If you own a brokerage account and like to manage your own investments, you may have come across the concept of options trading. This gives investors the opportunity to buy assets at a discounted price and increase their earnings. In a rising stock market, you could multiply your return on investment in just a few weeks or months. Options trading can also protect your investments from losses when the stock market dips.
But options trading also comes with risks. While you could potentially save money, you could also more easily lose it. Understanding the ins and outs of options trading can help you determine whether it is a good investment option for you.
What is options trading?
Options trading involves buying and selling options contracts. These contracts are linked to an underlying asset, and give the owner the right—but not an obligation—to purchase or sell a specific amount of that asset at a specific price, during a specific time frame. “In other words, you don't actually buy or sell the stock when you buy an option—you get a contract that gives you the right to buy or sell it at a certain price,” says Randy Frederick, managing director of trading and derivatives for the Schwab Center for Financial Research.
In a typical options trade, there is a seller and a buyer. The seller, also known as the writer, is the party that owns the asset and is offering an options contract. The buyer is the party that purchases the options contract and owns the right to buy or sell shares of the underlying asset, in exchange for a premium paid to the seller. As mentioned before, the buyer isn’t obligated to make a trade. If they don’t exercise the right to buy or sell before the options contract expires, they simply lose out on the premium paid to the seller.
Options contracts can expire on the same day they are purchased, or after several months or years. If you have reason to believe the price of a stock is going to change, owning an option can give you the ability to either save money when purchasing the stock or minimize your losses if you want to sell.
How options trading works
Options contracts typically represent 100 shares of an underlying asset, such as a particular stock, ETF, or other security. They are purchased for a premium, which is priced per-share.
Here are some key terms to know when dealing with options contracts:
- Underlying asset: The investment product that may be purchased or sold using an options contract.
- Type: An options contract can be either a put or a call, depending on whether you want to purchase or sell shares of an underlying stock.
- Strike price: The predetermined price that an options contract can be exercised at.
- Premium: The price you paid for the options contract if you purchased it or earned if you sold it.
- Maturity date: The date the options contract expires if it is not exercised.
For instance, let’s say a stock option is trading at $1.70. If you purchase the contract for 100 shares, you would pay a total of $170 (plus any applicable commissions) to own the contract. If you are the one selling the option, you would charge the buyer $170.
As the buyer of an options contract, there is incentive to pay a premium because of the potential for unlimited gains if the market changes in your favor.
Using the same example, let’s say a stock is currently trading at $100 per share. You purchase an options contract that gives you the right to buy shares for $110, with a $1.70 premium. If the price of the stock jumps to $120 per share while the contract is active, you can exercise your right to purchase the stock at the strike price of $110. Your total cost would be the price of the stock, plus the premium, or $111.70 per share ($11,170 total) instead of $120 ($12,000 total). That’s a savings of $830.
On the other hand, if you are selling an options contract, the hope is that the buyer will let the contract expire without exercising their right to buy or sell the underlying asset. This provides you with supplemental income in addition to any interest earned on the asset.
In this case, let’s say the buyer paid the premium of $1.70 per share for 100 shares of a stock. If the buyer believed the market price was going to increase, but it actually decreased, they might choose to let the option expire without exercising it. The seller would have earned the $170 premium for selling the contract and would still own the underlying stock, which may regain value in the future. In the meantime, they may choose to write a new options contract and earn more in premiums.
Types of options
There are two main types of options contracts. Depending on which transaction you want to complete, you can either purchase a call or put option.
Call option. This gives the buyer the ability to purchase an asset at the strike price before the contract expires. If you speculate that the price of a stock will increase in the near future, you would purchase a call options contract. On the flip side, if you are selling a call options contract, you believe the stock price will remain stagnant or decrease.
For instance, let’s say a stock is currently trading at $277 per share and a call option is available to purchase shares at $280. If you enter a call option contract under the assumption that the market price will increase much more at some point in the future—but before the contract’s expiration date—you will save money on purchasing shares of that stock, according to Andrew Crowell, a financial advisor and vice chairman of wealth management at D.A. Davidson Companies.
Put option. This gives the contract owner the option to sell a stock at the strike price before the contract expires. When you buy a put options contract, you anticipate the price of the stock will decrease. Conversely, when you sell a put options contract, you expect that the price will stay the same or increase.
Let’s once again say you own 100 shares of a stock currently trading at $277 per share, but you believe the price is going to fall in the future. You could purchase a put options contract that gives you the right to sell at $270 per share, limiting your loss to only $7 per share even if the market price falls below that amount. This protects you against a major loss on your investment if the value drops significantly.
What options cost
When it comes to buying an options contract, the price of the premium can be broken down into two parts: intrinsic value and time value.
Intrinsic value. When an option is “in-the-money,” it has intrinsic value. For instance, if you have an option that sets a stock’s strike price at $20, but the current market price is $25, it would be in the money with an intrinsic value of $5.
Depending on where the strike price stands in relation to the current market price, a call options contract may be in-the-money, at-the-money, or out-of-the-money.
View this interactive chart on Fortune.com
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Time value. The time value of an options contract is contingent on a variety of factors, such as the expiration date of the contract and current market rates.
As an options contract nears the expiration date, its value will decrease since there is less time to exercise the option—even if the option has no intrinsic value. This is because longer time spans present an opportunity for market prices to change, says Crowell.
Further, the greater a stock’s volatility, the more the option will cost, since there is a better chance that exercising the option will offer a hedge against losses or an increase in profits.
Keep in mind you’ll need an options account in order to purchase options contracts. Due to the complexity and risk of options trading, brokers won’t let just anyone do it. You’ll likely need a larger amount of capital than with a traditional stock brokerage account, and be required to provide additional information that helps prove you know what you’re doing.
Why investors use options trading
One reason to purchase an options contract is to hedge against losses in a declining stock market. You get the right to sell an asset at a guaranteed price, regardless of the current market conditions. This puts extra money in your pocket to leverage toward additional investments that you wouldn’t otherwise have if you sold your asset at the market price.
On the other hand, if you anticipate the value of a stock will increase, you can save money by purchasing it at a lower, agreed-upon price stated in your options contract as opposed to the current market price. And if that stock grows in value, you’ll see a greater return on investment since the initial cost was less than the actual value.
If you purchase an options contract, but the market doesn’t swing in the direction you expected, you are not required to exercise your right to buy or sell an asset. Options contracts have a finite lifespan and will expire if unused, which usually occurs on the third Friday of each month.
Pros and cons of options trading
Options contracts are high-risk, high-reward. They offer investors the ability to earn high profits in a short time span, but can cause you to lose money if you don’t accurately predict the market—something that’s notoriously hard to do.
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Pros
- You can purchase shares at a discount when the strike price is lower than the current market price, which can result in a higher return on your investment.
- Options have leveraging power since you are purchasing shares at a cost-efficient price, giving you an opportunity to earn interest on the savings or put it toward another investment.
- You can hedge against potential losses using a put option when you believe an asset’s value is going to drop.
Cons
- Options trading is a complicated process that the average investor may not be familiar or comfortable with.
- You may need approval from your brokerage firm before you can use your account to make options trades.
- If you don’t exercise your options contract, you lose out on the premium paid with no upside.
- If you are selling an options contract, you face the risk of incurring a greater loss on the sale than you earn through the premium.
The takeaway
Crowell says options are a good tool for investors who want to control certain variables. “They want to buy at a specific price, or they want to sell at a specific price—or they want to have protection against losses until a certain time has passed,” he says.
But this comes at a risk of total loss if the option expires before you exercise your right to buy or sell shares. Selling options contracts can also result in a loss far greater than any income earned from the premium. It’s a good idea to take the time to thoroughly research how options contracts work before assuming the risk involved.
