When you buy a stock, you decide how many shares you want, and your broker fills the order at the prevailing market price. The process is more complicated for options trading.
When you buy an option, you’re purchasing a contract to buy or sell a stock, usually 100 shares of the stock per contract, at a pre-negotiated price by a certain date. In order to place the trade, you must make three strategic choices:
- Decide which direction you think the stock is going to move.
- Predict how high or low the stock price will move from its current price.
- Determine the time frame during which the stock is likely to move.
- Decide which direction you think the stock is going to move
This determines what type of options contract you’ll buy. If you think the price of a stock will rise, you’ll buy a call option. A call option is a contract that gives you the right, but not the obligation, to buy a stock at a predetermined price within a certain time period.
If you think the price of a stock will decline, you’ll buy a put option. A put option gives you the right, but not the obligation, to sell shares at a stated price before the contract expires.- Predict how high or low the stock price will move from its current price
This is the strike price — the agreed-upon share price at which you would buy or sell the stock if you exercise the option. So, for example, if you believe the share price of a company that is currently trading for $100 is going to rise, you’d buy a call option with a strike price that is less than the $100 you’d pay for shares on the open market right now. If the price does indeed rise above the strike price, you make a profit. Similarly, if you believe the company’s share price is going to dip, you’d buy a put option (giving you the right to sell shares) at a strike price above $100. If the stock price drops, your contract has locked in your right to sell shares for more than they’re fetching on the open market.
You can’t just choose any strike price. Option quotes, technically called option chains, contain a range of available strike prices. The increments between strike prices are standardized across the industry — for example, $1, $2.50, $5, $10 — and are based on the stock price.
The difference between the strike price and the share price is part of what determines an option’s intrinsic value. Time is the other part of the valuation formula, which leads us to the final choice you need to make before buying an options contract.- Determine the time frame during which the stock is likely to move
Every options contract has an expiration date that indicates the last day you can exercise the option. Here, too, you can’t just pull a date out of thin air. Your choices are limited to the ones offered when you call up an option chain.
Expiration dates can range from days to months to years. Daily and weekly options tend to be the riskiest and are reserved for seasoned option traders. For long-term investors, monthly and yearly expiration dates are preferable.
The amount of time (called time value) and the intrinsic value (the difference between the strike price and the open market price of the shares) determines the cost of the contract, known as the option premium.Anatomy of an options trade: Call option example
Let’s go through one of the more basic options trading scenarios that an investor might use: buying a call option.
You believe that XYZ’s stock price is going to increase in the next month, and you want to lock in the option to buy shares at a lower price. You decide to buy a call option on XYZ with a strike price of $90 that expires in one month. The premium on that option is $3 per share. Here’s how much you’ll pay:
- The per-share cost, or premium: Remember, each options contract typically contains 100 shares. So you’ll pay $300 (the $3 premium multiplied by 100 shares) for the right to buy 100 shares of XYZ stock at $90 per share before the expiration date.
- Trading costs: Many brokers price options trades in two parts: a base rate (an option commission) and a per-contract fee. If your brokerage charges a $7.95 base rate and a 75 cent per-contract fee, you’ll pay $8.70 in commissions.
That brings your total tab for the call option on XYZ to $308.70.
Let’s say you’re right, and XYZ’s stock price rises to $100. Your option is, in options-speak, “in the money.” For a call option, that means the share price on the open market is higher than the option’s strike price. (For a put option to be in the money, the share price must be lower than the strike price.)
Now you have another choice to make. You can:
- Exercise the option and hold the shares. If you think the stock will continue to rise, you can exercise the option (buy the shares) and admire them in your portfolio. Your total cost to acquire the shares comes to $9,308.70. (The math: The $90 strike price multiplied by 100 shares, plus $308.70 for the original contract.) Right off the bat, you’ve gotten the equivalent of a 7.4% return compared with investors who waited to buy shares at $100. Note that partial trades are not allowed; options traders must exercise all 100 shares in a contract.
- Exercise the option and sell the shares. In this scenario, you’d buy the shares at the $90 strike price for $9,000 and sell them right away at $100 per share, for $10,000. Factoring in the $308.70 trading costs, you would make $691.30 — a 124% return on the initial price of the contract.
- Sell the options contract to another investor. If you don’t want to spend the money to buy the shares, you can always close out your position and sell the contract to another investor. If this is your plan from the outset, ideally the stock price moves shortly after you purchase the contract. The more time there is before the contract expires, the more the contract is worth. Let’s say the premium on your XYZ call increases to $12 from the $3 you originally paid. If you close out your position, you’ll pocket $891.30 ($1,200 as the recipient of the option premium minus the $308.70 you paid for the original contract).
The downside: What happens if your prediction is wrong
First, the good news: When you buy a put or call option, you are in no way obligated to follow through on the trade. If your assumptions about the time frame and direction of XYZ’s trajectory are incorrect — if the stock never rises above $90 or if it drops below your strike price — your losses are limited to a maximum of the $308.70 you paid for the contract and trading fees.
Had you been speculating and bought shares of XYZ on the open market before the price took a dive, your financial loss would cut a lot deeper.
The bad news, as you probably guessed: When your prediction doesn’t pan out during the time frame specified in your contract, the option expires worthless. Or, in the gentler terms of option traders, it’s out of the money.
However, if you’re a quick enough draw, you may be able to salvage a little of your initial investment. The option’s intrinsic value may have tanked, but you could limit your losses if you sell the contract before it expires, while it still has time value.Before you can start trading options …
If anything you’ve read so far gives you pause — the amount of capital required to trade options, the complexity of predicting multiple moving parts, the reliance on timing — that’s a good thing. That’s exactly what brokers require potential options investors to do before awarding a permission slip to start trading options.
Every brokerage firm screens potential options traders to determine their experience and understanding of the inherent risks of options trading and whether they’re financially prepared to handle them.
Account minimums and trading costs are important considerations for investors looking for the best brokerage firm to use. But even more important, especially for investors new to option trading, is finding a broker that offers the tools, research, guidance and support you need.
Updated Nov. 17, 2016.