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If you're a longtime investor, chances are you've at least heard of options trading.
But it's also possible you don't entirely know what options are, why you would trade them, or how you'd even begin.
That's exactly why we're going to show you what options trading is today.
What Are Options?
Options are contracts where traders have the right to buy or sell a stock at an agreed-upon price by an agreed-upon date.
While options give you the right to buy or sell a stock at a specific price, options contracts also change in value. That means you can sell them for a profit without ever buying the underlying stock.
You'll learn exactly how to do that in just a bit, but first we need to explain the three basic features of every options contract.
First, options are sold in contracts of 100. If an option for a stock costs $0.10, then a contract will run $1. You can buy as many contracts as you like, but you can't buy fewer than 100 options at a time.
The advantage is that you can control 100 shares of stock per contract for a fraction of the cost that it would take to buy 100 shares of the underlying stock. This leverage allows you to make a lot more money with less up-front cost. And since you don't own the stock, your risk is limited too.
Second, every option has a "strike price." This is the price the stock must trade above for call options or below for put options (more on these below) to be useful. When a call option trades above the strike price, then the option is "in the money" and can be exercised for a profit. In other words, an option in the money allows you to buy shares of a stock for less than they are currently trading.
Third, every option has an expiration date. This is the last day you can exercise the option to buy or sell a stock. If the option isn't in the money by then, then the option expires worthless.
You can buy options with expiration dates as early as next week or more than a year away. Since your option has more time to get in the money with a longer expiration date, these options are typically priced higher.
Out-of-the-money options with nearing expiration dates are priced lower since there's less time for the option to get in the money.
Now that you know the basics, here's more detail on the two types of options to trade…
What Are Call Options and Put Options?
When buying an options contract, you're either buying a call option or a put option.
If you think the share price of a stock is going to go up, then you want to buy a call option. A call options give you the right to call in stock at any point before the expiration date at the strike price. The higher the share price goes, the more your option is worth.
If a stock's worth $200 and your strike price is $150, then you can buy the stock for just $150, meaning you could make a profit of $50 per share.
For put options, it's the exact opposite. Put options give you the right to sell the stock at a specific price. If you expect a stock's price to drop, then you want to buy a put option.
This gives you the right to potentially sell a stock for a higher price than it's currently worth, so the more the price drops, the more profit potential your puts have.
As the price of the underlying stock moves, the price of the options moves as well.
That means you can cash in on options without ever buying the underlying stock.
Here's how to make money trading options…
What Is Options Trading?
There are two different ways you can earn money from options contracts. You could exercise your option – or right – to buy more shares of an underlying stock at your desired price if it's "in the money." Or you can buy an options contract and then sell it at a higher price as the price of the stock moves.
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Take a look at this example.
On May 20, 2019, Marvell Technology Group Ltd. (NASDAQ: MRVL) was trading for $22.06 a share. Money Morning's options trading specialist, Tom Gentile, got a bullish signal on the stock and decided to amplify his returns with options.
He found a call option with a strike price of $22.50 expiring on May 24 trading for $16 a contract. Two days later, Marvell stock jumped from $22.06 to $22.60, a mere 2.4% gain for shareholders.
But the option contract doubled in price to $34 a contract. That means options traders made a 112% gain while owners of the stock made just 2.4%.
In fact, if you had bought just $500 worth of Marvell options then, you'd have turned $500 into $1,062.50.
Of course, it's not without risk. But with options trading, you could see double- or triple-digit windfalls like in the scenario above.
That's just one example of an incredibly profitable options trade. But it emphasizes just how lucrative options trading is and can be.
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About the Author
Daniel Smoot is a Baltimore-based editor who helps everyday investors with stock recommendations and analysis. He regularly writes about initial public offerings, technology, and more. He earned a Bachelor's degree from Towson University.