What are stock options?
Stock options are the rave in 2020, with the emergence of the retail investor and trader a lot of people have flooded into the options market where the high leverage and cheap cost has made a lot of people a lot of money.
A stock option is a derivative instrument of an underlying asset, it’s respective stock. This derivative gives a market participant the right, and not the obligation to buy or sell a stock at an agreed-upon price and date. The two types of options are calls (betting the price of a stock will rise) and puts (betting the price of a stock will fall).
Key Points:
- Options are not obligations
- You can make money on the increased value of an option without having to own the stock
- There are two types of options, Call and Puts.
- One options contract represents 100 shares of an underlying stock.
How do stock options work?
Stock options are a zero-sum game meaning there are two sides to the option. The buyer and the seller. The buyer pays the seller a premium, while the seller receives the premium. The buyer’s premium value either increases or decreases with the options price movement. That is how they gain or lose money. While the seller’s gain is limited to the premium received from the buyer and cannot go past that but can decrease.
There are 5 main aspects of stock options:
- Expiration
- Strike Price
- Contracts
- Premium
- Greeks
An option’s expiration date is contractual, meaning that the trader or investor chooses a date in the future that they expect the option to fall or rise by. Unlike a stock that you can hold forever, an option eventually expires. There are short expiration dates and there are really long expiration dates. This helps the trade value the price of the call or put, which is represented in the cost of the option as time value. The longer the expiry the more you pay!
A strike price is a price at which you bet that the underlying will be trading by expiry. This determines should the option be expired or not. By expiry, the stock may be trading below or above the strike. However, before the expiration, if the price is trading below the strike but has moved higher since buying the call. You will still have an increase in premium. Assume a trader bets that Tesla (TSLA) will be above $600 by March 2021. This trader will buy Call options at a strike price of 600 with an expiration date in March 2021. Considering it is now November, that will cost him a pretty penny for all of that time value.
Contracts are the options number denomination, how many contracts can a trader buy or sell? They are the unit of size just as a share is to stock. In this case, 1 options contract holds 100 shares of the underlying stock in terms of controlling power. Should you decide to buy 1 call option contract of TSLA with a 600 strike and March 2021 expiry. You may be asked to pay $40.00 for example for the contract. However, it isn’t just $40.00. It is $53.75 multiplied by 100 (because there are 100 shares in the contract). So the call option is worth $5,375! By the expiry, if TSLA is trading at $655 you will have gained value in the option and have the right to exercise the option. You can buy TSLA for $600 and sell it for $650! If the underlying is less than $600 by expiry then you will lose the premium paid. Another caveat is if you bought TSLA in November when it was trading at $450 and in December, months before the expiration TSLA is trading at $550. You will still gain a lot of money on the options even if the strike is above the current price. You can sell the calls for a jump in premium!
Take a look at the image below. This is the profit loss of the option denoted in a percentage. Based on the strike, time, and change in price. If you buy this option and by early December you see Tesla go to $550, you have gained $1,272 or 23.7% of the position!
Premium is the cost of buying either a call or a put. This is identified as the cost of the strike that you purchase. You will have to multiply the cost of the option by 100 as we mentioned before to get the value of the premium. If a trader wanted to see a stock rise, they would buy call options. If the trader anticipated a fall in the price of TSLA, they would 5 put contracts. If the price of those puts for a month later expiry were $15.00. The trader would pay $15.00 x 100 x 5 = $7,500 for the whole position. This money would be attributed to the seller of these options on the other side.
The Greeks in options are the most complex aspect of the derivative. The Greeks are Delta, Theta, Gamma, Vega. They each reflect an options price movement. The Greeks affect the options worth depending on the expiry chosen. There is a lot to know about these variables.
Theta is the time decay value, within 30 days of the expiry we see theta that is farther out of the money decay fast.
Vega is a measure of volatility, the options price sensitivity in volatility changes of the underlying asset.
There are two options: American and European. American options can be exercised at any time. From when you purchase the option to the expiration date. European options can only be exercised at the expiration date. They are also more rave.
What are the most traded stock options?
The most traded options are important to know because you want to make sure you have liquidity and a tight spread when trading the option. That enables you to get in and out of the position quickly and at a favorable price!
The most traded options assets are on the SPY with a 50 days average options volume of 485,000. The SPY options are based on the ETF which encompasses the whole S&P 500 market.
On pure stocks, the highest volume options are on Apple stock. With an options volume of 130,000 on the 50 days, options average volume.
The point is, make sure you trade liquid options, which are typically on larger stocks! Your big-name stocks like the FAANG index, Facebook, Apple, Amazon, Netflix, Google.
Options Trading Example.
When trading options you should understand what the options chain is and how to use it. It is where the magic happens. In short, the options chain is where you can select the strike, expiry, put or call and see all of the Greek information for a calculated decision.
If I want to trade Netflix (NFLX) and I want to look at a December 24th, 2020 expiration for these options. I anticipate that Netflix will go up and I want to buy OTM (out the money) Calls at $500. If NFLX is trading at $480 or so right now. You anticipate NFLX will be above $500 by Dec 24th. You will pay $19.80 for each call option.
Should you buy 5 contracts, it will cost you $9,900. If the price doesn’t move above $500 by then you will lose the premium. The option expires worthless and you take a hit on the full $9,900. However to break even on the day of expiration you have to add the premium you paid for the option to the strike of the option. So $19.80 + $500 you need to see NFLX above $519.80 by expiry.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO AcademyTM is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.
