On a basic level what are options and options trading?
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Options are a contract whereby the buyer of the option is buying the right to buy or sell a set number of shares at a set price within a specific time window. Let’s just consider an option to buy (sell is the same in reverse).
TERMs:
Strike Price — agreed upon price to be paid per share of stock
Expiration Period — time within which you must exercise your option or it becomes worthless
Premium — amount paid for the contract. You are out this money whether or not you exercise the contract
Exercise — to invoke your right to purchase the shares
An options contract is merely a contract where the one selling the contract agrees to sell you a set number of shares for a specific price before a certain time. You pay the price in the contract regardless of what the current market price of the stock is. You do not have to exercise (buy the stocks) if you do not want to, but you can. If you chose not to exercise the contract then you are out only the cost of the premium (see above for term definitions).
Why would you want to do this? It is a form of risk management and leverage. Let’s say you a company is currently selling at $100/share. You think in a few months it is really going to go up in value. You buy a 6-month option with a strike price of $150 per share and a $10 per share premium.
You owe 10*100 = $1000 for the premium. At anytime within six months you can exercise the option and purchase 100 shares at $150 each ($15000). It doesn’t matter if the current market price of the stock jumped to $1000 per share before you decide to exercise the option, you get to buy it at $150 per share.
Let’s say 4 months after purchasing the options contract the market price is $300 (they had really good news and the stock price jumped). You decide to exercise your contract. You owe $150 * 100 shares = $15000 and now have 100 shares of the stock. You can then sell those 100 shares for the current market price of $300 and get back $300 * 100 = $30000. Remember that you paid a $1000 premium for the contract so in the transaction you made $30000 (market value of shares) – $15000 (purchase price of shares) – $1000 (premium) = $14,000. You just made $14,000 on a $1000 investment (note these numbers are a made up example and may not reflect realistic premiums). In actual practice, the contract option itself has a value very similar to the market value of the shares, so you could just sell the options contract for the $14000 (or so) dollars without ever actually buying the $15000 worth of stocks–this is the leverage type ability of options.
Let’s say instead of going up $300, the stock crashed and burned down to $25 per share. In this case, you do not exercise your option and you lose your $1000 premium. If you’d actually purchased the stock at $100 per share, then you’d be out 100 * ($100 – $25) = $7500 which is $6500 more than not exercising the options contract. This is the risk mitigation property of options.
NOTE: This explanation makes options sound like options are no brainer–you win more when you win and lose less when you lose. What isn’t explained here is that you will in general lose money more often with the options contract than with buying the stock directly so it isn’t a black and white better than investing in the actual stocks. Unless you really know what you are doing, I’d recommend against playing in the options market (I have never made an options trade because while I understand them in principal I don’t trust my ability to use them more correctly than just buying the stocks). There are also a lot more complicated options available.
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