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Options trading is an advanced type of investment for serious traders. Compared to regular buying and selling of shares on the stock market, options trading carries a higher degree of risk.

However, at the same time, the greater risk also entails greater money-making opportunities. In the United States, options are traded on the Option Exchanges including the Chicago Board Options Exchange (CBOE).

From most investors, options trading appears rather complicated compared to straightforward trading of shares. An option is an investment that gives the investor the right but not the obligation to purchase stocks at a specified price at a future date.

How options work

When you buy a stock option, the idea is to predict whether the underlying stock will go up or down in value over a specified time period.

Purchasing an option requires that the investor put a “down payment” on the right to purchase the underlying stock at a specified price on a specified future date. For example, let’s say that you purchase an option to buy a certain quantity of stock six months from now at $10,000. To buy this option, you pay $500 upfront to get the right to the option.

When the six months have elapsed, you can either buy or refrain from buying the underlying stock in the option. For example, let’s say that the value of the stock had actually gone up to a value of $30,000. You would have the right to buy the stock for $10,000 and would end up making $20,000 in profit. Actually, you would net $19,500 because you spent $500 to buy the option.

However, let’s say instead that the underlying stock is only valued at $8,000 after six months. In that case, you would refrain from buying the stock because you would be spending $10,000 to buy $8,000 worth of stock. By refraining to exercise the option, you lose the $500 used to buy the option.

Calls and Puts

The two basic types of stock options are the call option and the put option.

A call option is used when the investor believes the price of the underlying stock will go up in value. The put option is the opposite of the call option and is used when the investor believes the stock value will go downward.

Now a put option is different from a call option because it gives the investor the right to sell rather than buy the stock at a later date. For example, let’s say you purchase a put option for $500 to sell stock for $10,000 six months in the future.

After the six month period elapses, if the stock goes down in value to $5,000, you can still sell the shares for $10,000. Thus, you net $4,500, i.e., $5,000 minus the option price of $500. Note that in order to break even, the underlying stock would have to decrease in value by at least $500. That way you could sell the stock and recoup the payment made to purchase the option.

Advantages and Disadvantages of Options Trading

One of the reasons why options trading is considered risky is that it involves making predictions far into the future.

When you trade shares normally on the stock market, your actions are more based on real time conditions. With options many things can happen in the period between the time you purchase the option and the date on which you have the right to exercise the option.

On the other hand, options trading gives you the ability to make investments with “down payments” rather than having to pay all the money upfront. If you are able to correctly predict the direction of the stock’s value in the future, stock options give you the opportunity to trade many more shares than you could afford through ordinary trading.

The “down payment” that you use to buy an option is called the premium and is non-refundable. The strike price is the amount that you agree to optionally buy or sell the stock for at the later specified date. The last day that you have to exercise your option is known as the expiration date. If you do not exercise your right by that date, the option becomes worthless, i.e. you basically lose your premium.

Options Strategies

In addition to buying call or put options, you can also trade options before they reach their expiration date. In fact, most investors actually trade their options rather exercising their right to buy or sell the underlying stock, or simply allowing the option to expire.

Instead of waiting to see whether their predictions on options are correct, many investors trade the option once they are “in the money.” For example, let’s take the $10,000 call option discussed previously purchased for $500. Let’s say that after a few weeks, the value of the stock is $11,000.

Since the strike price is $10,000, the stock is $1,000 over the strike price and the option is considered “in the money.” When the value of the underlying stock goes up, the premium also goes up. So the investor can trade the option at the new higher premium and make money.

Conclusion

Options trading is a good alternative for those who want to make more money with less upfront capital but it also involves greater risk.

Anyone considering options trading should carefully study options trading strategy since it is more complicated than conventional trading.