Investing Fundamentals

What the F**k are Stock Options?

stock-options

What the f**k are stock options? Options are one of those personal finance concepts that can be intimidating if you aren’t familiar with it but when distilled down, is pretty straightforward. Our guest today, Kal Zurn, from Sharper Trades will break down what stock options are, how they work, what they are used for and why you should care.

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What Are Your Options?

Put simply; stock options are a contract between two people. Think of them like making a bet on a football game, two people bet $20, one wins, and one loses. When dealing with options, one bettor is the buyer, and the other is the seller. What you’re betting on is the likelihood of a future event.

A stock option gives the holder the right to buy or sell 100 shares of an underlying stock at a certain price, called the strike price, on or before the expiration date of the option. One option is equal to 100 shares. The holder is not obligated though to buy or sell the option. If the option isn’t executed before it expires, it’s worthless.

Stock options are leveraged, that’s why they are cheaper than buying actual shares of stock. One share of stock X costs $100, but you can buy an option for $10. You don’t own the shares; you control them. The options have an expiration date, that’s why they’re cheaper than owning actual shares.

Check out this video for a quick crash course on today’s topic.

Learn the Lingo

Strike Price: The strike price is the price at which the option holder can buy or sell the underlying security when exercising the option.

Call Option: A call option contract gives the holder the right to buy 100 shares of stock at a specific price within a particular time period.

Put Option: A put option contract gives the holder the right to sell 100 shares of stock at a specific price within a specific time period.

Expiration: This is the final date an option can be traded. Most contracts are short-term, less than one year. Longer contracts are called LEAPS.

How Does This Make Money?

Options allow traders to hedge their stock positions. They allow investors to take a leveraged positions on a stock and hedge the risk of the full price of buying shares.

An option buyer thinks the underlying stock will go up and the seller thinks it won’t. This is the two sides of the bet. The call option holder makes money when the strike price is less than the current market value of the underlying stock. The put option holder makes money when the strike price is higher than the current market value of that stock.

If you bet right, you make money.

Lock it In

A good example of options in the real world is an airline buying oil options. Fuel costs are an airline’s most significant expense when oil prices rise, their profits go down. To hedge against high oil prices, airlines buy options, which gives them the right to buy oil in the future for a price that is agreed on today.

If the price of oil goes higher than the agreed-upon price, the airline makes money; they won the bet. If it goes lower, they lose money; they lost the bet. But even if an airline is on the losing end of the bet, they were still able to budget their fuel costs because they had locked in the price. The airline may not make a profit, but they can control their losses.

You’re Not an Airline

Are stock options something you should jump into or are they just for big corporations? After all, options are betting on the future, and none of us can predict the future. When you buy shares of stock, you’re betting that the price will go higher one day. That’s the only thing you have to predict.

Prediction is very difficult, especially if it's about the future.

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When trading options, you have to predict three things and get them all right if you want to make money. What direction is the price going to go, up or down? How high or low will the price go? How long is the timeframe for things to happen? Remember, these contracts expire so you can’t just sit on them indefinitely like you can a share of stock. That’s a lot of moving pieces.

Cover the Spread

Options spreads are options trading strategies. A spread position is buying and selling an equal number of options in the same class of the same underlying stock but each with a different strike price or expiration date.

There are three classes of spreads; horizontal, vertical and diagonal. Horizontal or time spreads are created with options of the same underlying stock, same strike prices but different expiration dates. Vertical spreads or money spreads involve options of the same underlying stock, same expiration date but different strike prices.

Diagonal spreads are made up of options of the same underlying stock but have different strike prices and different expiration dates.

Spread strategies are used by investors to minimize risk.

The Options Store

You can buy and sell options through a brokerage firm, and you’ll be screened to assess your knowledge. Anyone can open an account to buy and sell stock, but there are more complicated requirements to trade options.

Traders are screened through a series of questions designed to assess their level of experience, to make sure they’re aware of the risks involved and if they are financially prepared to cover potential losses.

Based on your answers and the information you’re required to provide, you’ll be assigned an initial trading level that determines the type of trades you can place. You can trade options on the brokerage’s platform.

The standard options trading account is a cash account. The trader must have the full cash price for the trade in their account at the time of the trade. If the trader plans only to buy options to sell or exercise at a later date, the cash account is all that will be required. A cash account is the type most traders start out with.

A margin account requires only a percentage of the dollar amount of trades. A brokerage may only require 10% as a margin requirement.

There are two types of commissions, the base rate, and the per-contract fee. The base rate can range from $3-9.99 per trade and the contract fee from $0.15 to $1.25. Some brokerages combine the two into a single flat fee.

Crash Course

If this is all still confusing, you’re in luck! Kal can teach you all that he knows at Sharper Trades. The site has a free four-part course that will show you how you can use options trading to create a monthly income stream.

The videos are great, especially for those of you who learn better visually. Are options for everyone? No, there are a lot of moving parts, and if you like the kind of set it and forget it investing you get with a company like Betterment, options might be more work than you’re willing to do.

But many investors like them for the leverage. If you want to test the waters, be sure to check out Kal’s site first.

Show Notes

Harviestoun Ola Dubh Special Reserve 21: An old ale style beer.

Tool Box: All the best stuff to manage your money.

 

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