What are Options?
An option is linked to a specific instrument — a stock or ETF. It is essentially an agreement between buyer and seller: if its terms are met, the seller will deliver the asset to the buyer at the agreed price.
An option has an expiration date. The price at which a trade will take place when the asset is delivered is called the Strike: the closer it is to the current price, the more expensive the option. You can buy an asset if it is a CALL option and sell if it is a PUT option. For the opportunity to buy or sell an asset at a predetermined price, you pay money for the option plus $0.65 brokerage commission per transaction.
The seller is obliged to sell you the asset anyway if it is a CALL option, or to buy it if it is a PUT option. But you don't have to buy/sell it at all if the price of the asset hasn't gone in the direction you want or has stayed the same. So you can close the option position before the expiration date and this will allow you to get back some of the cost incurred when you bought the option.
What are Call Options (with examples)?
You expect the Skechers stock price to rise by around 30% in two months' time.
|
By the expiration date, the stock has risen to $59. The seller of the option will deliver the stock to you at $50. Great, the option worked and you made a profit of $890 because you bought 100 stocks in one lot! But there's no refund for buying the $10 option, you paid for the right to buy the stock at a certain price.
What are Put Options (with examples)?
You would expect Coinbase's stock price to fall by 30% within four months.
|
By the expiration date, as you anticipated, the stock had fallen to $30. And you ended up short with stocks at $35 - the option worked and you made a profit of $125! If the price of Coinbase stock didn't fall or you didn't have it in your portfolio, you can sell your option before the expiration date and get back some of the value of your option at $375. And if you have such an asset, it's good protection against steep drops in the stock.
Detailed Instruction How to Trade Options
Below we share the instruction how to trade options using Freedom Finance (Freedom24 platform). This marketplace is chosen as an example because they have the widest selection of financial instruments and our community fellows have been using this platform for options trading for years and the process is well known.
- Pros: wide selection of stocks and ETFs to trade options, no eligibility requirements, no number of previous trades needed and low minimum investment amount for trading options, highly rated broker.
- Cons: the user interface of the platform is a bit outdated.
* Freedom Finance services are NOT available to US citizens and residents.
- Apply for a Freedom Finance account — you need to prepare your identity document and a document confirming the address of residence (utility bill). The verification process is very fast, it will take 2 minutes to create your account.
- Deposit your account — to participate in an IPO, your account must have available funds in the amount you send IPO application for.
- Pick which options to buy or sell (Call or Put)
A call option is a contract that gives you the right, but not the obligation, to buy a stock at a predetermined price — called the strike price — within a certain time period. A put option gives you the right, but not the obligation, to sell shares at a stated price before the contract expires.
If you think the stock price will move up: buy a call option, sell a put option.
If you think the stock price will stay stable: sell a call option or sell a put option.
If you think the stock price will go down: buy a put option, sell a call option.
You may think of options like an insurance policy: You don’t get car insurance hoping that you crash your car. You get car insurance because no matter how careful you are, sometimes crashes happen.
4. Predict the option strike price
When buying an option, it remains valuable only if the stock price closes the option’s expiration period “in the money.” That means either above or below the strike price. (For call options, it’s above the strike; for put options, it’s below the strike.) You’ll want to buy an option with a strike price that reflects where you predict the stock will be during the option’s lifetime.
For example, if you think the share price of a company currently trading for $100 is going to rise to $120 by some future date, you’d buy a call option with a strike price less than $120 (ideally a strike price no higher than $120 minus the cost of the option, so that the option remains profitable at $120). If the stock does indeed rise above the strike price, your option is in the money.
Similarly, if you think the company’s share price is going to dip to $80, you’d buy a put option (giving you the right to sell shares) with a strike price above $80 (ideally a strike price no lower than $80 plus the cost of the option, so that the option remains profitable at $80). If the stock drops below the strike price, your option is in the money.
You can’t choose just any strike price. Option quotes, technically called an option chain or matrix, contain a range of available strike prices. The increments between strike prices are standardized across the industry — for example, $1, $2.50, $5, $10 — and are based on the stock price.
The price you pay for an option, called the premium, has two components: intrinsic value and time value. Intrinsic value is the difference between the strike price and the share price, if the stock price is above the strike. Time value is whatever is left, and factors in how volatile the stock is, the time to expiration and interest rates, among other elements. For example, suppose you have a $100 call option while the stock costs $110. Let’s assume the option’s premium is $15. The intrinsic value is $10 ($110 minus $100), while time value is $5.
This leads us to the final choice you need to make before buying an options contract.
5. Determine the option time frame
Every options contract has an expiration period that indicates the last day you can exercise the option. Here, too, you can’t just pull a date out of thin air. Your choices are limited to the ones offered when you call up an option chain.
How do you decide which expiration date is right for your strategy? Just as you need to make a price forecast for an underlying stock before picking an option's strike price, so to do you need to make a forecast of how long it will likely take for your trade to become profitable before picking an option's expiration date. As always, start with your outlook. Then, determine which specific option would be the most appropriate.
