Welcome side hustlers to the fun and risky land of trading options. Trading Options in the market is often how fortunes are made and lost over night. If you’ve ever dabbled in investing traditional stocks before, you will definitely have a leg-up on pure beginners.
Traditional investing involves purchasing stock of a publicly traded company at its current market trading price. In this example we will assume Snapchat (SNAP) is trading at $5 a share and for simplicity we will assume no fees or commissions. If you were to purchase 100 shares of SNAP at $5 a share, this would initially cost you $500. Later, if the price were to increase to $10 a share, you will have essentially doubled your money. The same 100 shares would now be worth $1000. Conversely, if the price were to decrease to $2.50 a share, you would lose half and your 100 shares would be worth $250. Granted stock prices don’t regularly swing that much or that fast. Traditional investing is meant to be longer term.
Options Trading – Calls
Options trading is not for the faint of heart. You must posses the stones to stomach quick ups and downs in prices. Purchasing a option is like a bet on a bet. You’re trying not only to guess the direction of the stock, but you’re also fighting time as well. In our Snapchat example let us assume the current market price is $14.27 a share. And you want to make a bet that the price will go above $15 a share before September 15, 2017. If you were to purchase 1 contract which is comprised of 100 shares, it would cost you $25 (100 * 0.25). Notice that there are two prices below for the call contract SNAP $15 expiring on 9-15-17, a bid and an asking price. The bid price is what people are willing to pay for the contract and the ask is simply the price people are asking for when selling the contract. To purchase the contract, the term is called “buy to open.” When you sell the contract, you “sell to close.”
After purchasing the contract, assume the market price of SNAP rises above $15/share. You are considered “in the money.” When an option is in the money, the value of your option should have increased. As I mentioned before, you are not only trying to guess the direction, but you are fighting time as well. This principle is called time decay. The closer the time gets to your expiration date, the faster the value of your option is going to decrease. When your contract is “out of the money,” your contract will be worthless at expiration (You lose your whole investment).
Why is this even legal then? It seems like gambling. Well it is, but it’s really tied to investing. When you purchase a call option, you’re buying the right to purchase shares at the strike price you chose ($15 /share in our example). If the contract was in-the-money and the stock was trading at $20 a share before your expiration date, you can “exercise” the contract and purchase the 100 shares at $15/share ($1500) even though the current price is now $20 a share ($2000). The premium or “intrinsic” value would be the difference of $500.
Options Trading – Puts
Man oh man aren’t you the cynic trying to buy a put option. You must be expecting the stock price to go down then. Back to our Snapchat example, let’s look at the right side of the image. Suppose you were to purchase 1 contract of the put option with a strike price of $14 and you’re expecting the price to go below $14 a share before the expiration date of 9-15-17. This would have cost you $42 (100 * .42) assuming no fees or commissions once again. You’re considered in-the-money when the market price of SNAP is trading below $14 a share. Thus when you exercise the option, you are forcing someone to buy 100 shares (1 contract) of SNAP from you at $14 a share even though the price is now lower than that. That’s cold, but it’s how the game is played.
Most people never even exercise the contract and simply trade the option itself before it expires. Buying the call or put option without the money to exercise it is considered a naked position.
Stay tuned. This is going to be a long series of articles on trading options. I can only hope with the information above that you got somewhat of the basics of trading options. As the next articles are posted, they will be linked below here. Until next time, keep side hustling.