What are stock options, and how are they different from buying and selling stocks? What determines a stock options price?
When you buy a stock, or go long a stock, you are said to have a BULLISH outlook on that stock, and you are hoping that stock will go up. Below is a screen shot from my tastyworks account what it would look like if you went long Tesla, TSLA. I am putting in an order to buy 100 shares of TSLA at a price of $308.50 per share.
When you buy stock, the cost of the trade is called a debit, and your broker will deduct the cost from your brokerage account and replace them with shares. Above, the total amount debited from my account for 100 shares of TSLA was $30,855.08
When you short a stock, you are said to have a BEARISH outlook on that stock, and you are hoping that stock will go DOWN. Below is a screen shot from my tastyworks account what it would look like if you went short Tesla, TSLA. I am putting in an order to short 100 shares of TSLA at a price of $308.49 per share.
When you short sell stock, the cost of the trade is called a credit, and your broker will sell the shares on your behalf, and credit your account the amount of the sale. To exit the trade, you will have to buy shares on the open market, hopefully at a lower price Above, the total amount credited to my account for 100 shares of TSLA, after commission and fees, was $30,843.51
I don’t know about you but $30,000 is a lot of money to me – that’s why I trade learned to trade STOCK OPTIONS
It takes a lot of money to buy and short sell stocks. And plus when you buy a stock you hope it goes up, but it can also go down. Same with short selling stock, it can go up or down. Research has shown that there is a 50 / 50 chance of being correct on the direction of a stock price.
NOBODY can keep picking stock directions consistently.
When you learn how to trade stock options, you aren’t just taking a 50 / 50 chance on a stock price moving up or down. You are using probabilities to tip the scale in your favor to get a better probability of being profitable. You can make strategic trading choices, if you know what to look for. When you enter the trade, you have a clear goal, and an exit strategy.
Also, options are exponentially less expensive than stocks, so it can enable option traders to do things in the market that would require a lot more money than they have.
Definition of a Stock Option
A stock option is a contract that gives the holding party the right, but not the obligation, to leverage a trading instrument (stock) at a set price for a limited amount of time.
An option allows you to buy or sell a stock, at a set price, before a set time. A lot of time the word underlying is used to describe the stock, ETF, index, etc. The term strike is often used to describe the price. The set time is called the expiration date.
The example below is a screen shot from my tastyworks account. Let’s use Apple, AAPL, as an example. At the time I took this, AAPL was trading at a price of $170.07 On the right side are the expiration dates available, starting with February 15th, then March 15th, then April 18th and so on. You can see in the middle the days until expiration or DTE. The February options are actually expiring today. The next month is March, at 28 DTE, and then Apr 18th, at 62 DTE. I’ll explain later what research shows to be the best DTE works in your favor, but for now it is just important to get the basics.
So I decide I want to look at options for April 18th, so I just tapped on April and it opened up to show the calls on the left, and the puts on the right. Let’s just focus on the calls on the left side, most option traders find them easier to understand at first.
AAPL is trading at about 170 per share, and you can see that the 155, 160,165 and 170 strike price are below the ITM line, which stands for in-the-money. The strike prices for 175 and up are called OTM or out-of-the-money.
The 170 strike has a bid of 6.55, and an ask of 6.60, which, just like stocks, means that someone is willing to buy that contract for 6.55, and someone else is willing to sell that same contract at 6.60, and somewhere in between there will be a sale.
I should note that the prices of stock options are listed PER SHARE, and each contract represents 100 shares, so you have to multiply the bid ask prices by 100. To buy or sell the above example will require 655 to 660 dollars, plus any commission and fees.
Buying Call Options
So if one was bullish on AAPL and thought that AAPL was about to go from 170 to 200 per share, you could buy 100 shares of AAPL at 170 per share, then hope AAPL stock goes to 200, and sell it.
- Buy 100 shares of AAPL @ 170 = 100 X 170 = 17,000
- Sell 100 shares of AAPL @ 200 = 100 X 200 = 20,000
- Total profit = (200 -170) X 100 = 3,000
So you risk 17,000 to make 3,000.
Or if you just bought 1 call to open a trade on AAPL
Buy 1 call on AAPL @ 170 = $660 + any commissions and fees, which would only be $4 if you trade with tastyworks. Let’s say you were correct and AAPL stock price went to 200 per share, before your option expired. You would have the option to exercise, would men you could buy 100 shares for the strike price of $170 per share, even though the stock has climbed to $200, or you could just sell the option, which, as long as it is before the expiration date, would have certainly climbed in value. At the very least they would be worth $3,000 and that would only be on the day of expiration. You would have to subtract the $660 in premium that you paid for that option, so your total profit would be
- $3,000 – $660 = $2,340
What would you rather risk, $17,000 or $660? It is a more efficient use of capital to use $660 than $17,000
Or, another possibility, instead of buying the 170 calls, you notice that the 190 calls are only trading in the $77 to $79 range. If you bought an OTM 190 call for $79, and AAPL went to $200 per share, you would have the right to buy 100 shares for 190, and could sell them for 200, for a profit of 1,000 – 79 = $921. Sure you didn’t make as much in this scenario, but your risk was far less.
The farther out of the money a call option is, the cheaper it will be, and the further deeper in the money a call option will be, the more expensive it will be.
Calculating Break Even Prices of Call Options
Let’s look again at the call options for AAPL. This is the same picture we saw before.
We already talked about buying the $170 call for $6.60. This would mean that AAPL would have to be above $176.60 per share, for us to break even. How did I come up with that? Easy – I just added the cost of the option to the strike price.
Now if you do the same equation to the 155 strike price, you would add $17.30 to $155 to find your break even of $172.30. Which is lower than the break even for $170.
So if you look at the $190 call you need AAPL to be $190.79 or better before you see any profit.
Buying cheap out of the money calls might seem like a great idea since they require the least risk and provide the most reward, but they also require the most movement to be profitable.
I recommend tastyworks, because they charge the lowest commisions on stock and options trades that I know of, plus there is no commision on closing orders. To read more about how tastyworks compares to TD Ameritrade, Interactive Brokers, and others, please read my full review ==> CLICK HERE
Next I will explain how you can buy put options to make money when stocks go down. Until then, if you have any questions or comments, please leave them below.