Options 101: The Basics of Trading Stock Options

What Does it Mean to Trade Stock Options?

Options are complex investments and can carry substantial risk. Before you decide to trade options, you should understand the basics. Options can be used with a wide range of financial products. This blog will focus on the most vanilla of examples, trading stock options.

What are Options?

Options are “derivatives” meaning they derive their value from an underlying asset. In basic terms, a stock option is a binding contract giving an investor the right to buy or sell a stock at a fixed price on or before a specified future date. The options contract, however, does not obligate the investor to actually buy or sell the stock.

Here is an overly simplistic example of how a basic options contract would work in everyday life. You find a painting at an art gallery that you want to buy; however, you won’t have the cash until you get your tax refund in two months. You really love the painting and negotiate with the gallery to give you the option to buy the painting in two months for $5,000. The gallery requires that you pay $500 for this option.

So, what could happen?

Suppose it is discovered that the painting was actually painted by Pablo Picasso under a pseudonym. The market value of the painting jumps to $1,000,000. Because you own the option, the gallery is obligated to sell you the painting for $5,000.

On the other hand, what if it is discovered that the painting is actually a mass produced poster and you see it for sale at the local dollar store. While the options contract does not obligate you to buy the painting, you are out the $500 you paid for the option.

In one example, you get an extraordinary return, but in the other example, 100% of the investment is lost. Because of the possibility of such different outcomes, options trading involves risk.

Basic Options Terminology You Need to Know

Call: A “call option” gives an investor the right to buy shares of a specific stock at the “strike price” on or before the “expiration date.”

Put: A “put option” gives an investor the right to sell shares of a specific stock at the “strike price” on or before the “expiration date.”

Expiration Date: The date the options contract expires.

Strike Price: The price at which the options contract may be exercised (i.e. the underlying stock may be bought at this price if it is a call option or sold at this price if it is a put option).

Holder: Someone who buys an options contract.

Writer: Someone who sells an options contract.

Given the complexity of options trading, it is important that you understand the various aspects and terms of an options contract before you invest. For more information about options trading visit the SEC’s and FINRA’s websites for investors.

This blog was brought to you by Rabin Kammerer Johnson, Business Litigation Attorneys.