Many new stock traders eventually get around to asking the question, how do stock options work? The thing is that stock options provide a whole new level of investing and trading. And this level can be very profitable to those who understand how the game is played.
Stock options are a part of the “derivatives market”. Basically, a derivative is a financial instrument whose value is derived from another form of asset. Futures and commodities are also considered derivatives.
The thing about derivatives is that you are playing at a more sophisticated level of the financial markets. Keep in mind that derivatives can also be any combination of these financial instruments. In fact, we see new types of investments come into the market all the time that are just new forms of derivatives.
What you have to understand is that derivatives can either be a great thing, or they can be a very bad thing. We can actually say the same things about stock options too, and we will examine the pros and cons of investing in them. If you wonder how do stock options work, then you have come to the right place as we will examine many facets of their existence, and how option traders typically utilize them. The interesting thing is the infinite number of ways they can be used.
The Basis Of How Stock Options Work
Before we enter into any more discussion about the nuances of stock options, we first need to nail down exactly how they work. More importantly, we need to understand their relationship to the stocks they represent.
Let us suppose that you have done thorough research and due diligence in the stock market. And after doing so, you are interested in buying stock offered by the ABC Corporation. You check out the current stock quotes and you see that it is presently priced at $78.50 per share.
You would like to buy 100 shares of ABC, but you only have $3500 available cash in your online stock trading account. Of course, you could buy around 40 shares, but you’d like to buy more than that because you feel strongly that the stock is going to make a big move.
Your alternative is to look at buying ABC stock options. When you buy an ABC stock option, you pay a “premium” today which gives you the option to buy 100 shares of ABC stock by a specified date.
Let’s say the current month is June. You notice that you can buy a September ABC $75 option for $800. This means that between now and September; you have the option to buy 100 shares of ABC stock for $75 per share – regardless of what the market does. If by August, the ABC stocks have risen to $100 per share, then you can still buy them at $75 per share!
Have you noticed the power of options yet from this example? A moment ago, we could only buy about 40 shares of ABC stock, right? However, after finding out about the September $75 options, we have enough in our trading account to buy 4 of those options – which is equivalent to 400 shares of ABC stock! That my friend is the power of stock options – leverage – and lots of it.
We also notice that we can buy a September ABC $80 option for $450. We could buy eight of these options – meaning we control 800 shares of ABC stock. But there’s a huge difference between the ABC $75 option and the ABC $80 option. The ABC $75 stock option actually has “real value” because ABC stock is trading at $78.50. There’s an important piece of stock option terminology here – this stock option is “in the money” which means that if you exercise the option to buy the stock, you will make money.
The $80 ABC stock option is “out of the money” and has no real value at the present time – it is completely speculative and only has “intrinsic value”.
There is one other benefit to buying options that also needs to be mentioned here. When you buy that option, the option’s cost is all you will ever lose regardless of what the stock does. If you bought 100 share of ABC stock and it dropped 20 points, you would lose $2000 (I’m hoping you would sell it way before then). However, if you bought the September $75 option, then the $800 is all you would lose.
Stock Option Relationship To Time
Time is the most important element of trading stock options. From the example we gave earlier regarding ABC stock options, we talked about September options. If we looked at December stock options, we might see that the $75 option costs $1100, as opposed to the $800 price for the September stock option. Likewise, we may see that the $80 option costs $750 instead of the $450 that the September stock option costs.
Now what do you think we’d see if looked at July options? We may see that the July $75 ABC stock option is trading at $365 and that the $80 July option costs $500. Do you see what is happening here?
Time is everything in the world of stock options. You notice that the July $75 option is trading at what the market would pay you for the stock if you exercised the option. Why should it pay you any more than that? The option has almost expired.
You see, every time you buy a stock option, the clock begins ticking on that option. If the underlying stocks remains flat and the price doesn’t move, the value of the stock option begins decaying. Time is the enemy of stock option traders. The fact is that all stock options eventually expire and as they get closer to the end, the rate of price decay grows exponentially.
As we said earlier about the power of stock options is leverage, the danger of stock options is time. At least when you buy stock, you still have the stock no matter how badly it performs. And the stock will almost always have some value left after the storm if over. But with stock options, they have zero value when they fall out of the money and expire.
This is exactly why so many new stock traders lose all their money trading stock options. Options are very sophisticated instruments and have many uses, but you really have to understand how do stock options work before investing your hard earned money.
Understanding Puts And Calls
Let us define stock options even further. If you have gone out and examined options that are offered in the real stock markets, then you have probably seen put and call options displayed in the price tables. Do not let this overwhelm you as it is just some more stock option terminology.
In the examples we have used in this discussion, we have talked exclusively about buying “call options”. A call option is an option to buy a certain stock at a pre-determined price by a certain time.
Now let’s talk about the “put option”. A put option is an option to SELL a certain stock at a pre-determined price by a certain time. Trading puts is the same as “shorting” a stock. When you trade stocks, you can either buy the stock – which means you are “going long” on that stock, or you can sell the stock – which means you are “going short”.
When a person thinks that a certain stock is going to drop in price, they will sell it short. And after the stock has dropped, they buy it back at the lower price. Notice they are buying low and selling high, but they are doing it in reverse.
I know that this is confusing, but I look at the transaction the same as going to a car dealer and ordering a specific car from them. The car dealer is actually selling short on the deal because I give him the money upfront and then he buys it at a lower price.
If it’s a little fuzzy, just reread the last few paragraphs again and let it sink in. If it’s still fuzzy, then don’t worry about it. Most of us don’t short the market anyways – I don’t because it is my opinion that falling markets behave much differently than rising markets and I don’t like trading them.
So in conclusion, a put option is for people who like to short stocks and it gives them the same kind of leverage and benefits that stock buyers get from call options.
Understanding Stock Option Pricing
Hopefully, in your quest to answer the question, “how do stock options work?” you have ventured out and priced some of them online or even in one of the financial publications. If you have done so, there’s a chance that it might have been confusing. I know it was for me whenever I first started looking at them.
Actually, it is very simple. The prices that the stock option boards are showing are the price per share when you buy that stock option. And from our earlier discussion, how many shares are in an option? That’s right, it’s 100 shares. That means all you have to do to figure out what the stock options will actually cost you is to multiply that number by 100.
For the life of me, I do not understand why in the world they price options that way. Why on Earth they don’t just put the full price of the option on those tables is a total mystery. I suppose old habits die hard. Just like when I first started trading stocks, they were priced by “1/8, 1/16, etc” when our own currency isn’t traded that way. Eventually, someone used their brains and realized it made no sense at all. I’m hoping they come to that conclusion with the pricing puts and calls options as well.
We talked about understanding the importance of time whenever you trade stock options. There’s another important element in understanding how do stock options work and that is liquidity.
Incidentally, this is the same pitfall that traders encounter when they trade small cap stocks, penny stocks, and other OTCBB instruments. The danger of liquidity is that you can take a very big hit when you first buy a stock option. In fact, that hit can be so big that even if the underlying stock makes a nice move, you still lose money on the trade.
The rule of liquidity is that if there are not enough options being traded, then you will get a lousy market price when you buy the option and when you sell the option. The best way to determine this is by looking at the “spread” between the bid and asking prices of the stock option you are considering. Whenever the spread is low, then there is good liquidity. If the spread is large, then the liquidity is not sufficient enough.
You can always use limit orders when buying options to ensure you get a good price, but what about when you try to sell the option? Sure, you can also use a limit order when selling options, but remember this is a decaying asset and time is working against you.
The best way to avoid a liquidity hassle is by only trading stock options of larger cap stocks. This way, you can get in and out of the market quickly, when the prices best suit your financial requirements.
Cashing In On Stock Options
The one thing about trading and investing in options that we haven’t discussed is cashing them out. With options, you actually have two alternatives. If your option is in the money, then you can exercise the option – which gives you the right to buy the stock at the predetermined price.
Your other choice is to sell the option outright. To be honest, this is the simpler and easier choice of the two. You will find that most option traders hardly ever exercise them. This is mainly because they are speculating on the intrinsic value of the options they trade.
The fact is that most stock options expire worthless. In the end, they are simply the musical chairs of the stock markets and you certainly don’t want to be left standing when the music stops.
It is my hope that you now understand a bit more about how do stock options work. If this is your first exposure to them, then your head is probably spinning a little bit. Like I have said, they represent a fairly sophisticated level of trading.
If you find yourself attracted to them, then I encourage you to read more about stock options. However, make sure you understand them thoroughly and have a solid strategy and trading plan before investing in them. Believe me when I say that they can wipe out your trading capital very quickly.