When someone starts out buying and selling stocks they typically purchase shares on the open market using popular online trading systems (like TD Ameritrade or eTrade). The beginning investor will usually purchase shares of a stock and hope to sell them at a higher price. After a few weeks or months, or years in the market, the trader will probably wonder how to buy options contracts. A bit riskier than owning common stock, options allow the trader to have much more buying power at a fraction of the price of owning common stock.
The first step in how to buy options contracts in the stock market is learning exactly what options contracts are.
What Are Stock Options
A privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on a specific date.
One typically hears about stock options as part of executive compensation plans. A CEO or other executive may be granted x number of stock options at a 15% discount of the current stock price. This basically gives the option holder the ability to purchase the stock at the option price at a point in the future. If the CEO does a great job and the stock of the company doubles, to say, $50 and the CEO has 50,000 stock options @ $20, the CEO has the right to purchase the stock @ $20/share even though it is trading at $50 – nice profit! However, if the stock price goes down, the options become worthless and the CEO can let them expire.
What Are Option Contracts
The typical individual investor will deal with option contracts. Options contracts are bought and sold like normal stocks. There is a bid and an ask price. We will focus on buying call options since that is the simplest type of option contact.
An Option Contract Controls 100 Shares of Stock
When you purchase an option contract, you are thus controlling 100 shares of stock in the company. Let’s say you think company XYZ is moving higher and currently trades at $50/share. You know they report earnings in a week and are certain they will blow away the numbers and have a pop in the stock price. You then might want to purchase $52 call options for $1.80 with an expiration 1 month from today.
The entire contract would then cost you $180, but you control 100 shares. Now let’s say you were correct and the stock skyrockets up to $60/share. You can then sell your options back to the open market or buy the stock outright @ the option price you secured which was $52/share. If the stock takes a nose dive, you can simply let the options expire and lose the $180, you can try sell the options (which might still lose you money) or you can purchase the stock at the options price.
How To Buy Options Contracts
The easiest way to buy options contracts is through an online broker such as TD Ameritrade or eTrade. You simply log-in to your account and enter the options trading desk. You’ll then want to filter through the various options chains to find the time horizon and price that suits your needs.
If you think the stock is heading higher in a year or two, you can purchase a leap option otherwise you can purchase basic call options for a point in the future. Once the transaction is complete you now control 100 shares of stock (per options contract) at which time you can sell (if the stock goes up) or sit on and exercise the options at a point in the future.
What Is An Option Chain?
An option chain is simply a listing of all the put and call option strike prices along with their premiums for a given maturity period.
Options Trading Basics
Options are a great way in investing in stocks but with much more flexibility. Again, an options is a contract that gives the buyer the right, but NOT the obligation to purchase or sell stock at a future date at a specific price – known as the strike price. Options do involve risk and may not be suitable for every investor.
Options can be thought of as an insurance product. Investors use options to prevent against loss.
Different Types of Options
Call Options give you the right to buy stock. 1 Call option = 100 shares of stock. The Premium is a fee associated with the option contract for the right to buy the stock at that price.
As intrinsic value gets higher, you pay more for the call option. The longer the time left before the expiration, the more premium you have to pay.
Put options give you the right to sell stock. 1 PUT option = shares of stock.
Options Trading Strategies For Beginners
As a beginner in options trading, we wanted to give you a few rules to live by. As you get more experience in trading options, obviously, do whatever the heck you want 🙂
- Do Not buy options contracts in high quantities out of the money
- Resist the urge to buy low-priced options because they look cheap
- Don’t carry options contracts into earnings
- Don’t hold positions through the expiration week
- Don’t short naked options – too much risk!
- Do read and study
- Stay on the sidelines during important news events
Basics To Master For Options Trading
- The difference between in-the-money and out-of-the-money options
- Difference between intrinsic and time value
- Why options are priced the way they are
- What affects option pricing
How To Buy A Call Options
When you purchase a call option, you ultimately believe the stock is going up. In our how to buy call options example up above, we detailed the steps, however, we need to reiterate them below. So the steps to buy a covered option would be:
- Find the stock that you think is going up
- Review the option chain for the stock
- Select an expiration month that suits your time horizon
- Select your preferred stock price
- Research and determine if that strike price seems reasonable
Interesting Notes About Stock Options
- Not all stocks have options that trade on them – typically only the most popular stocks will have options
- You can not always buy a call with the strike price that you want
- Most options are thinly traded and have a high bid/ask spread
- If you are relatively certain your stock will go up a few points before the expiration date, it would be profitable to purchase a call option with a strike price just slightly higher than the current stock price
What Is A Long Call?
As we stated earlier, buying calls gives you the ability to control more shares of stock while not having to purchase the stock outright. Long calls benefit the buyer as the stock moves higher. In order to be profitable, the call strike price plus the premium would need to be higher than the stock price when you are ready to sell the option – or have gotten close enough so someone is willing to pay more for it if you’re ready to sell it.
Profit Potential of Long Call Options
When purchasing long calls, you are essentially paying a premium for “time value” – meaning you have time to watch the stock move. Significant upward moves in price will benefit the position where as downward moves will negatively affect your position – they will lose you money.
General Rules For Buying Stock Options
Whether you are purchasing calls or puts, if you don’t want to lose all of your money, we have a few simple stock option buying rules for you to follow.
- Choose an expiration that gives the stock enough time to perform
- A large part of the value of options is time value
- Try not own options in the last 35-45 days – unless you’re a professional!
- Purchase options when the time value is expected to stay flat or rise – options prices rise when volatility is higher
- Don’t let your options expire, you generally want to sell them for a higher premium and you typically do not want to exercise your right to purchase the stock (because that’s a lot of cash for the average trader)
How To Exit a Long Call
A long call can be closed in one of three ways:
Sell The Call Option
Once purchased, the call option contract can be sold at any time (so long as there is someone to buy it).
Let It Expire
If a call gets all the way to expiration it turns worthless if it is out of the money (strike price above stock price).
Exercising Your Call
Use your “right to buy” in which you purchase the common stock shares at the strike price.
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