How to Trade Options

By Markets Fool.com

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To learn how to trade options successfully, you first need to understand what options are and how they work. A stock option is a contract that allows its purchaser to either buy or sell an underlying stock at a specific price on or before a specific date. An option to buy a stock is called a "call option," and an option to sell a stock is called a "put option," and the specific price is known as the "exercise price" for that option.

The graph below shows the potential payoff and profit curve at expiration for a person buying a call option. Note that the buyer only turns a profit if the stock closes above the strike price at expiration and the stock closes far enough above the strike price to cover the premium paid to the seller of the options contract and any commissions involved in the transaction.

Source: Wikipedia user Gxti.

On the flip side, the graph below shows the potential payoff and profit curve at expiration for a person buying a put option. In this case, the buyer only turns a profit if the stock closes below the strike price at expiration and the stock closes far enough below the strike price to cover the premium paid to the seller, as well as any commissions.

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Source: Wikipedia user Gxti.

Most options are standardized contracts based on 100 shares of the underlying stock. Options are only available on a stock if the company behind that stock has a large enough market capitalization and if market makers think there will be enough trading volume from market participants.

Options lingo
There are seven key transaction-related terms you'll need to know as an options trader. The table below explains the basics of each for both call and put options:

Action

Put Option Implication

Call Option Implication

Buy to Open

You purchase the right to sell the underlying stock at the exercise price on or before the expiration date.

You purchase the right to buy the underlying stock at the exercise price on or before the expiration date.

Sell to Close

You surrender the right to sell the underlying stock at the exercise price on or before the expiration date.

You surrender the right to buy the underlying stock at the exercise price on or before the expiration date.

Sell to Open

You take on the obligation to buy the underlying stock at the exercise price on or before the expiration date.

You take on the obligation to sell the underlying stock at the exercise price on or before the expiration date.

Buy to Close

You relieve yourself of the obligation to buy the underlying stock at the exercise price on or before the expiration date.

You relieve yourself of the obligation to sell the underlying stock at the exercise price on or before the expiration date.

Exercise

You exercise the right you purchased to sell the underlying stock at the exercise price on or before the expiration date.

You exercise the right you purchased to buy the underlying stock at the exercise price on or before the expiration date.

Assigned

The person on the other side of your position exercises their right to sell you the underlying stock at the exercise price on or before the expiration date.

The person on the other side of your position exercises their right to buy the underlying stock from you at the exercise price on or before the expiration date.

Expired

The option contract is no longer in force, and you no longer have the contractual right to sell (if you had bought the put) or the obligation to buy (if you had sold the put) the underlying stock at the strike price.

The option contract is no longer in force, and you no longer have the contractual right to buy (if you had bought the call) or the obligation to sell (if you had sold the call) the underlying stock at the strike price.

Table by author.

Options prices: What do you get or give up for your money?
A handful of key factors drive options prices. Two of the biggest are the price of the underlying stock relative to the exercise price of the option and the amount of time left until the option expires. The portion of the option price that's driven by the difference between the underlying stock price and the exercise price is known as the "intrinsic value" of the option. The portion that's driven by all other factors -- including time to expiration -- is known as its "time value."

For example, imagine a company whose shares trade at $51 per share. A call option on that stock with a $50 strike price that expires three months from now might trade at $2.50 per share. Of that $2.50, $1 represents the intrinsic value in the option, and the other $1.50 represents the time value. On that same stock, the $50 put option expiring at the same time might only trade at $1.50, as it has no intrinsic value with the underlying at that price but still has time value.

An option's intrinsic value changes as the underlying stock price changes. An option's time value generally shrinks as options get closer to expiration. The time value also changes based on the difference between the underlying stock price and the exercise price (the closer the two are, the higher the time value). The other major factors that drive an option's time value are the volatility in the underlying stock price movement, the dividend the underlying company pays,and prevailing interest rates.

There's a complicated mathematical equation known as the "Black-Scholes" formulathat attempts to model what an option should be priced at based on those key factors. The Black-Scholes formula does its job well, but you don't need to master the mathematics of it; online calculators are plentiful.

Options leverage: The knife that cuts both ways
Two key reasons people trade options are for speculation and for hedging (i.e., protecting the rest of their portfolio from unfavorable moves). Both of those tactics rely on the leverage options provide. For example, using the same call option on the stock described above, a $250 investment in the call options would give you exposure to $5,100 worth of the underlying stock.

If the stock closed at $55 per share at expiration, your $250 investment would be worth $500, doubling your money (before commissions) in the space of three months. Meanwhile, if you bought 100 shares of the underlying stock for a total of $5,100, then the move from $51 to $55 would net you a gain of $400 -- about 7.8%.

On the flip side, however, if the stock dropped to $50 at expiration, your call option would expire worthless, and you would lose 100% of your option investment. If you owned 100 shares instead of the call, that move would represent a $100 loss -- or about 2% of your $5,100 investment.

That leverage magnifies the impact of any moves in the underlying stock price. Combine that leverage with the fact that options expire, and it means that if you're going to speculate with options, you need to be right not only about what will happen, but when it will happen as well. Be extremely careful with the leverage involved, as you can easily lose more than 100% of what you invest in an options transaction.

Options trade like stocks -- but you need additional permissions
Thanks in large part to the additional risks involved in options, you'll need to fill out a more complex application with your broker to trade options than you would to simply purchase stocks. Because of that risk of losing more than 100% on an investment, options brokers have multiple levels of trade permissions. The riskiest of the strategies are generally available only to experienced options traders with both margin accounts and the highest options-trading permissions.

Once you have an appropriate level of permissions from your broker, the mechanics of trading an option are very similar to the mechanics of buying or selling a stock. Just be sure to remember that a stock option derives its value from the underlying stock and that the leverage and the expiration date add additional risk. With that in mind, you'll be better prepared to balance the risks with the potential rewards and develop an options strategy that might work for you.

The article How to Trade Options originally appeared on Fool.com.

Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.