As you learn about trading options, you'll find that options traders use terms unique to the options markets. Understanding what terms such as "strike price," "exercise price," and "expiration date" mean is crucial for trading options effectively. You'll see these terms often, and understanding them has a significant effect on your chances for profitability on an options trade.
- Options traders use terms unique to options markets, and understanding the terms is crucial for effectively trading options.
- Options are contracts between traders to buy or sell a security or asset traded on an exchange; they are known as derivatives because they derive from the underlying asset.
- Important options terms include "call," "put," "strike price," "exercise price," "expiration date," and "naked options."
Before getting into options terminology, it's helpful to get some background on options themselves. Just like stocks and bonds, options are securities that trade on an exchange. They fall into a category called "derivatives" because they're derived from, or linked to, another security, and their prices are dependent on the price changes of that security. You'll also hear the security or asset the option is derived from called "the underlying asset" or "the underlying."
Call and Put Options
You can buy or sell two different types of options: a put or a call. If you buy a put option, you've purchased the right, but not the obligation, to sell the underlying asset at an agreed-upon price. Call options work in reverse: They give you the right to purchase the underlying asset at a predetermined price, but not the obligation.
Options are often used to hedge or limit your risk on investments. For example, suppose you want to purchase a certain stock, but only if you think the price will jump up. You would buy a call option to lock in the stock price to make sure you can buy it for your portfolio before the price jumps.
You would buy a put option if you owned the stock but wanted to make sure you could sell it if the price drops below a certain level, so you don't lose money. Options are often referred to as insurance policies because they give you a certain level of protection against price fluctuations when used strategically in your investing portfolio.
In addition to buying call and put options, traders sell them to enact other investing strategies.
Option Strike Price
The option seller sets the strike price for each option they sell; the seller is also called the "option writer." When you buy a call option, the strike price is the price at which you can buy the underlying stock if you want to use the option. For example, if you buy a call option with a strike price of $10, you have a right, but no obligation, to buy that stock at $10—even if its price increases to more than $10.
You could also sell the call option for a profit. Your profit then is approximately the difference between the underlying stock price and the strike price.
When you buy a put option, the strike price is the price at which you can sell the underlying asset. For example, if you buy a put option that has a strike price of $10, you have the right to sell that stock at $10, even if its price is below $10.
You may also sell the put option for a profit. The profit is approximately the difference between the strike price and the underlying stock price. Just like the call option, you may also exercise your option and sell or short the stock at $10, even if it is trading at $5 on the stock exchange.
The Exercise Price
An option buyer pays a price called a "premium," which is the cost of the option, for their right to buy or sell the underlying asset at the option's strike price. If a buyer chooses to use that right, then they are "exercising" the option. In other words, the option's strike price is synonymous with its exercise price.
Exercising an option is beneficial if the underlying asset price is above the strike price of a call option or the underlying asset price is below the strike price of a put option.
Traders don't have to exercise an option because it is not an obligation. You only exercise an option if you want to buy or sell the actual underlying asset. It's important to note that most options are not exercised, even the profitable ones.
For example, say you bought a call option for a premium of $1 on a stock with a strike price of $10. Near the expiration date of the option, the underlying stock is trading at $16. Instead of exercising the option and taking control of the stock at $10, the options trader will typically sell the option, closing out the trade. In doing so, they net approximately $5 per controlled share.
Since one option controls 100 shares of stock, this trade nets $500. The math is as follows: A $16 share price less the strike price of $10 means the option is worth approximately $6. The trader paid $1 for the option, so the profit is $5. The option is worth approximately $6 because other factors affect the value of an option aside from the underlying stock price. These other factors are called "Greeks," for the Greek letters that represent them.
The strike price (or exercise price) is the price at which you take control of the underlying stock should you choose to exercise the option. Regardless of what price the underlying security is trading at, the strike price (or exercise price):
- Is known when you buy the option contract
- Doesn't change for that specific option
- Is fixed
The Option's Expiration Date
Options contracts specify the expiration date as part of the contract specifications. For European-style options, the expiration date is the only date that an in-the-money (in profit) options contract can be exercised. That is because European-style options and positions can't be exercised or closed before the expiration date.
U.S.-style options can be exercised, or bought or sold, on any day up to the expiration date.
For U.S.-style options, the expiration date is the last date that an in-the-money options contract can be exercised. Options contracts that are out of the money (not in profit) on the expiration date are not exercised and expire worthless.
For example, if you buy a call option with a strike price of $10, and the underlying stock currently trades at $9 on the stock exchange, there is no reason to exercise that option; it is worthless on the expiration date. Any premium paid for that option is forfeited.
Options traders who have bought options contracts want their options to be in the money. Traders who have sold (or written) options contracts want the buyer's options to be out of the money and expire worthless on the expiration date. When a buyer's option expires worthless, that means the seller gets to keep the premium as a profit for writing or selling the option.
Which Options Make the Best Buys?
There isn't any specific methodology that can point to the best options to buy or sell for each investor. Everyone has their own objectives for maximizing profit, hedging risk, and choosing which securities make sense for investing purposes.
However, if you're searching for ideas on where to start looking, consider trading options on the most popular stocks. They will have a lot of volume (trading activity) and a lot of options-trading activity. For example, Bank of America Corp (BAC), Meta (FB), formerly Facebook, and Micron Technology (MU) are three active stocks with more than 100,000 options being traded on them every day.
You can also choose stocks with expensive options, such as Amazon (AMZN) and Google (GOOGL), especially if you decide to sell them. This can net you a nice income if the buyer doesn't execute the options, or at least get you the stock at a decent price if the buyer does execute the options, depending on your strategy.
You could also buy options that are popular, with a lot of liquidity or trading activity, but only for stocks priced under $20. This works well if you choose to sell naked options, because it won't require you to have a large amount of margin available to buy the stock if the options are exercised.
To sell an option naked means writing or selling the option without having a position in the underlying security. You would buy the option at a more favorable price, close out the trade, and make money on the price differential to take profit. This riskier strategy has, theoretically, unlimited downside and is best used by seasoned traders.
Frequently Asked Questions (FAQs)
Can you sell a call option before the stock hits the strike price?
Assuming there aren't any restrictions on your account and you have sufficient funding, you can buy and sell options as you please. You don't need to wait for a call option to hit the strike price to sell the option.
How do you exercise an option?
You can exercise an option at any time from the moment of purchase through the day of expiration. Your broker should offer this choice alongside similar orders like "buy" and "sell." Ensure you have the buying power to cover the exercise. For example, if you have a call option with a strike price of $40, you'll need $4,000 to exercise the option.
What are delta, gamma, and theta in options?
Delta, gamma, and theta are all examples of option Greeks. These terms refer to an option's price sensitivity. Delta is the amount that the option's price moves for every $1 that the underlying stock moves. Gamma measures how much the delta changes every time the underlying stock moves by $1. Theta is often called "time decay" because it measures how much the option price would move in a day if all else remained consistent.
How are options taxed?
Options are taxed like stocks. If you hold an options contract for one year or less, your gains are taxed at your normal income tax rate. If you hold an options contract for more than a year, you qualify for more favorable long-term capital gains tax rates, which can be as low as 0%.