Analyzing and trading options give investors more leverage than trading stocks. Whereas a stock may require the trader to put up 50% of its value, many options only require 10-20%.
That’s a significant difference. Each option also allows the trader to control 100 shares of the underlying stock.
In this 101 guide, we’ll look at single-legged options strategies. That means buying single options contracts. Some strategies involve pairing different options contracts and even using more contracts to open a single trade. But those types of strategies are beyond the 101 level.
Analyzing And Trading Options Vs. Stocks
An option is a derivative of the underlying (i.e., stock). If the stock didn’t exist, the option wouldn’t exist. It’s simply a mathematical financial creation. The stock represents a real company and isn’t just a mathematical representation of something else.
Buying a stock is a simple transaction. Enter the number of shares and click buy. You can get a little more targeted with your price by setting a limit order. For example, if ABC stock is trading at 105 and you want to buy 25 shares at 100, you set a limit to buy at 100. Your buy order will only be triggered when the stock price reaches 100. Once the order executes, ABC needs to go up for your trade to make money. That is called a long trade (as opposed to a short trade — price of ABC goes down).
Options can be purchased in a similar manner. Instead of shares, you deal with contracts. Each options contract represents 100 shares of the underlying stock. Also, you aren’t buying contracts based on the underlying stock’s price. Instead, you are buying based on the option’s price.
Let’s go through an example. On March 17, 2021, ABC was trading for $105. The ABC April 110 Call option contract was trading for $0.80. Let’s clarify what these prices actually are. The "105" is the last traded price. ABC has a current bid-ask of $104.50 to $105.25, which means the next trade will probably be just under 105. The ABC April 110 Call contract has a bid-ask of $0.75 to $0.80. Its next trade may be under $0.80.
The bid-ask values are called a spread. In liquid stocks, the spread is very small (same for options contracts). Options contracts can have a large bid-ask spread, even if the stock is fairly liquid. A large spread means you’re more likely to pay more for the option than if it were liquid.
Calls Vs. Puts
You may have noticed that the call option’s price moved down with the stock price (or bid-ask to be more precise). A call option is also a long trade. As the stock price rises, the call option price rises with it and vice versa.
However, the option price moves at a different rate from the stock price. There is something called the greeks that determines how quickly the option’s price rises compared to the stock. But the greeks are an advanced topic.
If you're betting that the stock price will go down, you want to buy a put. As the stock price moves lower, the put price moves up. It's the opposite of the call option's price behavior. But since you are buying a call to open the option position, the trade only gains value when the option's price moves up.
Risk vs. Reward
In the above example, we bought the ABC April 95 Call option contract. What does all of that mean? ABC is, of course, the underlying stock that the option is based on. April is the month that the option expires.
This is a monthly option. All monthly options expire on the third Friday of the month. That means the option will expire on April 16. You have until that date for the option to gain in value over what you paid for it. Some options expire every week or few days.
The 110 is called the strike price. It represents the stock price that you believe ABC can at least reach before April 16. What happens if ABC is only at 105 by April 16. The option you purchased at $0.80 will expire worthless
Each option is worth 100 shares of the underlying. Because you paid $0.80 for the option, that means it cost you 0.80 x 100 = $80. So you would lose $80 in this case. If ABC went up by $5 to $115, however, the option would likely be worth at least $500 (5 x 100 = $500). So, in this case, you'd make $420 ($500 - $80 = $420).
These examples demonstrate the draw of buying options contracts for many traders. If the trade goes against you, your downside risk is limited to the premium you paid up front ($80 in our example). But your upside reward potential is unlimited and leverage helps to amplify your returns.
You've probably heard that there are many free investing apps today that no longer charge commissions on stocks. That's also true for options...but not exactly. Sounds like double talk, right? Here's what we mean.
Before brokers began removing commissions, options traders would pay a base commission plus a fee for each options contract. It might look like this for five contracts:
- Base Commission: $1
- Contract Fee: $0.65 x 5 = $3.25
- Total Cost: $1.00 + $3.25 = $4.25
While most brokers have eliminated the base commissions, it's important to note that the overwhelming majority still charge the contract fee. So this is what the new cost might look like for a broker that charges a per-contract fee of $0.65:
- Base Commission: $0
- Contract Fee: $0.65 x 5 = $3.25
- Total Cost: $3.25
So, in a way, commissions didn't really disappear for options with most brokers. They just reduced them. While rare, a few brokers have removed the contract fee for options as well including Robinhood and Firstrade.
We haven't talked about multi-legged options trades or margin. These topics are a bit more advanced. This article should help with the basics of options trading and understanding how it works. But rest assured, there's a lot more to learn about choosing the right strike, expiration date, multi-legged configuration, and analyzing the greeks!
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him on the About Page, or on his personal site RobertFarrington.com.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.