Upbeat music plays throughout.
Narrator: Options trading is an alternative way for investors to invest in the performance of a security, such as a stock or ETF.
By trading options, an investor attempts to capture the up or down movement of a security while only investing a fraction of the cost it would take to own the security itself.
For example, consider a stock that's currently trading at $100 per share. If you purchased a share and the price went up $5, you'd have a 5% return. With the right options strategy, you could profit from the same stock price jump, though it's a little more complicated than just the stock movement. It's not just the direction of the price move you need to look at, but the timing and volatility as well.
The ability to make more with less is one of the benefits of options trading. However, the potential for greater profits comes with greater risk of losses.
To help you understand why, let's take a closer look at how an options contract works.
Unlike a stock, when you buy an options contract, you're not purchasing the security itself. Instead, you're purchasing a contract that gives you the right to buy or sell a security at a certain price before a certain date.
Let's look at an example. Suppose there's a coffee shop chain called StoneCurb Coffee. StoneCurb stock is currently trading at $50 per share.
An investor believes that the stock price of StoneCurb will rise. So she considers taking advantage of this anticipated price movement by buying 100 shares of stock, but she is concerned about the initial capital requirement.
Now let's assume that there's another investor. He already owns 100 shares of StoneCurb stock and plans to hold on to it for a while. He thinks that the stock price will not increase much over the next few months.
Both investors can use a "call" option.
This type of options contract gives the buyer the right to buy shares of StoneCurb stock at a set price, called a strike price, at a set time, called expiration. In this case, it's $55 per share in four weeks' time.
Typically, each standard options contract represents 100 shares. So this one contract would give the buyer the right to buy 100 shares of StoneCurb stock at $55 per share.
On-screen text: Disclosure: This example does not take into consideration commissions or transaction costs. Commissions and fees will impact returns and must be considered in any trade.
Narrator: The buyer purchases the contract by paying the options premium. For this example, let's assume the total premium is $100. The premium, or options price, is determined by several factors, including the stock price, time until expiration, and implied volatility, which is how much the stock is expected to move during the life of the contract. This premium gets credited to the seller of the call option and helps partially offset the original purchase price of the stock. Our buyer pays the $100 and purchases the contract.
Now, let's examine what could happen to this investment.
Suppose our buyer's instincts were right, and StoneCurb stock is selling at $60 per share at or near expiration.
Remember, the call option gives the buyer the right to purchase shares of this stock for $55 per share. The buyer could exercise the call to purchase 100 shares for $5,500, and then turn around and sell them at market value for $6,000. This doesn't, however, account for the options premium the buyer paid to open the call, so the total profit here would be $400, or the $500 profit minus the $100 it cost to buy the long call.
An alternative is to simply sell the options contract instead, which should result in the same profit. Because shares of StoneCurb have risen $5, the contract is essentially worth $500, so if our buyer sold her contract, she could potentially make around $400 in profit—the value of her contract minus the $100 premium she originally paid for it as well as any commissions and fees.
While the buyer's investment paid off, things don't work out as well for the seller. Although he was able to collect $100 for selling the option, he missed out on a portion of the stock's appreciation because he was obligated to sell his stock at $55 per share.
Now, let's rewind.
Suppose the stock moved in the opposite direction and is now selling for $45 per share on the last trading day prior to expiration.
The buyer's contract gives her the right to purchase shares of StoneCurb for $55 per share. Because no one would want to pay $55 for a stock that's selling at $45 in the open market, the buyer's contract will likely expire worthless. The buyer is now on track to lose 100% of her initial $100 investment plus any trading commissions and fees.
For the seller, the option expiring worthless is good news. He still owns his shares of stock and made $100 selling the option. Although the value of his shares declined, he was able to keep the options premium minus any commissions and fees for selling the option.
Keep in mind that this is a simplified example. The pricing of options is very complex, which is why it's important to educate yourself about options and their risks before you invest.
While the biggest change comes from the price of the underlying instrument that the contract represents, there are other forces like time decay and implied volatility that influence options prices.
While we showed you one example, options can be used in a variety of ways. There are call options, which we just saw, that can be profitable to own if the price of a stock goes up. And then there are put options, which can be profitable to own if the price of a stock goes down.
Calls and puts can also be combined in a variety of ways. By buying and selling these options, investors have the potential to make money when the market moves in any direction and create strategies with a variety of risk levels.
You've taken the first step in understanding options. Check out more of our investing education to learn more.
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