Now is more of an exciting time than ever to think about investing in the stock market if you haven’t thought about it before. The impact of COVID-19 has drastically impacted the stock market, opening up new doors of opportunity that did not exist previously. A thriving economy helped increase stock prices while the aftermath of COVID-19 drew many companies to their 52 week low.
With many valuable companies trading at extremely low prices, now is the time to do your research, understand more about the stock market, and make yourself another stream of income. Developing your own stock option trading strategy can extremely profitable and can minimize your losses.
In such a volatile market, I chose to focus specifically on options and continue to share what I learn on BeginnerStockoptions.com. It is my goal to share as I learn myself as the best way to really “get” something is to share, teach, and discuss it with others. Stock options explained right here for you, the reader.
If you are interested in learning more, click here to get your copy of Trading Options for Dummies.
What is a Stock Option?
A stock option is the right granted to an investor, not an obligation, to buy or sell a stock at a specifically agreed upon price and date. Stock options are traded on exchanges similar to the stocks themselves. The price of an option can be lower or higher than the current market price of the stock and options. Call and put options are placed on whether a trader believes a company’s stock market price will go up or down.
Stock option investors have 3 options prior to their stock option expiration date:
- Exercise the option: buying or selling the number of shares associated with the option.
- Selling the option
- Letting the option expire
Components of a Stock Option
The strike price is the price an investor expects a stock to increase above or below by a specific date. Strike prices determine whether an option should be exercised. For example, a stock trader might believe a company such as JNJ or Johnson & Johnson will go up in the future and place a call option for a specific month and a particular strike price.
Each option has a specific date that it expires, simply called the expiration date. Most conform to a calendar and typically expire the third Friday of each month in which the stock was written. Some companies only have options available with monthly expiration dates while others have weekly expiration dates. It is important to help traders price the value of the put and the call.
The number of options a trader is looking to buy are called contracts. Each single contract that is bought holds 100 shares of the underlying company stock. If you bought 3 contracts of JNJ, that would be 300 shares of underlying stock.
Premiums are the amounts of money paid from the buyer to the seller for the option contract. For example, let’s say you buy 5 May JNJ call option contracts at a strike price of $170 at a cost of $0.91. Each 1 option contract contains 100 shares and the price for the premium is represented for 1 share. You would owe the seller of the JNJ calls a $455 premium (5 X 0.91 X 100).
Premium = (cost of option) X # of Contracts X 100
Call Options – Bet that a Stock Price will Increase
Call options allow the buyer to buy shares of stock at a set price within a set time period. People consider buying calling options when they anticipate that a particular market stock price will increase in the future. Say a company is about to release a new product, release positive earning and growth reports, or any other positive news that may increase the value and sales of a company, buying a call could potentially make you some money.
Now let’s say that we have a stock trader, Anne. She thinks that Walt Disney stock is going to increase in the future to over $120 per share, up from the current market price of $100. Anne decides to buy 10 May 29th $120 Calls which trade at a price of $0.17 per contract. This would result in Anne spending $170 to purchase the calls.
For Anne to earn a profit, the stock would need to rise above the strike price and the cost of calls, or $120.17. If the stock does not rise above $120, the option is worthless and expires; Anne would lose her entire $170 premium.
Put Options – Bet that a Stock Price will Drop
Put options allow the buyer to sell shares of a stock at a set price within a set time period.
Our trader Anne thinks the company stock for the Walt Disney (NYSE: DIS) is going to drop. Say DIS is currently trading at a market price for $100 per share. Anne decides to buy 10 May 29th $85 Puts for DIS for $0.65 per contract. It would cost Anne a total of $650. For Anne to earn a profit, the stock would need to drop below $84.35. If the stock closes above $85, the options would expire worthless, Anne would lose her $650 premium.
You are On Your Way
The stock market and stock options can seem intimidating at first, however I believe anyone can learn how to do it. Be sure to allow yourself the time and patience to learn it. It is important to learn the basics and develop a trading strategy based on facts and understanding.
Now that you know what is a stock option is, the difference between a put and a call option, and the basic components of a stock option, you have begun the path towards creating a better financial future for yourself. Now is the time to learn how to join the lucrative game of stock option trading.
Practice: Look up a stock, find its options, choose an expiration date, choose a strike price for a call and a strike price for a put, and try to determine what the total cost would be to buy a contract.