Investing in stocks is something many of us have heard of, but few of us really know what it means. The thing with investing in stocks is the unreliable nature of the whole system. Sure, there might be some sort of mechanism that can be analyzed and you might figure out the external factors at play that govern the prices of the stocks as well.
Still, for laymen, the stock market can be rather overwhelming when just starting out in investing. That’s why there are many stockbrokers who will give you advice on when and what to buy and sell. However, having the money for this kind of investment is not something many of us have just laying around.
Here’s where trading options come into play. By buying an option, you secure the purchase of a stock at a set price only in the future. Let’s say that you’re considering buying a stock worth $2000, but don’t have the money ready at the given moment. What you can do is buy an option that will guarantee you the option to buy the stock at the given price before a particular date. If, for the sake of this example, you don’t have the $2000 for another two months, you can negotiate buying an option for this stock at the given price.
An option is basically a contract that guarantees you an option to buy the stock at the given price. The option in this example may cost $300, which you pay right now. The option then gives you the possibility to buy the stock at the price of $2000 even if the stock rises to a worth of $6000 by the day your contract expires. The owner of the stock has to sell it to you for the agreed upon price. So, in total, you pay $300 for the option and another $2000 for the stock itself; but in return, you get a stock that is now worth $6000. Your profit is $3700 ($6000 – $2000 – $300).
Of course, there’s always the possibility for the stock to fall to a lower price.
Let’s say that in the same example, the stock price falls to $500 from the initial worth of $2000. Two months earlier, you purchased the option to buy the stock at a price of $2000. You paid $300 for that option, but now the stock is worth only $500.
You have two possibilities now. The first possibility is to buy the stock and pay $2000 for something that is worth only $500 at the moment. If you add the cost you paid for the option, this would create a loss of $1800 ($2000 + $300 – $500 = $1800).
The second possibility in this example is to let the option expire. You don’t have to buy the stock at the rate you agreed upon, you only have purchased the option to do so. Sure, you’ll still lose $300 (the money you spent for buying the option), but this is much better than losing $1800 in the first possibility.
This example is a simplified version of what happens in options trading. Different options have different conditions. As we mentioned earlier, options are basically just contracts, and as such, there is a lot of different variables that come into play when constructing these contracts. Some may be basic, like in our example; others may include different conditions that have to be met in order for the deal to go through as it was agreed upon when signing the contract.
That’s why it is very important to read everything that comes into your hands if you’re new to the option trading game. Even more experienced traders need to have a trained eye for different kinds of option contracts in order to avoid convoluted conditions that may cause losses without knowing that there was a possibility to lose.
In order to understand what these convoluted phrases in contracts mean, you should consider learning about the basic terminology of options trading. The term strike price is the price of the stock that is the subject of the option you consider buying. In the example above, the strike price is $2000. If the stock goes above this price, the option is for calls, while the terminology for puts is used to describe stocks that go under the strike price.
Another important term in stock trading is expiration date. This is the date by which the purchase has to be made. Letting your option expire can lead to losing the amount you paid for the option. In the example we mentioned earlier, the expiration of the option made us lose $300, but that’s nothing compared to the loss we would have had if we were to buy the stock at a much lower price than the initial strike price of $2000.
However, expiration dates are not always good things. If we take the first example in this article (the one in which the stock skyrockets to a worth of $6000), letting the option expire would still lead to losing $300. But, unlike as in the aforementioned case, in this case we could have made a profit of $3700. Instead, we lose $300 for not paying attention to the current price of the stock or by simply forgetting about the exact expiration date.
This is why trading options is something experts usually do, especially selling options, which can prove to be quite demanding. You have to have an overview of the market in order to hit it big with options trading.
Another big part options trading plays in the big picture of the stock market is speculation. Sometimes, if the right people hold enough options of a certain stock, there is a possibility for the market to fluctuate, creating an inherent shift in the price of that same stock. This way, options become a kind of indirect way of influencing the stock market by speculation.
If you want to get into options trading, it’s very important to understand what exactly you are agreeing to. It may be best to have an expert guide you through the process for a while until you feel comfortable on your own, or you can learn the foundation of options trading yourself by reading and then simulating the trade.