Options are a leveraged way to invest in stocks. You end up getting more bang for your buck.
It's not quite as direct as just buying a stock, but the beauty is that options give you more flexibility and control over the cost and timing. More on that shortly…
Simply put, a stock option is a contract that gives an investor the right (but not the obligation) to buy or sell shares of an underlying stock at a set price on or before a set date.
You can buy and sell options contracts on regular stocks, indexes, ETFs (exchange-traded funds), and futures contracts in the commodities world.
For example, if you wanted to play options on ExxonMobil Corp. (NYSE: XOM), XOM stock would be called the "underlying asset/security."
When talking about stocks, each options contract is comprised of 100 regular shares of the underlying asset. For example, when you buy an option at $0.85, you are really paying $85.00 for options on 100 shares (one contract).
Okay, now let's go over some basic terminology that you'll need to know when executing trades…
Options 101: Four Simple Terms of the Options Trade
Whether you're buying or selling options, there are two main elements that make up every trade:
Strike Price: This is the set price at which your option is exercised — i.e. the target price of the underlying asset.
Expiration Date: This is the month and year that the option expires. If the right to buy or sell isn't exercised by the expiration date, the option expires worthless. All options expire on the third Friday of the corresponding month.
The strike price and expiration date are fixed from the beginning of each options trade and don't change for the duration of it.
For example, you would say, “Buy ExxonMobil January 25 calls.” Where ExxonMobil is the underlying security, the third Friday in January is the expiration date.
Puts and Calls
Just like you'd do when weighing up a stock trade, you have to decide whether you think the underlying asset is going to rise or fall. When playing options, there are two basic forms:
Call Options: You buy calls when you think the underlying asset is going to rise. These give buyers the right to buy the stock at the stated price on or before the stated date.
Put Options: You buy puts when you think the underlying asset is going to fall. These give buyers the right to sell the stock at the stated price on or before the stated date.
You can find a complete list of a company's available call and put options at the various strike prices and expiration dates on its options chain.
These are available on the majority of financial sites. For example, on Google Finance, you put the ticker of the underlying security into the search box and click "Enter."
On the top left menu, it will say “Options Chain.” Simply click that, and it will give you the put/calls chain with the various strike prices. There will be a drop-down menu to change the expiration date.
Beginner's Corner: Buying Call Options
Using the power of leverage can help you control shares for less…
Let's say XYZ is trading around $11 and you think it's headed higher. You want to buy 100 shares, but that would cost $1,100 – and maybe you don't want to spend that much upfront and tie up your capital. Maybe you can't afford to pay it all now.
Here's the options alternative…
Rather than pass on the trade, you can buy one call option contract on XYZ in anticipation of its value rising in the future. This gives you the right to buy those 100 shares at your desired strike price at or before options expiration for a much lower cost.
For that right, you pay the option seller to "hold" the shares for you at that set price until expiration (in other words, the premium).
You just have to decide how high you think XYZ shares will rise – and over what period of time – so you know which option to buy.
How To Buy
To execute an option buy, the official lingo is "buy to open."
So, having looked at XYZ's options chain, you decide to buy the $15 call, which expires in seven months.
To ensure that you get the best possible execution price for this trade (and on any trade, for that matter), make sure you use a limit order when you "buy to open." This is basically an instruction to the brokerage to only buy the asset at or under a specific price.
The best way to do it is to set the limit order price about halfway between the bid price (the price a buyer is willing to pay) and ask price (the price at which a seller is willing to sell) on the options chain.
Remember that the current price of an asset only reflects the last trade, whereas the bid and ask prices are a more accurate representation of the price you can buy and sell for. So rather than pay the "market price," the better play is to use limit orders. Once the price hits your limit price, the trade will be executed.
So for example, if the bid price for the $15 call option is $0.45 per contract and the ask price is $0.55, you'd instruct your brokerage to: Buy to open the XYZ November 2009 $15 call with a limit order of $0.50."
And in our XYZ example, given that the contract comprises 100 shares, your outlay for the $15 call would be $50 ($0.50 x 100 = $50). As you can see, that's significantly less than the $1,100 you'd shell out for buying the 100 shares outright.
So with $15 as your strike price, you now have the right to buy those 100 XYZ shares for $15 a piece any time before the expiration date on the third Friday of November. Ideally, you want the shares to be higher than $15 by expiration, thus enabling you to either buy them for less than the current market price, or make you a very good profit on your call option.
This is the beauty of buying call options – you greatly increase your leverage. To control the same number of shares (100), you have just $50 at risk versus $1,100. You'll also emerge with a greater profit, as option prices move more dramatically than the underlying asset.
The danger here is that if XYZ’s share price doesn't move higher, the option will expire worthless and you'll lose the money you paid for it. That's why it's imperative you don't spend more than you can afford to lose.
But what if you think a stock is headed lower?
The Bear Pit: Profit from the Downside
Usually, when investors play the downside, it's commonly referred to as "going short" or "shorting" an asset.
You can short indexes, stocks, currencies… virtually anything you want. However, doing so through a regular stock-based trade can be a risky game because the rules are different.
When you short a stock, for example, you do so without actually owning it. Instead, you're "borrowing" shares from someone who has a long position on the asset, so you're actually on the hook to somebody else, rather than just yourself.
Once you've "gone short," you want the stock to fall, so you'll be able to replace the shares you borrowed (i.e. buy them back) at a lower price. Your profit is the difference between the price you borrowed the shares and the buyback price.
But if the stock rises, you're in trouble. That's because you're now obligated to buy the shares at a higher price than you borrowed them. Your losses are unlimited for as long as the stock keeps rising and until you buy back the shares.
Worse still… if many other investors shorted the stock, too, you're fighting to buy back the shares with them in an attempt to stop your losses. This is known as "short covering," and the sudden demand can artificially inflate a stock.
Simply put, while shorting a stock can prove very lucrative if you're right, the consequences if you're wrong can be disastrous. And for many investors, the risk-reward ratio just isn't good enough.
But the market offers some flexible alternatives. And there's a better, safer way to play the downside: Buying put options.
For example, if you think XYZ shares are set to decline, you could buy the November $7.50 put option. And in the same way, you'd want the share price to rise higher than your call option, you'd want it to sink below your put option if you were playing the downside.
This is also a good strategy to use when you want to hedge against any potential downside on a stock. For example, if the market is particularly volatile, or the company has an upcoming earnings announcement and you want to protect your position, you could buy a put option.
When you do this at the same time as executing a stock buy, this is known as a "married put."
Hedging Your Bets
This is known as "hedging," where you employ strategies that help you weather the inevitable downturns and essentially give you another way to profit.
To execute a put-buying hedging strategy, you must already own at least 100 shares of a company. That's because there are 100 shares in one options contract.
So for example, if the market or stock is particularly volatile, or if there's an upcoming earnings announcement and you're worried that it will release negative news, rather than short the stock, you could do this…
You need to get a sense of how far the stock might reasonably fall — and over what time period — so you know what strike price and expiration date to pick for your put options.
Select the expiration date and strike price. Remember that for every 100 shares of the stock you own, you can buy one put option at that level. Doing this gives you the right to sell your shares at that price by options expiration. If the stock doesn't drop to that strike price by expiration, although your stock position may still be okay, your puts will expire worthless and you'll lose your investment.
If the stock falls, your put will make money. But if the stock rises and the put loses value, your loss is only limited to what you paid for the put option contract(s), rather than the unlimited losses that can rack up if you shorted the stock and got it wrong.
If you buy put options at the same time you execute the stock purchase, the transaction is known as a "married put."
Buying put options is a good strategy to use when you want to hedge against any potential downside because, rather than losing money as your stock declines, you at least cover your bases and offset some of the loss.
In-The-Money Or Out-Of-The-Money?
When selecting which strike price to use for your put options, you have two choices: In-the-money or out-of-the-money.
When you're talking about puts, in-the-money options are higher than the current share price. Out-of-the-money options have strike prices lower than the current share price — and are your best bet. Here's how a trade would work…
Out-Of-The-Money Put Options:
For example, let's say you bought a stock for $15 and it's now $20.
If you think it's set to decline, you could protect your existing gains by buying the $17.50 out-of-the-money put contract for $0.40. When you do, you have the chance to sell your shares at that $17.50 anytime up to options expiration.
To work out the profit on the trade, you simply subtract the option premium price ($0.40) from the strike price ($17.50) for a total of $17.10.
Then, if the stock trades below $17.50, you have the right to exercise your options for a profit. That profit would be the sell price ($17.10) minus your original entry price on the stock ($15) – $2.10.
As you can see, buying put options is a much simpler and safer way to play the downside on your stocks. Unlike the short-sell strategy, where your losses are unlimited as the stock rises until you buy the shares back, puts give you more peace of mind, as your losses are limited to what you pay for the options. Next time you want to play a stock's decline, do it with put options.
The Bottom Line…
Options prices are based on several factors, including strike price, expiration date, the volatility of the market, and the company and underlying asset in question.
The further out you go in time, the more expensive options are for the same strike price. Obviously, Microsoft has greater odds of hitting $85 next year rather than this Friday. You pay more for time.
The same goes for strike price: The farther away you are from “in-the-money,” the less you pay.
The more volatile a stock is, the more you will pay for the options.
And the more of a name brand the company is, the more you will pay for options.
So the next time you think oil will fall 40%, the market will become more volatile, or housing will jump — try an options play. A 5% one-week move in the underlying security could result in a 100% gain in your bank account.