Three Ways to Buy Options.
When you buy equity options you really have made no commitment to buy the underlying equity. Your options are open. Here are three ways to buy options with examples that demonstrate when each method might be appropriate:
Hold until maturity.
. then trade: This means that you hold onto your options contracts until the end of the contract period, prior to expiration, and then exercise the option at the strike price.
When would you want to do this? Suppose you were to buy a Call option at a strike price of $25, and the market price of the stock advances continuously, moving to $35 at the end of the option contract period. Since the underlying stock price has gone up to $35, you can now exercise your Call option at the strike price of $25 and benefit from a profit of $10 per share ($1,000) before subtracting the cost of the premium and commissions.
Trade before the expiration date.
You exercise your option at some point before the expiration date.
For example: You buy the same Call option with a strike price of $25, and the price of the underlying stock is fluctuating above and below your strike price. After a few weeks the stock rises to $31 and you don’t think it will go much higher - in fact it just might drop again. You exercise your Call option immediately at the strike price of $25 and benefit from a profit of $6 a share ($600) before subtracting the cost of the premium and commissions.
Let the option expire.
You don’t trade the option and the contract expires.
Another example: You buy the same Call option with a strike price of $25, and the underlying stock price just sits there or it keeps sinking. You do nothing. At expiration, you will have no profit and the option will expire worthless. Your loss is limited to the premium you paid for the option and commissions.
Again, in each of the above examples, you will have paid a premium for the option itself. The cost of the premium and any brokerage fees you paid will reduce your profit. The good news is that, as a buyer of options, the premium and commissions are your only risk. So in the third example, although you did not earn a profit, your loss was limited no matter how far the stock price fell.
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Buying Stock Using Stock Options.
Stock Options Are a Viable Addition to Some Investors' Portfolios.
When long-term investors want to invest in a stock, they usually buy the stock at the current market price and pay full price for the stock. One alternative to paying the full price at purchase is to buy it using margin. Basically, this is a 2:1 loan from your brokerage, allowing you, for example, to buy $1,500 worth of stock with an investment of only $500.00.
Another way to buy stock without investing the full amount of the purchase at the point of sale is to use stock options.
Buying stock options allows you to leverage your purchases far more than is possible in even a margined stock purchase.
Stock Options.
A stock option is a contract giving you the right -- but not the obligation -- to buy or sell an equity, usually a single stock, at a specified price. Options are time-limited, although the limits vary widely. If you do not exercise your right before the expiration date, your option expires and you lose the entire amount of your investment.
Stock options can be used to trade a stock for the short term, or to invest for a longer term. Since all options are time-limited, however, most options are used in the execution of a shorter-term trading strategy. Stock options are available on most individual stocks in the US, Europe, and Asia. Note that in contrast to the 2:1 leverage of margin trading in the stock market, option trading effectively leverages your investments at dramatically higher ratios.
This allows you to control a large amount of assets with only a small investment. It also dramatically increases your risk.
Buying Stock Using Stock Options.
When using stock options to invest in a particular stock, the reasons for investing in the stock may be the same as when buying the actual stock.
Once a suitable stock has been chosen, one common options trade is executed as follows:
Sell one out of the money put option for every 100 shares of stock Wait for the stock price to decrease to the put options' strike price If the options are assigned (by the exchange), buy the underlying stock at the strike price If the options are not assigned, keep the premium received for the put options as profit.
Advantages of Stock Options.
There are three main advantages of using this stock options strategy to buy stock.
When put options are initially sold, the trader immediately receives the price of the put options as profit. If the underlying stock price never decreases to the put options' strike price, the trader never buys the stock and keeps the profit from the put options. If the underlying stock price decreases to the put options' strike price, the trader can buy the stock at the strike price, rather than at the previously higher market price. As the trader chooses which put options to sell, they can choose the strike price, and therefore have some measure of control over the price they pay. Because the trader receives the price of the put options as profit, this provides a small buffer between the purchase price of the stock and the breakeven point of the trade. This buffer means that the stock price can fluctuate slightly before the price decline eventuates in a loss.
Another Example Trade.
A long-term stock investor has decided to invest in XYZ company. XYZ's stock is currently trading at $430, and the next options expiration is one month away. The investor wants to purchase 1,000 shares of XYZ, so they execute the following stock options trade:
Sell 10 put options (each options contract is worth 100 shares), with a strike price of $420, at a price of $7 per options contract. The total amount received for this trade is $7,000 (calculated at $7 x 100 x 10 = $7,000). The investor receives the $7,000 immediately and keeps this as profit.
Wait for XYZ's stock price to decrease to the put options' strike price of $420. If the stock price decreases to $420, the put options will be exercised, and the put options may be assigned by the exchange. If the put options are assigned, the investor will purchase XYZ's stock at $420 per share (the strike price that they originally chose).
If the investor does buy the underlying stock, the $7,000 received for the put options will create a small buffer against the stock investment becoming a loss. The buffer will be $7 per share (calculated as $7,000 / 1000 = $7). This means that the stock price can fall to $413 before the stock investment becomes a loss.
If XYZ's stock price does not decrease to the put options' strike price of $420, the put options will not be exercised, so the investor will not buy the underlying stock. Instead, the investor will keep the $7,000 received for the put options as profit.
Conclusion.
Options have other uses beyond the scope of this article. In several investment situations, however, it may make sense to invest in options rather than the underlying stock. Note, however, that the basic fact of option trading -- that you are highly leveraging your investment -- inevitably means your risk is similarly greatly increased.
How to Buy Stock Options.
How to Buy Stock Options. When investing in the stock market the more an investor can lessen his or her risk on a given stock purchase the better. This is where stock options come in. Rather than buying the actual stock, an option investor pays only a small percentage of the stock price for the option to buy or sell the stock at a later date. There are steps to this process that any investor should know.
Understand the different type of options that are available. The two main types of options are puts and calls. Puts give the buyer an option to sell the underlying stock at a certain price during a given period. Calls allow the buyer of the option the ability to buy the underlying stock at a certain price in a given period.
Track and research the performance of the underlying stock. If, after the research, you expect the stock to rise in price, you should consider purchasing a call stock option. However if you expect the stock price to fall, the put stock option is the correct purchase. There are many permutations of these basic options principles, but these are the trading options for beginners. In the option business, they call this directional trading.
When you see, call or put a price of $2.00, the cost of this option is not $2.00 but $200.00. This is because stock options sell in lots of 100 share options. This is a common mistake for beginning options investors.
Decide which stock option you want to purchase and if you want a put or call option on the underlying stock. Again, a put is option to sell and a call is option to buy the underlying stock. You will need to contact a broker or visit an online option-trading site to place the order. See Resources below for information.
Buy the stock options for the given market price. Be sure to check the strike date of the option. The strike date is when the option expires. If you do not exercise by this date, it expires and you lose your investment. It is usually a good idea buy to stock options with the latest strike date. However, sometimes the stock option will be cheaper the closer it is to the strike date. Despite being cheaper, these short strike dates carry more risk.
Getting Acquainted With Options Trading.
Many traders think of a position in stock options as a stock substitute that has a higher leverage and less required capital. After all, options can be used to bet on the direction of a stock's price, just like the stock itself. However, options have different characteristics than stocks, and there is a lot of terminology beginning option traders must learn.
[There's a common misconception that options are confusing and overly complex, but that simply isn't the case. Build on what you learn from this article and see how you can leverage options to build a more robust through taking Investopedia Academy's Options for Beginners course. ]
Two types of options are calls and puts. When you buy a call option, you have the right but not the obligation to purchase a stock at the strike price any time before the option expires. When you buy a put option, you have the right but not the obligation to sell a stock at the strike price any time before the expiration date.
One important difference between stocks and options is that stocks give you a small piece of ownership in the company, while options are just contracts that give you the right to buy or sell the stock at a specific price by a specific date. It is important to remember that there are always two sides for every option transaction: a buyer and a seller. So, for every call or put option purchased, there is always someone else selling it.
When individuals sell options, they effectively create a security that didn't exist before. This is known as writing an option and explains one of the main sources of options, since neither the associated company nor the options exchange issues options. When you write a call, you may be obligated to sell shares at the strike price any time before the expiration date. When you write a put, you may be obligated to buy shares at the strike price any time before expiration.
Trading stocks can be compared to gambling in a casino, where you are betting against the house, so if all the customers have an incredible string of luck, they could all win.
Trading options is more like betting on horses at the racetrack. There they use parimutuel betting, whereby each person bets against all the other people there. The track simply takes a small cut for providing the facilities. So, trading options, like the horse track, is a zero-sum game. The option buyer's gain is the option seller's loss and vice versa: any payoff diagram for an option purchase must be the mirror image of the seller's payoff diagram.
The price of an option is called its premium. The buyer of an option cannot lose more than the initial premium paid for the contract, no matter what happens to the underlying security. So, the risk to the buyer is never more than the amount paid for the option. The profit potential, on the other hand, is theoretically unlimited.
In return for the premium received from the buyer, the seller of an option assumes the risk of having to deliver (if a call option) or taking delivery (if a put option) of the shares of the stock. Unless that option is covered by another option or a position in the underlying stock, the seller's loss can be open-ended, meaning the seller can lose much more than the original premium received.
You should be aware that there are two basic styles of options: American and European. An American, or American-style, option can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American style and all stock options are American style. A European, or European-style, option can only be exercised on the expiration date. Many index options are European style.
When the strike price of a call option is above the current price of the stock, the call is out of the money; when the strike price is below the stock's price it is in the money. Put options are the exact opposite, being out of the money when the strike price is below the stock price and in the money when the strike price is above the stock price.
Note that options are not available at just any price. Stock options are generally traded with strike prices in intervals of $2.50 up to $30 and in intervals of $5 above that. Also, only strike prices within a reasonable range around the current stock price are generally traded. Far in - or out-of-the-money options might not be available.
All stock options expire on a certain date, called the expiration date. For normal listed options, this can be up to nine months from the date the options are first listed for trading. Longer-term option contracts, called LEAPS, are also available on many stocks, and these can have expiration dates up to three years from the listing date.
Options officially expire on the Saturday following the third Friday of the expiration month. But, in practice, that means the option expires on the third Friday, since your broker is unlikely to be available on Saturday and all the exchanges are closed. The broker-to-broker settlements are actually done on Saturday.
Unlike shares of stock, which have a three-day settlement period, options settle the next day. In order to settle on the expiration date (Saturday), you have to exercise or trade the option by the end of the day on Friday.
Most option traders use options as part of a larger strategy based on a selection of stocks, but because trading options is very different from trading stocks, stock traders should take the time to understand the terminology and concepts of options before trading them.
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