An option is exactly that — it’s a choice (or option) an investor has when playing the stock market. It’s a securities contract, a “call” or a “put,” that gives you the right to buy (call) or sell (put) the underlying equity, index, or ETF at a predetermined price (strike price) during a preset time period (expiration date).
You’ve already seen how options strategies work every day without realizing it. In fact, you probably have purchased the right to protect yourself against risk in some area of your life, such as home, health or car insurance. Those same principles can be applied to options trading.
Let’s use car insurance as an example. You purchase a new car after taking time to decide which model you want based on safety ratings, how smooth the ride feels and how well it will accommodate your needs. But would you drive that shiny new car off the lot without taking precautions in the event that something happens to your investment? Probably not (and not just because car insurance is required by law).
When you buy an insurance policy — be it automobile, health, life or homeowner’s insurance — you pay a monthly or yearly premium for the protection it provides. The policy ultimately might be valued at several times more than what you actually pay for it, but the nominal amount you’re charged for this security net is a small price to pay in comparison.
At the end of the year, when your car insurance needs to be renewed and you haven’t been involved in any accidents that required you to file a claim, you still come out a winner because you didn’t lose any more than your initial investment (your premium) and you drove for a whole year with peace of mind because you had the insurance in the first place.
That’s the same principle used for options trading, but replace that well-researched vehicle purchase with a favorite stock holding. For example, let’s say you think Allstate (NYSE:ALL), which is trading at roughly $30 a share, will rise to $35 within the next few months, but you don’t want to tie up thousands of dollars of your hard-earned cash. By instead purchasing one options contract (which controls 100 shares) at $1.50 per contract, only $150 would be tied up, as opposed to the $3,000 required if you bought 100 shares of the stock outright.
Options pricing will be covered in more detail a bit later.
What are Options: Two Basic Types
There are two basic types of options: calls and puts. Every options strategy, no matter how complex, uses one or both of these option types as its building blocks.
Call options are derivatives that give the buyer the right, but not the obligation, to buy a security (i.e., to “call” it away from its owner) at a specified price during a specified period of time. Typically, you buy calls when you’re bullish about the direction of the market and/or about a particular stock’s prospects.
Put options give you the right, but not the obligation, to sell a security (or “put” it to someone else) at a specified price during a specified period of time. Put buyers are generally bearish on the market and/or a stock’s potential, so they purchase puts to try and profit from an expected downside move.
Put buying is similar in theory to shorting stock because the trader is motivated by expectations that the shares will fall below a certain price. The put buyer actually incurs less risk than the short seller, however, because the maximum potential loss when buying options is the premium paid to enter the trade. Investors who short stocks must come up with a lot of capital to buy shares of the stock (aka “cover their shorts”) if the price rallies higher.
For all options, there are always two parties involved — someone buying and someone selling. There are also pros and cons for each strategy. The key to successful options trading is determining which choice is right for you at which time. Hopefully this introductory guide helps you understand the terminology and strategies so you can make informed and confident decisions when you’re ready to trade!
The chart below is a quick review of what calls and puts allow you to do.
When you trade an option, you are actually buying (or selling) an options contract. One options contract controls 100 shares of the underlying stock. For example, if Allstate (ALL) is selling for $30 per share, it would cost you $3,000 to own 100 shares. But by purchasing the call option, you can control those 100 shares for a fraction of the cost — $1.50x 100 (representing 100 shares) = $150 per contract. The variables behind option pricing will be discussed later.
Each options contract controls 100 shares of stock, so when you hear people talk about one contract, they are effectively talking about 100 shares. Two contracts would be the equivalent of 200 shares, five contracts would be 500 shares, and so on.
Click here to keep learning: What are Options Contracts?