Options trading involves trading the option to buy or sell a stock, at a set price (strike price), until the option expires. With commodities, this is also known as futures trading. Options expire on the third Friday of each month. Options with expirations of over a year are called LEAPS, which stands for Long Term Equity Anticipation Securities. Option premiums (the cost to buy the option) can start as low as $.05, depending on the underlying price of the stock. The most common price range of premiums is around $2.50 – $5.00. When you buy an option, your are buying the option to buy 1oo shares. So, if you buy 5 options with a premium of $5, then you will spend $500 for your 5 options ($5 x 100 shares).
There are two basic options: calls and puts. A call is the option to buy a stock at the strike price. The object of a call is to have the stock price go up. Your option is considered out of the money if the stock price goes down and never rises above your strike price before expiration, then you will lose your premium – the amount you paid to buy the option. Your option is in the money if the stock is trading above your strike price.
A put is just the opposite of a call. The object of buying a put is having the underlying stock price go down. A put is the option to sell a stock at the strike price. A put is in the money if the underlying stock is trading lower than your strike price, and a put out of the money if the stock price is trading higher than your strike price.
An option can still have a premium if it is out of the money. This is considered time value. An option premium is determined by two factors: tive value and intrinsic value. Intrinsic value is how much the option is in the money.
More Advanced Options Trading
You can also sell calls and puts. Selling (or writing) a call while you hold the current stock is termed a covered call. Covered calls are used very often and it’s a way the investor can bring in extra money during a stagnant or down trending market. If you sell a call without holding the underlying stock, this is termed a naked call. Naked calls are very risky because the stock price can go up infinitely and when the calls are exercised you are obligated to give the buyer the shares at the strike price but you have to buy them at the market price (you lose the difference between the strike price and the price on the open market).
Buying a put while holding the underlying stock is termed a married put. An investor buys the put for protection or insurance from the stock price falling. A married put is like an insurance policy – you are guaranteeing yourself a sell price of your stock until expiration.
Selling (or writing) a covered put means you have the cash secured in your margin account to cover the cost it would take to buy the stock back at the strike price from the buyer if the stock is put to you. If you don’t have the cash secured upon selling the put, then this is termed a naked put. You are liable for the cost of all the shares at the strike price if the put is exercised (put to you).
A straddle is buying both a call and a put at the same time. The object of a straddle is that the investor believes the stock is going to significantly move up or down. If the stock price rises above your call strike or falls below your put price, then you are in the money. A straddle is used when the stock is very volatile and is expected to move, but you just aren’t sure which way.
A short stradle is the opposite of a straddle. A short straddle involves selling a call and a put at the same time. The investor thinks the underlying stock is not going to move allowing the options to expire worthless and the investor profits the premiums from selling the options.
A spread is the buying and selling of the same option type (call or put) at the same time. A credit spread is when a higher premium option is sold and a lower premium option is bought. The investor is credited more than is debited (the money made from selling the options is more than what it cost to buy your options). A debit spread is just the opposite – more money is spent on buying then options then what is received from selling the options.
A calender (or horizontal) spread is when the expiration dates on the long and short leg of the option differ. A vertical spread is when the strike prices of the long and short leg differ, not the expiration date.
