If you are expecting to be a successful stock market investor, you would be well-served to make sure you have as many trading opportunities as possible. That means opening the door to opportunities like stock options.
Investing in some of the world’s best corporations has proven to be a great way to increase wealth over time. Unfortunately, not everyone has the financial capital resources to buy enough stock to make a material difference. That’s a circumstance where stock options might be able to open the door for someone to participate in the market. For astute and experienced investors, stocks options open the door to some rather interesting and possibly lucrative investment strategies.
Regardless of your objectives, you need a basic understanding of what stock options are and how they work. The following information should serve as a basic education regarding stock options.
What Are Stock Options?
At the most basic level, stock options are a wager that a particular stock is going to go up or down. There are in fact two basic kinds of stock options: calls and puts. A call option is the right to buy 100 shares of the underlying stock at a stated “strike price” at some point in the future (expiration date). Conversely, a put option is the right to sell 100 shares of the underlying stock at the stated “strike price” at some point in the future (expiration date).
Options are available for a majority of the top corporations in the world. They are listed on the top market exchanges, listed in alphabetical order. Each company’s available stock options are listed in order of strike prices, which are typically available in stock price increments of $5. They are also listed based on expiration date under each stock with each expiration falling on the third Friday of each month for which options are available.
How Options Work
The best way to describe how stock options work is by example. While the focus of this example will be a call option, a put option would basically work in the opposite direction.
Currently, Walt Disney Corp. (symbol: DIS) is selling at $148 a share. If you were interested in buying 100 shares of DIS stock, it would cost you $14,800 plus broker commissions. If you cannot afford that size of investment but firmly believe DIS is poised to move upwards in the immediate future, you could buy a stock option.
Let’s assume you want to buy a DIS $150 (strike price) option with an expiration date of February 21, 2020. The price of the option might be listed at $3 a share or $300 plus commission to buy the option. Since the actual stock price is $148, the option requires you to pay $5 per share of premium. Premium would be defined as the difference between the option strike price and the stock’s actual price. With the option in hand, you now have the right to buy 100 shares of DIS for $15,000 on or before the expiration date. You also have the right to sell the option before expiration.
If Disney’s stock were to drop and never exceed $150, the option value would eventually drop to nothing by expiration. If the stock price does rise above $150, the option might rise, but it would also eat up premium. For all intents, you would need DIS to rise to $155 before your option would be “in the money” for your valuation purposes. That’s where you would start deriving a real profit beyond premium. Remember, you always have the right to sell the option prior to expiration.
Options Trading Strategies
As you get involved in stock options trading, you will learn there are certain options trading strategies you can use to create income or protect other positions. At the most basic level, you can write covered or uncovered calls and collect the premiums you would be paying if you bought the calls. A covered position is where you actually own the underlying stock and represent you are willing to sell it at the option stock price. With uncovered call writing, you would need to go buy the stock should the option get exercised. This is just one of many possible option strategies.
If you want to up your stock investment game, buying stock options and employing options trading strategies are great ways to get involved. However,you need to educate yourself before you jump in and make your plays.