Options Trading 101: Stock Options Trading Basics

I firstly remind below the basics of Options for the rest of the article to make sense for the readers who do not have opinions about Options. There are numerous underlying assets that can be traded as an option contract from stocks to FX products, from equities to commodities and many more. In this article, I summarized the basic concepts of stock options trading. 

An Option is a contract allowing the recipient the right, but not the obligation to transact a known transaction (buy or sell) of a known asset at a known price in a known pre-defined time frame

Options that can be exercisable at any time during the time period are called “American Options”.  Options that can be exercised only at the end of the period are “European Options”.

Other important characteristics of Options:

Expiration Date: The date an option’s final value is determined and can no longer be traded. Stocks typically have options with expiration dates ranging from a few days to two years away. 

Strike Price: The price at which shares (the underlying asset) will be bought/sold if an option is exercised. 

Option Contract Multiplier: The number of shares an option contract can be converted into. Typically, equity options like AAPL options have a contract multiplier of 100 (each option can be converted to 100 shares of stock). It also means that 1 option is equal to 100 shares.

One of the biggest benefit of trading options that they can leverage your returns relative to a simple stock trade. Let me illustrate below with an example:

Stock Trade => Buy 4 shares for $150 and Sell 30 days later for $160
The profit on that trade is $40

Profit => $40: 6.7% Return ( $40 profit / $600 investment)

Option Trade => Buy the 30-day, 150 Call for $5,

Sell for $10 in 30 days (stock price @ $160)

The profit on that trade is $500 (100 multiplier * $5)

Profit => $500 100% Return ( $500 profit / $500 investment)

So, you can see that by trading an option you can leverage your returns immensely relative to just a stock trade. Unfortunately it’s not all good news when trading options. Because if the stock price had stayed at $150 over that 30-day period, then the trader would have lost the entire $500 in that option. 

The Options Types:

Call Option => Gives buyers the right to buy 100 shares of stock (per contract) at the option’s strike price before the option expires. 

For example; if the strike price is $100, buyer has right to buy 100 shares of stock for $100 before the option expires. 

So, why not buy the call with the lowest strike price?

Because calls at lower strike prices cost more money as there is more value in the ability to buy shares at lower prices, and there is higher probability that a lower strike call option is valuable at expiration. 

Let’s assume the current strike price is $100. So, the option price might be $5 at $100 strike price, and $1,75 at $110, and $0.25 at $120.  

Trade Example: 

Stock Price => $50

Trader’s Prediction => Share price will increase to $60 in 2 months

Option Trade => Buy the 50 call that expires in 60 days for $5

Stock Price in 60 Days                                                        P/L of Trade

$0                                                                                         -$500 (call worthless)
$50                                                                                       -$500 (call worthless)
$55                                                                                        $0 (call worth $5)
$60                                                                                        $500 (call worth $10)
$65                                                                                        $1000 (call worth $15)

See below P/L table of buying 100 shares of stock without an option contract:

P/L (100 Shares) 

-$5000
$0
$500
$1000
$1500

We can easily see here why options can be good trade instruments if managed successfully. When we compare buying the call option to buying 100 shares of stock, we can see that when the stock price decreases significantly, the loss on the shares is far more significant than the loss of the call option. However if the stock price stays the same and does not increase, there will be some losses on the call option whereas the stock position won’t have any losses at all. When the stock price increases significantly, we can see that the P/L on the stock position is actually a little bit higher that the call option’s profitability. But in terms of return on investment you’ll have a far greater % return on investment when you look at the call option and compare it to that stock position. That’s because to buy a 100 shares of a $50 stock you have to put up $5000 whereas in this example you only needed $500 to get similar profitability. 

Call options can also be sold, which turns the position into a bearish trade. In this trade, the P/L is completely different than a long call option position. 

Let’s say that we’re looking at a stock that’s trading around $100, and we sell the call option with a strike price of $110 for $5. If the stock price trades sideways, decreases, or even increases slightly (below $110) the position will profit ($5 * 100). So that call option will expire worthless as long as the stock price is below the strike price of $110 at expiration. However the stock price increases significantly, then selling that call option could turn out to be a very dangerous position, because there’s no limit to how much the stock price will increase. Therefore, theoretically there’s unlimited loss potential when selling call options

See below the hypothetical P/L of this position (selling the call option): 

Position: Selling a Call Option @ $110 for $5

Stock Price @ Expiration                                                  Call P/L

$200                                                                                     -$8500

$115                                                                                      $0

$110 or less                                                                         $500

Put Option => Gives buyers the right to sell 100 shares of stock (per contract) at the put’s strike price before the option expires. 

For example; if the strike price is $100, buyer has right to sell 100 shares of stock for $100 before the option expires. Opposite of call options, put options gain value when the stock price falls, as the ability to sell shares at the put’s strike price becomes more valuable as the share price decreases. 

Assume that we have a put option with a strike price of $85. That means that we have right to sell 100 shares of stock (per put) for $85/share before the put expires. If the stock price is at $70, the $85 put option will be worth at least $15. 

Trade Example:

Stock Price => $200

Trader’s Prediction => Stock price will fall to $190 in 30 days. 

Option Trade => Buy the 30-day $200 Put for $6.5

Stock Price in 30 Days                                                                      P/L of Trade

$250                                                                                                     -$650 (put worthless)
$200                                                                                                     -$650 (put worthless)
$195                                                                                                     -$150 (put worth $5)
$190                                                                                                      $350 (put worth $10)
$175                                                                                                      $1850 (put worth $25)

 

Put options can also be sold like call options, if a trader has bullish expectations. Assume the stock is currently trading at $190, and instead of buying put we sell the $170 put for $7. If the stock price trades sideways, increases, or even decreases slightly (above $170) the position will profit ($7 * 100). Selling a put options is a highly risky strategy same as selling a call. Assume that the stock price decreased dramatically to $150, the $170 put will be worth $20 at the expiration. Because the ability to sell shares $20 higher than the current share price is worth $20/share. In this situation, the loss would be $1300 per put contract.  

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