Trading stocks and trading options are different because stocks and options have varying features. As an investor, you must strive to learn and understand the concepts and terminologies used in options before venturing into trading. Options are derivatives which means they obtain value from the underlying stock or security. Read on for more insights about options trading.
Stock Options Trading
Options trading is similar to speculating on horses at a racetrack. Everyone places a bet against everyone else present while the track retains a small percentage for offering the facilities. Options trading as is the case with speculating on horses is a win-or-lose game.
An option seller’s loss is an option buyer’s gain and vice versa. One core difference between options and stocks is that options are contracts that allow investors to purchase a stock at a defined price at a defined date.
Stocks, on the other hand, give investors a small ownership percentage in a company. Worth mentioning is that there are two edges of each options transaction, a seller and a buyer. For each purchased option there will always be someone disposing of it.
Classifications of Options
There are two key options types; puts and calls. When investors purchase a call option they get permission to buy a stock at the set price. However, they are not under obligation to do so. The set price is also known as the strike price as long as the option has not expired.
When investors purchase a put option they get the right to dispose of the stock at the set price before the expiry date. However, they are not under any obligation to do so. When investors sell options, they form security that was non-existent previously, writing an option.
This security explains one of the key option’s sources seeing that neither the options exchange nor the affiliated company supplies the options. When an investor writes a call they could be obligated to dispose of shares at the set price before the expiry date.
When investors write a put they could be obligated to purchase shares at the set price before the expiry date.
There are two standard options styles that; European and American. European style options are only exercisable on the expiry date, while an American style option can be used any time from the buying date to the expiry date.
Many listed options or exchange-traded options are American style while a big percentage of index options are European style. Stock options are American-style.
Understanding Option Pricing
An option’s price is also referred to as the premium. An options buyer cannot incur more loss than the initial contract fees paid regardless of how the underlying security behaves. In this case, the buyer’s risk hardly surpasses the total option amount. On the other hand, they enjoy unlimited profit potential.
From the premium an option seller receives from a buyer, they incur the risk of taking delivery (in the case of a put action) and being liable to deliver (in the case of a call option) the stock shares.
The seller’s loss remains open-ended if the option is not protected by a position or another option within the underlying stock. In this case, the seller could lose more than the initial fees received.
It’s important to understand that options are available at specific prices. Stock options are usually traded with set prices at intervals of between $0.5 and $5. Only set prices within an equitable range on the prevailing stock price are often traded. Here, in the money and out of the money options may be unavailable.
Understanding Options Profitability
When a call option’s set price surpasses the existing stock price the call will be unprofitable. Investors will not purchase stock at higher prices than the stock’s current market price. If a call options set price is lower than the stock’s price it can be defined as in the money because an investor can purchase the stock for reduced prices than the existing market price.
On the other hand, put options are said to be out of the money when the set price falls below the existing stock market price. Investors cannot dispose of stocks at lower prices than the existing market price. Put options are declared in the money when the strike price surpasses the stock price because investors can dispose of their stocks at a higher set price than the existing stock market price.
All stocks will expire at a particular date, referred to as the expiration date which can be approximately nine months for ordinary listed options. Long-term options contracts, also known as LEAPS (long-term equity anticipation securities) are available on a wide range of stocks with their expiration dates stretching to three years from the date of listing.
While options trading is riskier than stock trading, executing it properly can bear more profits for investors than conventional stock trading.