You Can Make Money Trading Stock Options
If you have never traded stock options before, you have come to the right place. I will explain to you in a very clear and simple matter what call options are, what put options are, and how to trade them.
- How Do Stock Options Work?
- You Can Trade Two Types of Stock Options, Calls and Puts
- Bulls Trade Call Options and Bears Trade Put Options
- How to Exercise Stock Options Before They Expire
- How to Price a Stock Option, Intrinsic Value and Time Value
- The Black-Scholes Calculator for Stock Option Prices
- How Much Money Can You Make Trading Stock Options
- The Role of Your Broker and the Options Exchange
- Stock Options Are for Advanced Traders
How Do Stock Options Work?
Trading stock options is different from trading stocks. An OPTION is an agreement, or contract, where one party agrees to deliver something to another party within a specific time period and for a specific price. A STOCK OPTION is a contract to buy or sell stocks in the future. The stock option spells out the company stock, the stock price and the date the option expires. With an option you can bet on the direction of a stock's price, just like the stock itself. Traders buy and sell options instead of buying and selling the stock itself, because an option gives them higher leverage and requires less capital. But options are different from stocks.
Computer Option Trading Screens
Unlike a stock, when you own a stock option, you do not own a share of the company. Because stock options are much cheaper than the actual stock, you can buy more options with your money, and gain more from the movement of a stock price. This financial leverage is the reason traders are drawn to stock options. Most traders buy stock options with the intention of selling them for profit. On the flip side, a stock option is good for only a few months from the date it is listed, and after that it EXPIRES worthless. Options expire on the third Friday of the expiration month. Some options called LEAPS, an acronym for Long Term Equity Anticipation Securities, have long-term expiration dates of up to three years.
You Can Trade Two Types of Stock Options, Calls and Puts
There are two types of stock options, CALLS and PUTS. Buy the Call option if you are bullish on stocks, and buy the Put option if you are bearish. Here's how CALLS and PUTS work. A $700 January CALL option on Google gives you the right to BUY 100 shares of Google stock at $700 per share any time until the third Friday in January. For this option, $700 is the strike price, the third Friday in January is the expiration date, and Google is the underlying stock. Whenever the Google stock price is above the $700 strike price of your CALL, your option is said to be IN THE MONEY.
A $500 February PUT option on Google gives you the right to SELL 100 shares of Google stock at $500 per share any time until the third Friday in February. For this option, $500 is the strike price, February is the expiration date, and Google is the underlying stock. If the price of Google stock is below the $500 strike price of your PUT, your option is said to be IN THE MONEY.
Bulls Trade Call Options and Bears Trade Put Options
Do you expect the price of Google shares to rise above $700 in the future? Then you could purchase a CALL option with a $700 strike price. But if you expect the price of Google stock to fall below $500, you can purchase a PUT option with a $500 strike price. If the stock price changes as you predict, and the price change is enough to cover the cost of the option you bought and the broker commission, you will make money. Traders who were holding puts during the stock market decline of 2008 made big gains. A PUT option also is different from selling a stock short, i.e. selling a stock you don't own. When you want to sell a stock short, you must first borrow the stock to short it. But when you buy a PUT options you are not borrowing anything.
How to Exercise Stock Options Before They Expire
Many investors buy and sell their options with no intention of ever exercising the options. They take their profits simply by trading out of the options. They do not want to take possession of the underlying security. However, you can EXERCISE your option if you want to. If you own a PUT option and want to EXERCISE your option, you can sell 100 shares of your Google stock at $500 per share to the writer of the option. If you own a CALL option and want to EXERCISE the option, you can buy 100 shares of Google stock at $700 each from the writer of the option. All stock options can be exercised at any time before they expire. These are called American-style options. Some index options, i.e., those with a stock index as the underlying security, can be exercised ONLY on the expiration date. These are called European-style options.
How to Price a Stock Option, Intrinsic Value and Time Value
How much does a stock option cost? The price you pay to buy an option contract is the listed price called its premium, and is always less than the price of the underlying stock. The price is quoted as per share, so the cost of an option on 100 shares is 100 times the quoted price. Two prices are quoted for the option, the bid price to sell an option and the asking price to buy an option. The difference between the bid and ask prices is the spread for the dealer.
The pricing of stock options is complicated, but there are two main influences on the price of an option. The price of an option increases if the price of the underlying stock increases. The price of the option decreases as the expiration date gets closer. Supply and demand for the option also has a small affects on its price.
The price of an option has two components, its Intrinsic Value and its Time Value. If your CALL or PUT option is in the money, your option has intrinsic value. For example, a $50 Call on a stock selling at $52 in the market is intrinsically worth $2, because you could exercise the option for $50, sell the stock you receive for $52 and pocket your $2 gain. But any option also has the potential to appreciate over time, its Time Value. The listed price of an option takes both intrinsic value and time value into account. So the intrinsic value increases when the option is in the money, and the time value decreases over time.
The Black-Scholes Calculator for Stock Option Prices
You can determine the theoretical price of an option with an online calculator tool based on the Black-Scholes Formula. The Black-Scholes Formula, developed in 1973, provides a way to calculate the price of an option. The Formula advanced the world of finance and earned its creators the 1997 Nobel Prize in Economics. The formula is a partial differential equation that uses 5 input values, which are the current stock price, the strike price, time until expiration, cost of money and volatility, to determine the price of the option. Volatility measures how much the stock price changes over time. The online calculator will show you that the price of an option is higher if the price of the underlying stock is high. Similarly, the option price is higher for more volatile stocks. The formula uses any stock dividends and the current interest rate as the cost of money. The option price is higher if the option is in the money, and higher if there is a long time until the option expires. You can try out the option pricing calculator here.
Black-Scholes Option Pricing Formula
How Much Money Can You Make Trading Stock Options
How much money can you make trading stock options? If you are good at predicting short-term stock prices, you can break the bank by trading stock options. Here's an example of big gains. Suppose you purchase a call option on XYZ, rather than buying the stock at $4.28. Suppose you buy the January $10 Call option. The the premium is $.70 per share, so your cost to buy the option is $70.00 (100 * .70). In order to break even on the trade, XYZ shares have to rise to $10.70. If you are right and shares zoom to $20.00 and you sell the options back to close it out just before they expire, You'd make $1000 on your option (($20 -$10) * 100 shares). That's a return of over 1400% on your $70, 14 times your original investment. And you would net $970 after the premium (1000-70). If, instead, you bought shares of XYZ stock at $4.28 and sold them at $20, you'd have a 428% gain, compared to 1400% gain with options. But leverage makes it more interesting. $70 was all it cost to buy the CALL option. With that same $70, you could buy only 16 shares of XYZ, and would make only $251, compared to $970. This example does not include your broker's commissions for the trades.
Make money with call options
But, as you know, very few people can predict stock prices, especially price movements during three short months. And very few stocks move from $4.28 to $20 in three months or less. Consequently, 70% of options trades are losses. About 30% of options expire out of the money, worthless. About 10% of options are exercised, and 60% of all options are resold in the marketplace, often for a loss. That's why online financial sites like Motley Fool advise against stock options trading for most investors.
The Role of Your Broker and the Options Exchange
The stock options you buy and sell through your broker are exchange-traded options with standard contracts and with standard pricing. Your broker will settle your option trades in one day, unlike the three-day settlement for stocks. The exchange guarantees that the options contract will be fulfilled. If you decide to execise an option, your broker will arrange for the transfer of shares of stock. Large institutions can enter into private options among themselves, called over-the-counter options, which do not trade on an exchange. In addition to stock options, you can also trade options based on other underlying securities, like commodity options, bond options, stock index options. There are also interest rate options, options on futures contracts and many more derivative options available to option traders.
Option trading is overseen by the Securities and exchange Commission (SEC). The Chicago Board Options Exchange, CBOE, is the largest options exchange. Stock options are traded by mutual funds, pension plans, hedge funds, university endowments and corporations, as well as the general public.
Stock Options Are for Advanced Traders
Stock options are an advanced financial instrument. There are strategies for the writers of options, strategies to help you hedge your portfolio from loss, and strategies to make money using two or more options on the same stock. Option traders sometimes use exotic trading strategies with names like the butterfly spread, the iron condor, the straddle and the strangle.
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