Getting Down to the Basics of Options Trading

Are you thinking about adding options to your investing arsenal? If so, it's important to educate yourself about what they are and how they work before you jump in. Options can be versatile and flexible, with opportunities designed for any type of market movement—up, down, or sideways. However, they're a bit less straightforward than traditional investments, and they come with their own lingo, which can take some getting used to. And, admittedly, options involve significant risks and aren't suitable for everyone.

Check out this high-level overview to help you decide if using options is right for you.

The Building Blocks

Options are contracts that give the owner (holder) the right to buy or sell an underlying asset, like a stock, at a certain price (the strike or exercise price) on or before a certain day (the expiration date). A standard contract is 100 shares and the price to purchase it is called the premium.

There are two types of options: calls and puts. And each transaction involves a buyer and seller who have different outlooks on the market and different rights and obligations.

A Closer Look at Calls

Let's look at why someone might consider buying or selling a call option.

So how does a call option work? Think of it as an extension of a buy and hold investment strategy except you need to select a strike price and expiration date. For example, let’s say XYZ stock is trading around $20. You’re very bullish on XYZ so you buy 1 XYZ Call with a strike price of $25 expiring in January 2019. The option premium for the contract is $5. Your maximum loss is the amount you pay for the contract, $500 ($5 option premium x 100 shares) and your maximum gain is unlimited since there is no cap on how much the stock price could increase, not accounting for transaction costs. The breakeven point is $30 ($25 strike price + $5 option premium paid), so you are hoping that XYZ’s stock price rises above $30 before or on the expiration date.

Puts in Practice 

Now let's look at why someone might consider buying or selling a put option.

So how does a put option work? Let’s say ABC stock is trading around $20, but you think the company’s sales are going to decline and the stock will go to $10. You buy 1 XYZ put with a strike price of $20 expiring in January 2019. The option premium is $2. Your maximum loss is $200 ($2 option premium x 100 shares) and your maximum gain is $1800 ($20 strike price - $2 option premium x 100 shares) if the stock goes to $0, not accounting for transaction costs. The breakeven point is $18 ($20 strike price - $2 option premium), so you are hoping that the price of XYZ stock falls below $18 before or on the expiration date.

The Key: Education 

The basic call and put options described above are just the beginning. There are many different ways you can use options. Some are more complex than others. Understanding how options work and the potential benefits and risks of exercising contracts and transferring rights in a security (assignment) are essential for deciding what role calls and puts might play in your investment strategy. Depending on your risk tolerance and goals, options could be a way to potentially enhance your portfolio.