What are Stock Options, and Should You Trade Them?
The beginners guide to understanding derivatives.
Good morning investors,
Stock options are just one form of derivatives in the financial markets. But they are quickly becoming the most popular in both the eyes of Wallstreet and retail investors. Both, however, for very different reasons.
Today, we will talk about what stock options are and determine if they are right for you.
LEGAL DISCLAIMER: I am not a licensed financial advisor. Everything I say I strictly my opinion, do your own research before making any investment decision.
What are Stock Options?
Stock options are a type of employee incentive and investment vehicle that lets you purchase shares of the company’s stock at a predetermined price and date.
More specifically, a stock option is an agreement between an investor and the company which gives the holder the right to buy 100 shares of the company’s stock at a predetermined price for a given period of time. Companies usually issue stock options to employees as part of their compensation package. The holder can exercise their rights and buy shares from the company at any time during or after this period, but not before.
That is the more orthodox definition.
There are two types of options contracts that make up all strategies: hedging, income, and speculation in the options world.
Calls and Puts.
A call is a type of option that an investor purchases when they assume the underlying stock (like Apple or Google) will go up within a specific time period.
Example:
Stock XYZ is $50/share, and you assume that this stock will go up within at least six months.
You pay a premium for a call option with a strike price of $55 and an expiration date of six months from the current date.
The benefit of buying an investment vehicle like an option is that the return on your investment will grow exponentially compared to just owning the common stock like shares. If your assumption is correct, you’ll get paid more than you would just owning shares with the same amount of premium you spent on the call option.
Put options are bought when you assume that the underlying stock will go down. The mechanics function the exact same way that calls do.
Also, if you were to hold your option contract for its complete duration and on the day that it expires, the stock price is not above the strike price you selected, it will expire worthless. However, if it is above the strike price, most brokerages will exercise your contract(s), meaning you will buy 100 shares of that stock per contract at the strike price you selected. For this reason, most people don’t hold their contracts to the expiration date.
Should you Trade Options?
Most likely not, unless you are willing to take a lot more risk and manage your position. For a reason I mentioned above, if the underlying stock price isn’t above your strike price by the expiration date, you lose your total investment. ( in the case of calls )
Retail traders nowadays use options mainly as short-term investment vehicles, typically buying options less than six months away. The problem with that is because options allow investors to have outsized returns in comparison to shares. The shorter the expiration date of your contract, the riskier the contract.
However, every person’s risk tolerance is different, so if options sound like the type of investment vehicle you’re looking for, then you should do some more research, make a plan, and start small.
Options are a lot more complex than what I described above. However, I tried to lay it out as simply as possible so that anyone could understand them. There are complicated math formulas that determine an option contracts price, and they use these things called “The Greeks” to figure out how the option price will move in time—taking things into account like days to expiration, volatility, the stock price, and the change between how the option moves given a dollar increase.
I will talk about different types of option trading strategies and go into more depth in future posts.
But thats all for today. I hope everyone learned something; if you enjoyed today’s article, consider sharing it with a friend if you feel like it.
Have a great day, and remember to live in the moment.
