Stock options offer a unique way to invest and trade in the stock market. They provide leverage, allowing you to control potentially significant gains with a smaller upfront investment compared to buying the stock itself. This article will introduce you to the basics of options trading, including key terms and strategies.
Understanding the Contract
An option contract grants you the right, but not the obligation, to buy or sell 100 shares of a particular stock at a predetermined price (strike price) by a specific expiry date. There are two main types of options:
-
Call Option: A call option gives you the right to buy 100 shares of a stock at the strike price by the expiry date. You can think of it as a down payment on a future purchase.
-
Put Option: A put option gives you the right to sell 100 shares of a stock at the strike price by the expiry date.
Key Terminology
-
Exercising an Option: When you decide to use your right to buy or sell shares with a call or put option, respectively.
-
Strike Price: The predetermined price at which you can buy or sell the stock if you exercise the option.
-
In-the-Money (ITM): When a call option's strike price is lower than the current stock price, or a put option's strike price is higher than the current stock price.
-
Out-of-the-Money (OTM): When a call option's strike price is higher than the current stock price, or a put option's strike price is lower than the current stock price.
-
At-the-Money (ATM): When the strike price is very close to the current stock price.
-
Long Options: When you buy a call or put option.
-
Short Options: When you sell (or write) a call or put option.
-
Combo or Option Strategy: Using a combination of buying and/or selling multiple options contracts.
-
Debit: The cost you pay to buy an option or option strategy.
-
Credit or Premium: The money you receive for selling an option or option strategy.
Option Strategies
Option strategies involve combining multiple option contracts to achieve specific investment goals. Here are some common examples:
-
Debit Call Spread: A bullish strategy where you buy a call option at a certain strike price and sell another call option at a higher strike price. This reduces your potential profit compared to buying a single call, but also limits your risk.
-
Credit Call Spread: A bearish strategy where you sell a call option and simultaneously buy another call option at a lower strike price. This reduces your potential profit compared to simply selling a naked call (selling a call without owning the stock), but also limits your risk.
-
Strangle: A neutral strategy where you sell (naked) a call option and a put option at different strike prices. You profit if the stock price stays between the two strike prices at expiry.
-
Iron Condor: Similar to a strangle, but with built-in protection by using debit spreads (buying and selling options) instead of naked options. This reduces your potential profit but also reduces your risk.
Understanding the Risks
Options trading carries significant risks. It's crucial to remember that options are leveraged instruments, meaning a small price movement in the underlying stock can have a magnified effect on your investment. Here are some key points to remember:
-
Options can expire worthless: If the option expires out-of-the-money (OTM), the contract holds no value, and you lose the entire premium paid.
-
Assignment risk: If you hold a long option (call or put) that expires in-the-money (ITM), you may be obligated to buy or sell the underlying stock. This can happen even with spreads if not managed properly.
Further Learning
Options trading offers a variety of opportunities, but it's important to have a solid understanding of the risks involved before diving in. Consider these resources for further exploration:
-
Investopedia offers video explanations of call and put options.
-
Tastyworks provides a comprehensive glossary of options trading terms.
-
OptionsPlaybook offers explanations of various option strategies.
Remember, options trading can be complex. It's advisable to start with a paper trading account to simulate real-world trading without risking actual capital before putting your money on the line.
