Options trading is a fast-paced investment that can affect many outcomes in the stock market. If you’re new to options trading, it may seem like a very aggressive market. But once you know what to look out for, it will become more clear what options trading really is about and how to do it successfully.
In order to help you grasp the concept of how to buy options, we will take a brief look at what they are, what the basics of options trading is, and what you need to know if you want to get into buying options.
What are options?
An option is a contract that grants you the right to buy a given asset at an agreed upon price before a certain expiration date. These types of assets tied to the option can be anything, but we mainly think about stocks when we talk about options. You can read more about what options trading is here.
However, these underlying assets are not bought simply by buying options. You just buy the option to buy the asset at a later time.
Let’s say for example you want to buy a new car. The car costs $10,000. You currently don’t have the money, but you will have it in 6 months. So you make a deal with the seller to buy an option for the car. He agrees and you pay him, let’s say, $500 for the options with an expiration date of 6 months.
The buyer is not obliged to sell you the car for $10,000 before the 6 months expire. This amount is called the striking price. Now, let’s assume that two months after buying the option for the car, someone finds out that the car was owned by none other than Marilyn Monroe. Of course, it is now worth much more than the initial striking price of $10,000. You do some research and find out that it now has a worth of $100,000.
However, since you bought the option to buy it at a price of $10,000, the seller has to sell it to you at this agreed upon price before the 6 months expire.
As you can see, options really have no worth intrinsically, but rather depend on the worth of the asset they’re tied to, in this case the car. In the stock market, the assets are, of course, stocks, but the same principle applies.
In this example, you now have a number of choices on how to act in order to make a profit. We will list these possibilities and stick to our example in order to demonstrate what these possibilities mean for you and what risks and profits everyone entails.
Trading before the option expires
The option you have for the car expires in three months, but its worth already rose from $10,000 to $100,000. The logical thing to do is to buy the car at the striking price of $10,000 and make a profit of $90,000. If you calculate into this the $500 you spent for buying the option in the beginning, you made a $89,500 profit. This is not bad at all and it is one of the basic tactics many beginners and professionals use to make a profit with options trading.
The possible downside to this tactic is the fact that the cost of the car might drop after you buy it. Let’s assume that you have the option to buy the car and the worth goes up like in the example. You immediately buy the car, but then two weeks later a historian finds out that it is not Marilyn Monroe’s car, but a fake. Furthermore, the car suffers from corrosion in the engine and is not usable at all. You get it checked and find out that it is really worth only $2,000. You now have made a loss of $8,500 ($2,000 – $10,000 – $500) because you bought the car prematurely. To avoid this, there’s another tactic frequently used by options traders.
You may already have guessed what this tactic involves. You have another six months’ time before your option expires, so you wait and see what happens. This tactic is very safe as it gives you the possibility to make a profit without hurrying into buying the assets (in this example the car) immediately after you find out that it is worth more than the striking price.
Using the same example as before, you have the possibility to buy the car for $10,000 and the historians find out that it is Marylyn Monroe’s car. The worth of the car skyrockets, but you don’t have to rush into buying it because you can wait until the expiration date to do so. If in the next 6 months the price stays high, you still have the option to buy it at the price you agreed upon. However, let’s assume that after two months you find out about the fake Marylyn Monroe and the corrosion. You DON’T have to buy the car, but you will lose the money you paid for the option. Here’s where the third tactic comes into play.
Letting the option expire
You bought the option for the striking price of $10,000, but suddenly the car is only worth $2,000. What do you do? Well, you don’t have to buy the car. Yes, you’ve already paid the $500 for the option to buy, but it’s still better than to make an even greater loss. If you let your option expire, you only lose those $500 instead of the $8,500 you might have lost if you bought the car immediately.
The downside here is when the car suddenly rises in value and you don’t use your privilege to buy it at the striking price. Let’s say that the car really is Marylyn Monroe’s, and you waited until after the expiration date of the option to buy it. When the option expires, you lose the possibility to buy it at the striking price of $10,000. That’s why you have to always be on the lookout when trading options, and always pay attention to the current market and how it behaves.
If you’d like to learn more about How To Trade Stock Options – click here.