The Basics of Trading Stock Options
A stock option is in effect a legal contract where the buyer has the right but not the obligation to buy or sell 100 shares of a company’s stock at a pre-determined price (the strike price) for the life of the contract. A call option is a contract to buy 100 shares, and a put option is a contract to sell 100 shares.
In general, the one who is selling the put or call is willing to sell it because he collects a premium in return for risking his 100 shares. Both put and call options are offered with various expiration dates up to three years in advance. The more time remaining until the option expires, the more premium the call writer can charge. The most important thing to remember about options is that they, unlike the underlying stock, expire after a certain amount of time (option contracts can last from a week to three years).
The buyer is willing to pay the premium for the right to own the shares in the future because he or she is purchasing time-limited leverage. Leverage in the sense that you your returns can be great if the stock moves significantly up or down, but time-limited in the sense that the options can expire worthless if the stock price does not move up or down as the buyer anticipates.
Federal and state laws require brokerages to make sure that investors are aware of the risks and are sufficiently experienced and solvent to trade options. Different brokerages maintain somewhat different standards, and these requirements are often modified based on changes in the current economic climate, but some experience in stock trading is required in all cases.
Brokerages typically offer at least three levels of options trading. The first level is selling options that are “covered” by stock that you already own, that is, selling covered calls. The second level is buying call and put options as either investments or hedges, and the third level is being cleared to sell options even if you don’t actually own the 100 shares underlying each contract you sell. This is called selling “naked” put or call options.
Selling Covered Calls
An example of selling covered calls is discussed below. If an investor owns 10,000 shares of company A, then he or she could sell up to 100 covered calls or puts based on those shares. Most investors who sell covered calls or puts do so as an income strategy. That is, they hope to be able to collect the premium from selling the options and still keep the stock after the expiration date of the option contracts. Selling covered calls is an ideal, relatively conservative strategy if you own a stock that you are pretty sure is not going to go up much before the call you sold expires. So if your stock just had an earnings report and no news is expected for a while, why not sell calls and make a few bucks in premiums while you are waiting. If, however, big news does come and the stock price moves up above the strike price of the call you sold, your shares will be called away and the new owner of the shares will make the profit on any appreciation above the strike price. You do, of course, receive the strike price per share, so you are not losing money, you are just not making the profit you would have on the shares if you had not sold the covered calls.
Buying Puts and Calls
Investors generally buy puts and calls as leveraged investments or as hedges for an investment they already have (think insurance). There are many strategies for buying puts and calls to maximize your investment returns such as straddles, strangles and so forth (to be discussed briefly below), but the basic strategy is using calls or puts as your investment vehicle for a time-limited “long” or “short” investment.
The other basic strategy when buying outs or calls is pretty similar to the idea of insurance. If you already own 10,000 shares of a small biotech company that has a big FDA approval decision coming up, you might consider buying a few puts with strike prices below the current stock price as “insurance” to protect yourself if the FDA denies approval (the puts will increase dramatically in value with a large drop in the stock price)
Selling Naked Puts and Calls
Selling “naked” calls and puts. i.e., where investor does not own the underlying stock, is highly speculative. It is important to remember that the investor will be responsible for purchasing 100 shares of the underlying equity for every option contract he or she sold if/when the purchasers of the option contracts decide to exercise. If things go as planned, then you get to rake in the premiums for the option contracts you sold without ever even having to buy the shares, but if things go against you, you will have to buy 100 shares for each contract you sold that is exercised. This obviously can result in huge losses, and brokerages insist on knowing that you have significant assets to cover potential losses before they let you get involved in selling naked puts and calls
Advanced Option Strategies
Using both puts and calls to create an “option spread” is a typical advanced option strategy. The basic idea behind creating an option spread is that you can pre-define your risk while still maximizing your potential profits by utilizing the leverage of options. Option spreads are designed to take advantage of the volatility or lack of volatility of stock. Some spread strategies like bull call spreads or bear put spreads are designed to be profitable when a stock price is expected to move moderately, whereas other strategies like the Iron Condor spread are set up to profit even if a stock is only moving in a tight trading range.
Option spreads can be pretty basic, like bull call spreads that just involve a long and a short leg, or highly complex like butterfly spreads that involve multiple call and put positions.