If you have spent time in the stock market or talked to people who do, you must have heard about stock options trading. Like most people, you may have also found the whole idea very confusing, making it difficult for you to know what it’s all about.
In this article, we will seek to bring some clarity by looking at what stock options are, how they differ from trading stocks, and why traders typically use them.
What is options trading?
Stock options are contracts that confer on the options buyer the right (but not the obligation) to buy or sell a stock (the underlying security) at a specific price (strike price) on or before an expiration date.
Right vs. obligation
The first key thing to notice is that stock options confer rights, not obligations. In essence, option buyers can choose to exercise the right or not, depending on whether the trade moves in their favor or not.
However, once an option buyer has chosen to exercise the right to buy or sell, the option seller (counterparty) has an obligation to trade. For example, if the option buyer exercises the right to buy (sell), the seller must sell (buy).
The options contract
A single options contract represents 100 shares of the underlying stock.
For every option contract, the options buyer will pay a premium to the options seller. This premium is usually quoted per share. For example, if you buy one option contract of AAPL, the premium can be $2.5 per share, a total of $250 for the contract.
Calls and puts
There are two types of options: calls and puts. Calls confer on the buyer the right to buy while puts confer on the buyer the right to sell. Traders use calls when they believe the price of the underlying stock will rise and puts when they expect the price to drop.
If AAPL is trading for $200 and you believe the price will increase to $250 within the next two months, you can purchase a call option with a strike price of $200. Suppose you are right and the market price rises to $250, you can then exercise the option by purchasing AAPL for $200 per share and go on to sell in the spot market for $250 per share.
Suppose the trade goes against you and the price falls to $150. You can choose not to exercise the right in which case you only lose the upfront premium you paid.
Stock options trading vs stocks trading: The key differences
There are 5 main differences between stock options trading and stocks trading:
Capital requirement: To enter a stock options contract, you only need to pay the premium but to purchase a stock, you need to part with the full amount (the number of shares multiplied by the price per share).
Ownership: When you purchase a stock, you have ownership rights in the company. However, purchasing an options contract only gives you the right to buy or sell the underlying stock, a right you may choose not to exercise.
Time: Option contracts have expiry dates while you can hold on to your shares in a company for as long as you desire. Also, the closer an options contract is to its expiration date, the lower its time value. Stocks don’t have time value or expiration dates.
Commissions: Trading platforms tend to charge higher commissions for options.
Trading strategies: With stocks, you can only go long or short but with options you can pursue various trading strategies to achieve certain goals.
Why stock options?
There are two main reasons why traders choose options.
First, they can amplify your profits. Paying only the premium to enter into a position is a form of leverage. In the example above, you only need to pay $250 to enter a contract worth $20,000. If things go well, your rate of return will be far higher than if you had put down $20,000 in cash.
Second, they can help you hedge against market risk. If you go long on a stock, you can hedge against the risk of a significant price drop by purchasing a put option.
Suppose you went long at $200 per share and also bought the put option with a strike price of $200. If the price goes down to $150, you can exercise your put option by selling to the options seller for $200 instead of selling in the spot market and taking a $50 loss.
Third, if you want to earn income from the stock market, you can be an options seller. The premium you receive is non-refundable and when the market goes against options buyers, they will not exercise the right.
Options are complex and volatile. Moreover, some of the options trading strategies can be very risky for beginners to handle.
However, if you have the skills and experience to use them, they can minimize your risk and maximize your returns.
If you are in the UAE and want to trade US stocks or US stock options, sign up for Sarwa Trade to get access to some of the most popular stocks and stock options available in the market.
Sarwa Trade is a low-cost, secure, and easy-to-use platform that will make your trading journey seamless and enjoyable.
