This post is not about best stock trading strategies or anything exciting like that but if you have no idea what a stock option is, you are in the right spot. This is about options trading for beginners, today i’m just going to talk about what a stock option is and how its different from just stocks. When most people start investing on their own they usually start off with stocks and don’t even know what a stock option is. If I were to tell you that you could make 100x more money with 10x less risk when using stock options, would you be interested in learning more? I know that I was. Now it’s getting exciting. Options can provide a high rate of return with a small investment. Options can be really complex but here is just a little over view on what a stock option is.
Options are also known as derivatives because the option contract derives its price and value from the underlying asset on which it is based. The value of an option fluctuates as the price of the underlying asset rises or falls in price. An option is the right, but not the obligation, to buy or sell a stock or index for a specified price on or before a specific date. A call option is the right to buy a stock/index, while a put option is the right to sell a stock/index. The investor who purchases an option, whether it is a put or call, is the option “buyer”. Conversely, the investor who sells the put or call “to open” is the option “seller” or “writer”.
Options are contracts in which the terms of the contract are standardized and give the buyer the right, but not the obligation, to buy or sell a particular stock/index at a fixed price (the strike price) for a specific period (until expiration). All option contracts traded on U.S. securities exchanges are issued, guaranteed and cleared by the Options Clearing Corporation (OCC). OCC is a registered clearing corporation with the SEC and has received ‘AAA’ credit rating from Standard & Poor’s Corporation. The ‘AAA’ credit rating corresponds to OCC’s ability to fulfill its obligations as counter-party for options trades.
The options investor may be looking for long term or short term profits, or they may be looking to hedge an existing stock or index position. Whatever your objectives may be, you need a thorough understanding of the markets you will be trading.
The Difference between stocks and options
One important difference between stocks and options is that stocks give you a small piece of ownership in a company, while options are just contracts that give you the right to buy or sell the stock at a specific price by a specific date. whenever you buy 1 share of stock you only control one share. But when you buy 1 option contract you control 100 shares of stock. This is called leverage and that is why you can get such high rate of return with little money.
It’s important to remember that there are always two sides for every option transaction: a buyer and a seller. In other words, for every option purchased there’s always someone else selling it.
The two types of options are calls and puts. When you buy a call option, you have the right, but not the obligation, to purchase a stock at a set price, called the strike price, any time before the option expires. When you buy a put option, you have the right but not the obligation to sell a stock at the strike price any time before the expiration date.
What’s awesome about options are that you can make money both ways, when the stock price is rising and when the stock price is falling. Buy a call option when going up and buy a put when going down. If you wanted to profit when the price is going down with just using regular stocks, you would have to short the stock which could lead to unlimited loss. Using a put option you would only lose what you bought the put option for so it would be a way safer investment. So what i’m trying to say is a call option profits when the price of the underlying security moves higher. A put option profits when the price of the underlying security moves lower.
The price of an option is called its premium. The buyer of an option can’t lose more than the initial premium paid for the contract, no matter what happens to the underlying security. So, the risk to the buyer is never more than the amount paid for the option. The profit potential, on the other hand, is theoretically unlimited.
When the strike price of a call option is above the current price of the stock, the call is out of the money. When the strike price is below the stock’s price, it’s considered in the money. Put options are the exact opposite: They’re considered out of the money when the strike price is below the stock price and in the money when the strike price is above the stock price.
Note that options are not available at just any price. Stock options are generally traded with strike prices in intervals of $0.50 or $1, but can also be in intervals of $2.50 and $5 for higher-priced stocks. Also, only strike prices within a reasonable range around the current stock price are generally traded. Far in- or out-of-the-money options might not be available.
The underlying security in options trading is defined as the financial instrument on which an option contract is based or derived. It is a stock or Exchange Traded Fund (ETF) that you have the right to purchase or sell. The symbol used for the underlying security in options trading is usually the symbol used by the exchange on which the underlying security is traded. For example, GE is used for General Electric and SPY is used for the S&P 500 Index ETF.Strike PriceThe strike price is the actual price at which the option holder may buy or sell the underlying security as defined in the option contract. For example, a GE Mar 20-Strike call gives the buyer of the option the right to buy 100 shares of General Electric at $20 per share between now and the monthly option expiration which is usually the third Friday of the month expiration Date. The expiration date is the actual date that an option contract becomes void. Monthly options normally expire on the third Friday of each month. Be aware that at expiration options that are not closed prior to expiration and are in-the-money will be exercised automatically.
Trading options is very different from trading stocks because options have distinct characteristics from stocks. It’s important for traders to take the time to understand the terminology and concepts involved with options before trading them. This is just a quick overview of what options are and I will go in greater detail in my next blog post.
Happy trading and leave a comment if you got any questions I would like to hear them.
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