Understanding the basics of options. This is a brief options 101 defining what are options.
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) before a certain day (the expiration date). A standard contract is 100 shares and the purchase price of the option is referred to as the premium.
Options are typically used to speculate on the direction of a security or index, hedge against market downturns, or pursue an additional income goal. This is why many active traders add them to their arsenals.
There are two types of options: call options and put options. Each has its benefits and risks, and these change depending on if you’re the buyer or seller of a call or put option. Let’s start with calls.
A call option gives the owner the right, but not the obligation, to buy shares of stock or another underlying asset at the strike price of the option within a specific time period. The seller of the call is obligated to deliver, or sell, the underlying stock at the strike price if the owner of the call exercises the option.
So how does a call option work? Let’s say XYZ stock is trading around $20. You’re very bullish on XYZ so you buy one XYZ call with a strike price of $22 expiring in January 2019. The options premium for the contract is $1. Your maximum loss is the amount you pay for the contract, $100 ($1 options premium x 100 shares), and your maximum gain is unlimited because there is no cap on how much the stock price could increase, not accounting for transaction costs. The break-even point is $23, not including transaction costs ($22 strike price + $1 option premium paid), so you’re hoping that the price of XYZ’s stock rises above $23 before or on the expiration date.
A put option gives the owner the right, but not the obligation, to sell shares of stock or another underlying asset at the strike price of the option within a specific time period. The put seller is obligated to purchase the underlying at the strike price if the owner of the put exercises the 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, causing the stock to fall to $10. You buy one XYZ put with a strike price of $20 expiring in January 2019. The options premium is $2. Your maximum loss is $200 ($2 options premium x 100 shares) and your maximum gain is $1800 ($20 strike price - $2 options premium x 100 shares) if the stock goes to $0, not accounting for transaction costs. The break-even point is $18, not including transaction costs ($20 strike price - $2 option premium), so you’re hoping that the price of XYZ stock falls below $18 before or on the expiration date.
Learn more about the basics of options by watching this video.
While options are definitely not for everyone, TD Ameritrade can help you pursue options trading strategies with powerful trading platforms, idea generation resources, and the support you need.
Learn more about the benefits and risks of trading options
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A long call or put option position places the entire cost of the option position at risk. Should an individual long call or long put position expire worthless, the entire cost of the position would be lost.
Maximum potential reward for a long put is limited by the amount that the underlying stock can fall.
This strategy provides only temporary protection from a decline in the price of the corresponding stock. Should the long put position expire worthless, the entire cost of the put position would be lost.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
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