How do stock options work? What is stock option trading? Is this something anybody can do?
Stock options are a great way to make a lot of money with very little investment. They aren’t really that hard to understand, but you need to study a little on how they work, how they relate to stocks, and the differences between calls and puts, etc.
I’m not sure that your average investor even knows how a stock works, let alone what a stock option is. I know when I tell people that I am a stock option seller, they don’t seem to understand. I am hoping to change that.
Trading stock options isn’t really that complicated, and honestly, it can be fun and extremely profitable. Stock options give regular retail investors like you and me the flexibility to make money in the stock market when it is going up, going down, or even when it is range bound.
What Are the Benefits of Stock Options?
Stock options give investors the ability to
- Control a bigger position with less money – A single option contract represents 100 shares of the underlying stock, but costs just a fraction of the price you would pay for 100 shares.
- Get huge returns from small stock movements – Since the cost basis of stock options are so low, you can see much higher gains than you would if you would just buy the stock.
- You can use options to lower your cost basis, and preserve your capital.
- Stock options allow you to trade higher priced stocks than you would be able to afford, especially if you have a smaller account.
- Generate regular income from the stock market – You can design strategies that will allow you to generate regular income from the stock market.
- Stock options allow you to determine your risk, and probability of profit, before you enter a trade.
- Make money even in declining markets – you can use puts and calls to make money, even when your assumptions are incorrect.
- Make money from volatility – Use strategies like selling spreads and iron condors to make money off of market fear.
- Reduce and even eliminate stock market risk.
Call and Put Options
There are two types of stock options, calls, and puts.
A call option gives the holder the ability to buy a stock at a predetermined price (the strike price), before a predefined date (the expiration)
A put option gives the holder the ability to sell a stock at a predetermined price (the strike price), before a predefined date (the expiration).
Buying and Selling Stock Options – Calls
Remember, a call option gives the holder the right to purchase a stock. When you buy a call you are saying you want to buy that stock at a certain price. Someone who buys a call thinks that stock will be worth more that the price of that contract. That buyer is going to pay a premium for that contract, thinking that it will be worth more, at a later date. The person who sold that contract, disagrees, and is thinking that the stock will not be at that price, and is willing to collect that premium.
They say a picture is worth a thousand words, so Let’s look at a what some of these terms mean. Below is a screen shot of the SPDR S&P 500 ETF – SPY looked like on 8/27/2018. This is an actual screen shot of my personal account at Tastyworks.
I regularly trade the SPY, since it is one of the most liquid equities there is. At the time I took this, SPY was trading at $289.80. The left side, in green, shows bid/ask price for calls that expire September 21, 2018. The right side, which is red, is the bid/ask for puts, of the same expiration. The black numbers in the middle show the strike prices, and you can see at the top it says “25d” which means there is 25 days until expiration.
Using the example above, someone who thinks that SPY is going to be higher than 289.90 in the next 25 days might want to by a call option. They might look at the 285 strike price, which has an ask of 6.28. This means a call buyer would pay $628 (100 x 6.28) for the ability to pay 285 for 100 shares of SPY. Take note that the 285 strike price is less than where SPY is currently trading at 289.80, so it is said to be IN THE MONEY, or ITM.
This buyer is paying a premium of 6.28 PER SHARE to buy SPY at 285. So to be profitable, SPY would have to be $291.28 (285 + 6.28) or more, at expiration.
If SPY rallies, and goes from 289.80 to 300 in the next 25 days. The person would have the opportunity, to buy 100 shares of SPY for 285, and sell them for 300. Their profit would be calculated as the selling price, less the purchase price, including the premium paid. This would be
(300 – 285 – 6.28) X 100 = $872
So in this scenario, they would have risked $628, and would have a profit of $872.
I should mention, you don’t have to wait until expiration to make your money. As the underlying equity moves, you can sell your option. As the stock increases in price, so does your option. Most people don’t hold their options until expiration, they just resell them, for profit (or loss if your assumptions are incorrect).
Or maybe instead of buying the 285 strike, they decided to look at the 290 strike, which is just AT THE MONEY or ATM. At the money options are less expensive than in the money options, because they have a higher strike price. Someone is asking 3.20 for the 290 strike, so a buyer would pay around $320, for the opportunity to buy 100 shares of SPY at $290
So using the same scenario above, Let’s say SPY is $300 at expiration. The total profit would be
(300 – 290 – 3.20) X 100 = $680
The total risk would be $320, and the profit would be $680. Not a bad return.
BUT, if SPY goes the other way, down, what happens? Well Let’s assume SPY falls to 280 by expiration. Using our first scenario where the call buy bought a 285 call for 6.28, the opportunity to buy SPY at 285 isn’t such a great deal, since it is higher than what SPY is actually at. That option will expire worthless, and whoever sold that option gets to keep all that premium that the buy paid, and they profit $628 (if they still hold that position).
The same is true in the second example, where the $290 strike was sold at $3.20 premium per share. The call seller will keep all of that premium.
Buying and Selling Stock Options – Puts
Remember, a put option gives the holder the ability to sell a stock at a predetermined price (the strike price), before a predefined date (the expiration).
Let’s look at the same screen shot as before.
Suppose someone sees SPY at 289.80, and think it is going to go down. They might look at the right side of the picture above and see the 290 strike price has an ask price of 3.09. So if they bought that today, they would have the opportunity to sell SPY at 290.
It may seem odd that we are talking about selling something, but we haven’t bought anything. That is something that a lot of people who are just learning how to trade stock options struggle with. I wish I had some clever trick for you to use to remember the difference between puts and calls, but I don’t, sorry.
So Let’s say SPY falls to 285 by expiration, the total profit is calculated the same way. Sell price – Purchase Price – Premium Paid) X 100. So the profit from this trade would be
(290 – 285 -3.09) X 100 = $191
If they were lucky enough and SPY crashed and went all the way down to 270, their profit would be
(290 – 270 -3.09) X 100 = $1691
But what happens if their assumption was incorrect, and instead of going down, SPY goes up, and closes above 290? Well, if SPY started moving the wrong way, I would just sell the put before I lost too much money, But, if the person who bought that put did nothing, they would lose all of their investment, $309, and the person who sold that put would keep all that premium.
Buying VS Selling Options
In both of the examples above, there is a party buying options, and another party selling options. It is a personal preference, and I will get into the benefits of each another time.
But basically, if you believe a stock is going up, you can
- Buy Calls – Your risk is limited to the amount you pay for the option, your reward is unlimited, a stocks price is unlimited to the upside.
- Sell Puts – Your risk is limited to the difference of the strike price and the put price that you collected. Your maximum loss would be if the stock went to zero. This is called selling naked puts sometimes.
If you believe that a stock is going down, you can
- Sell Calls – Your risk is unlimited, and the reward is capped at what you collect from the sale of the calls. This is called selling naked calls. I don’t recommend this, since your risk is unlimited to the upside. I’ve never done this, and I suggest you don’t do this, until you are extremely wealthy and experienced at trading options.
- Buy Puts – Your risk is limited to the price you pay for the put option, and the most you would make would be if the stock fell to zero. Put strike price – Price you paid for the put option.
I hope this helps understand a little about what is stock option trading. I’ve been trading options since 2012, and I remember it can be a little daunting at first. But I believe it isn’t as hard as it seems at first.