share. One hundred shares (called a “lot)” of the stock would cost $1,000.00, but the option for 100 shares, would only cost $20.00.
There are many types of options, which are used in different strategies, but the basic types of options are Calls and Puts. A Call option is traded if a stock is thought to rise; a Put option is traded if it is believed that the stock will go down.
Example: XYZ trades at $100/share and is thought to be heading up. Let’s say you decide to buy 2 CALL options with a strike price of $110. You pay $1/share, which means you paid $200.00. (If you would have bought the stock, it would have cost you $2,000.) As the stock rises, the value of the option also rises. Let’s say the stock rises quickly to $120/share. Now, the option value may be worth $5/share.
There are basically three things that can happen here:
- You Could sell your options, your profit would be $800 (200 shares X $5 – $200 investment).
- Someone may exercise your options, meaning they purchase the stock that is now worth $120/share at the option (strike price) of $110/share. They are getting it $10/share cheaper (a great deal for them). You would only retain your investment expense ($200). It’s a wash, no gain, no loss, which is the reason you have to be on your toes and take a profit on the options before they are exercised.
- Options expire worthless on the third Friday of each month. If the options are not sold or bought, during the holding period, they are gone.
There is a (decay) process that must be considered when trading options. You bought this option for $1/share. Even if the stock is appreciating, the option will depreciate slowly as time runs out. So again, you must be on your toes.
Think just the opposite for a PUT option. You think XYZ stock will go down. You buy options on it; as the related stocks depreciate, the value of the option increases.
22 Comments
Not for me, I think. I like stuff I can start and forget about.
Nice article and very interesting.
I am just excited. Thanks my dear!
I have to think about this some more…thank you for the information.
Very interesting and informative lots of tips here
Thanks for explaining how all this works! Nice article, well done!
Great article, Wess. These are some really helpful tips!
Westbrook,
Thanks for the information you have provided on stock optins trading.
You have described only the less, but mostly sure, risk part of it. That is buying stock options. It may be either put or call.
But the most risky is the one that is also most profitable and most done these days. That is selling options.
Both are equally opposite in terms of risk and its surity. But selling options is what gives the options trader real money after the expiry day. And I believe this is what most options traders do, like any insurance business.
Don’t you agree?
Thanks,
-fornls.
this is very informative… good advice and info… thanks for sharing this!
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Fornis,
Trading stock options is one of the riskiest ways to gamble in the stock market, but can be very rewarding and profitable if played properly, the related stocks go your way, and you have a little luck. I have traded options for years and I would have to disagree with you that the risk and surity are equal. There is nothing sure in trading options except the rules such as the decay factor. I wrote an example using a call option and ended the article by stating that the PUT option is just the opposite of the CALL option. I did not want to spend more time writing so I ended it that way. However, I plan to write about puts in order to complete the picture. There are many strategies used in options trading, which I plan to write about. The traders who make out the best are those who have money to play with. Not only can options be bought and sold, they also can be written, which I will explain in future articles.
Great article and good information but I don’t think Ill risk putting money any where near the stock market especially right now.
Westbrook,
Thanks for the response. I think we haven’t come to a common understanding.
I am asking about selling options. It can be a CALL or a PUT. When you sell an option, you take unlimited risk for fixed amount of possible gain. This gain comes when the stock does not reach the strike price and the expiry date passes.
Most of the time we can easily think of some bounds for the market during a given period. Let us take this month. Today being feb 22. If feb 28 is the expiry (let us assume), we can safely think that in the next 6 days the down jones may not rise/fall by 2000 points. Hence from the present value of 7365, I will try to sell put/call options for 5365/9365 limits safely assuming the index will not cross those points. If somebody buys my option contract for some price, and the expiry date comes, I will keep the money.
But there is risk that I will lose as much proportionally as the index crosses beyond that price if it crosses. The gain that I can make is dependent on how much risk I want to take. Because nobody buys an option from me if they think that the strike price is way too far and the option is just worthless.
So it is a situation based. If there is a feeling in the mind of the option buyer that the index will most likely cross certain value, he will try to hedge by buying an option. Now the option seller sells the corresponding option for a greater price if the risk that is felt at that time is price.
I have found that many institutional investors find it easy to sell options like big insurance firms sell insurance to businesses. And they indeed succeed. Because it again involves lot of trials to average the loss and gains to prove their profits.
Westbrook,
You have written about selling option as well at one point, but it was not very clear to me.
This is something that I’ve thought about doing for several years, but I haven’t been able to come up with the courage or extra bucks to really give it a shot.
thanks for the information! I will keep it in my pocket and reference it when I’m ready to take another look at this option.
Denise Kawaii,
When it comes to trading with courage, direct stock trading gives good flexibility. Trading options is inflexible (or dry). A lot of thought has to be applied when dealing with as they involve lots containing multiple shares at once (100s or 1000s).
When you trade stocks, you can trade few stocks then reverse the trade with more stocks if you are quick to correct yourself.
So if you try to gain leverage from stock options, you lose flexibility. In other words the ability to have multiple chances if you were to fail. Don’t you like second chance? You need it in stock trading compulsorily. Otherwise our portfolio will be burnt eventually!
Fornis, I have been away for awhile. Sorry for not getting back to you. I am tied up doing taxes so I will not spend much time on this right now. One of my endeavors is that I am a tax preparer. I will write more on options in the future, but for now, I said in the last sentence of my last comment that “options can also be written.” When you write an option, you do it to sell either calls or puts. You can sell (write) call or put options on stock positions that you hold. Since options are traded in “lots” (a lot is 100 shares), you must have a hundred shares of a stock for each lot that you write an option on. For example, if you write 10 call or put options, you must own 1000 shares of the related stock. This is because if someone decides to exercise your option, you are allowing someone to purchase the stock that you own at a cheaper price than the market price. If you own a lot of stock – and institutional traders do – you can write a lot of options. Writing (selling) options is much less risky than trading the actual stock or buying options. It is very difficult to time stock price fluctuations and you are fighting time when you buy options, but it is a fact that only about 5% of all written options are exercised, so you get to keep the premium that you collected on most of the options that you (wrote) sold. Keep in mind that writing and selling options on the postions that you own is less risky and therefore safer, but you make less money than if you know how to trade options. There are methods that can be used to be more successful, such as straddles, which I will discuss in future articles.
Westbrook,
I heard about straddles but didn’t focus on that much. As I could trade well with direct stocks, I didn’t consider options trading.
If there are better methods in this too, then let me learn them.
Informative piece–it’s good to know/learn about this.