An investor doesn’t need to be the Wolf of Wall Street, a CFO, an Ivy League graduate or a math wizard to understand how to trade options.
Once trained, even dummies can do it! Just realize trading options involve financial risks.
This article is intended to prepare investors to understand and manage the risk of option trading. To start, understand that options are a financial derivative. This means that options derive their value from an underlying security, which could be a stock, bond, index, or other financial asset. Options are a contract between a buyer, who is known as the option holder, and a seller, who is known as the option writer.
This contract gives the option holder the right, but not the obligation, to buy or sell an underlying security at a specific price by an expiration date. This specific price is known as the strike price. If the option holder decides to buy or sell the underlying security at the strike price before the expiration date, then this means that he is exercising his right on the option; the alternative would be not to exercise his right and the option would expire as worthless. When the holder exercises his right on the option, then the writer is obligated to sell, or buy, the underlying security to, or from, the holder.
To buy an option, the option holder has to pay the option writer a premium. For example, if the premium of an option is listed as $0.10, then the option premium will cost a total of $10. This is the case because one option contract equals 100 shares of the underlying stock.
There are two types of options known as calls and puts. If the option holder owns a call option, then it is his right to buy the shares of the underlying stock at the strike price by the expiration date. He would purchase a call option if he thinks the market value of the company’s stock is increasing. If the option holder owns a put option, then it is his right to sell the shares of the underlying stock. He would purchase a put option if he thinks the market value of the company’s stock is decreasing.
A person would write a call or put option to make a profit from the premiums paid to him. He would write a call option if he believes that the market value of the company’s stock is going down. He would write a put option if he believes that the market value of the company’s stock is going up.
Let’s get into a few examples that can piece all this information together:
(1) Call Option: Coca-Cola Bottling Co. (NYSE: COKE) stock is trading at $130. Buy a call option for COKE, if COKE is expected to rise in value. The strike price of the option is $132 and the expiration date is in one month. To buy the call option, pay a premium to the option writer of $1 per share, or a total of $100. Within that month, the price of COKE stock goes up to $135. To profit, exercise the right acquired on that option, and buy 100 shares of COKE at $132 (the option writer sells them to you). Immediately sell those 100 shares at the market price of $135. This generates a profit of $3 per share, or $300. Due to paying the premium, however, the profit becomes $200. If the COKE stock didn’t go above the strike price of $132 within the month, then the call option would expire worthless; the writer of the option would keep a profit of $100.
(2) Put Option: McDonald’s Corporation (NYSE: MCD) stock is trading at $160. A put can be purchased if MCD is expected to fall in value. The strike price of the option is $157 and the expiration date is in three weeks. A premium is paid to the option writer of $1 per share, or $100. Within those three weeks, the price of MCD stock goes down to $155. The holder of the put option then can exercise his right on the put option, and buy the MCD shares at $155, but sell them at $157 (the option writer buys them). This generates a profit of $2 per share, or $200. After paying the premium, it gives the put option buyer a profit of $100. If the MCD stock didn’t go below $157 within the three weeks, then the put option would expire worthless; the writer of the option would retain a profit of $100.
These examples indicate how to trade options profitably. With an understanding of these basics, options can be demystified.