Stock options work by giving you the right to own shares of a stock at a fixed price by a specific date.
Options come in contracts of 100, which means each contract gives you an option to buy over 100 shares of a stock.
One of the benefits of options is that they can be purchased for a fraction of the price of the underlying stock. This allows you to profit from a stock without ever having to buy it - or sell shares short - and thus without risking a larger portion of your trading funds.
While options trading can be lucrative and even reduce your risk, learning how to trade options can be a hurdle for many traders.
Fortunately, it doesn't have to be. We'll show you what you need to know to get started and realize just how easy it can be to trade options.
And we'll start with the key terms you'll need to know...
Understanding Stock Options Trading
To understand stock options trading, it's necessary to know some of the main terms.
The first terms to know are "calls" and "puts."
Call options give you the potential of realizing a profit if the underlying stock increases in price between your purchase of the option and the expiration date.
Put options give you the potential of realizing a profit if the underlying stock drops in price between your purchase of the option and the expiration date.
The next terms to know are what makes up the options contracts, starting with the strike price. This is the price you can buy or sell shares of the stock for.
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"In the money" means the stock is trading above the strike price, in the case of a call option, or below the strike price, in the case of a put option.
"Out of the money," on the other hand, means an option is trading below the strike price in the case of a call or above the strike price in the case of a put. In other words, it's not worth exercising the contract.
And a share price at about the same level as the strike price is "at the money."
Now that you know some basic terms, here's how to trade stock options.
Here's one options trading strategy to use.
How to Trade Options
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Money Morning's options trading specialist, Tom Gentile, advises that beginning options traders should start by looking at how equities do around reporting season.
Stock prices often fluctuate around reporting season. Good or better-than-expected profits can cause them to rise; poor or worse-than-expected performance can cause them to fall. Stocks can fluctuate in anticipation of earnings reports and then lose gains or losses after the news dies down.
Take the case of Yelp Inc. (NYSE: YELP). Tom Gentile realized that Yelp stock frequently fluctuated before its earnings reports - and that the next one was going to come on May 10.
Tom estimated a 5% to 10% rise in the shares around earnings reporting season - which means options could return a 50% to 100% climb. He also thought that the option should be sold on May 9, to exit with any profits gained before the share price fell post-earnings.
So Tom recommended buying a call option for about $3 per share on April 18, about three weeks before earnings were reported. He planned an exit for May 9. At that point, the price had gone up to $4.92 - a 64% trading profit.
Remember, if you exercise an option to purchase a stock on Oct. 15 for $75 per share and it's selling for $100 per share on that date, you gain $25 in profit for each share in the option contract. That's why options trading is so potentially lucrative.
But as we said up top, along with the potential for large gains comes a potential for losses as well. Because options traders can lose if the market goes in the opposite direction of their options, it's always prudent to set a stop-loss order. A stop-loss can be set to sell if a trade loses a specific percentage or a certain dollar amount. That way, any prospective risk is effectively managed.
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