By analyzing and trading options, investors get more leverage than stocks. While a stock may require a trader to put up 50% of its value, many options only require 10-20%.
That is a major difference. With each option, the trader can also control 100 shares of the underlying stock.
In this guide, we’re going to look at one-legged option strategies. That means buying single option contracts. Some strategies involve pairing different options contracts and even using more contracts to open a single trade. However, these types of strategies go beyond the 101 level.
Analysis and Trading Options Vs. Stocks
An option is a derivative of the underlying asset (ie the stock). If the stock didn’t exist, the option wouldn’t exist. It’s just a mathematical financial creation. The stock represents a real company and is not just a mathematical representation of something else.
Buying a share is a simple transaction. Enter the number of shares and click Buy. You can make your price a little more targeted by setting a limit order. For example, if ABC shares are trading at 105 and you want to buy 25 shares at 100, set a limit to buy at 100. Your buy order will only be triggered when the share price reaches 100. Once the order is executed, ABC needs to go for your trade in order to make money. This is called a long trade (as opposed to a short trade – the price of ABC goes down).
Options can be purchased in a similar manner. Instead of stocks, you deal with contracts. Each options contract represents 100 shares of the underlying stock. Also, you are not buying contracts that are based on the price of the underlying stock. Instead, you buy based on the option price.
Let’s go through an example. On March 17, 2021, ABC was trading for $ 105. The ABC April 110 call options contract traded for $ 0.80. Let’s clarify what these prices actually are. The “105” is the last price traded. ABC has a current bid-ask of $ 104.50 to $ 105.25, which means the next trade will likely be close to 105. The ABC call contract dated April 110 has a bid-ask of $ 0.75 to $ 0.80. His next trade could be below $ 0.80.
The bid-ask values are known as the spread. With liquid stocks, the spread is very small (as with options contracts). Options contracts can have a large bid-ask spread even if the stock is fairly liquid. A large spread means you are more likely to pay more for the option than if it were liquid.
Gets Vs. Puts
You may have noticed that the price of the call option has decreased (or, more specifically, bid-ask) with the share price. A call option is also a long trade. When the share price rises, the call option price rises and vice versa.
However, the option price moves differently than the share price. There is such a thing as the Greeks who determine how quickly the price of the option goes up compared to the stock. But the Greeks are an advanced subject.
If you are betting that the stock price will go down, you want to buy a put. When the stock price goes down, the put price goes up. This is the opposite of the call option pricing behavior. However, since you are buying a call to open the option position, the trade will only gain in value when the price of the option goes up.
Risk versus reward
In the example above, we bought the ABC April 95 call option contract. What does it all mean? ABC, of course, is the underlying stock on which the option is based. April is the month the option expires.
This is a monthly option. All monthly options expire on the third Friday of the month. That means the option will expire on April 16th. Until that date, you have time to gain in value in excess of what you paid for it. Some options expire every week or a few days.
The 110 is known as the strike price. It represents the share price you think ABC can hit at least before April 16. What if ABC is only 105 by April 16? The option you bought at $ 0.80 will expire worthless
Each option is worth 100 shares of the underlying asset. Since you paid $ 0.80 for the option, it means that it will cost you 0.80 x 100 = $ 80. So in that case, you’d lose $ 80. However, if ABC increased $ 5 to $ 115, the option would likely be worth at least $ 500 (5 x 100 = $ 500). So in that case, you’d be making $ 420 ($ 500 to $ 80 = $ 420).
These examples show the drawing of call option contracts for many traders. If the trade is against you, your downside risk is limited to the premium you paid in advance (in our example $ 80). However, your upward premium potential is unlimited and the leverage helps increase your returns.
You’ve probably heard that there are many free investing apps out there today that no longer charge commissions on stocks. The same goes for options … but not exactly. Sounds like double talk, doesn’t it? Here is what we mean.
Before brokers began removing commissions, options traders paid a base commission plus a fee for each options contract. For five contracts it could look like this:
- Basic Commission: $ 1
- Contract fee: $ 0.65 x 5 = $ 3.25
- total cost: $ 1.00 + $ 3.25 = $ 4.25
While most brokers have eliminated base commissions, it’s important to note that the vast majority are still charging the contract fee. Here’s what the new cost might look like for a broker charging a contract fee of $ 0.65:
- Basic Commission: $ 0
- Contract fee: $ 0.65 x 5 = $ 3.25
- total cost: $ 3.25
In a way, the commissions on options didn’t really go away with most brokers. They just reduced it. While this is rare, some brokers have dropped the contract fee on options like Robinhood and Firstrade.
We haven’t talked about multi-legged option deals or margins. These topics are a little more advanced. This article is designed to help you learn the basics of options trading and understand how it works. But rest assured, there is a lot more to learn how to choose the right strike, expiration date, multi-legged configuration, and analyze the Greeks!