Happy Fourth of July, Evolvers!
As I enjoy the holiday, I keep thinking about how the options market is a strange place…
There are foreign concepts, like implied volatility (IV), that you must understand. Then, you have confusing differences in strike prices and expiration dates to deal with (more on that later)…
Plus, there are serious risks on the other side if you don’t know what you’re doing.
Sometimes it’s embarrassing or awkward to ask someone outright about a topic you aren’t familiar with.
But after going over a bunch of questions I’ve received from students recently, it’s clear that I need to clarify a few things.
To some Evolvers, these questions may seem elementary…
But even if you’re familiar with these ideas before reading this … it’s always a good idea to go back to the basics and brush up on the fundamentals of how options function.
And no better time to do so than on a holiday when the market is closed!
With that in mind, keep reading to see my answers to the most-asked questions about options trading…
What Are the Different Types of Options?
There are nearly infinite variations on how you can trade them, but only two types of options contracts exist — calls and puts.
Calls are directionally bullish — you buy them if you think a stock will go up.
Conversely, puts are directionally bearish — you buy them if you think a stock is heading lower.
One isn’t necessarily better than the other, but some traders prefer trading calls over puts, or vice versa.
I tend to trade more puts than calls as it’s always been easier for me to nail the downside as opposed to the upside.
But I encourage you to learn to trade both sides of the chart. This is how you become a truly versatile trader.
What’s the Strike Price of an Option?
Every options contract has an attached strike price. This is the price level the stock needs to reach for your contracts to pay out.
If you’re trading calls, you want the stock to exceed your strike price.
If you’re trading puts, you want the stock to stay below your strike price.
Choosing the correct strike prices is one of the most important aspects of options trading (but more on that in a minute)…
“What’s the Expiration Date of an Option?”
Along with a strike price, every contract comes with an expiration date — think of it as the lifespan of your contract.
Options are depreciating assets, meaning that they start losing intrinsic value from the moment the contracts are written. The expiration date determines how quickly that intrinsic value decays.
Additionally, expiration dates have a big effect on the way options contracts react to the moves of the underlying stock.
Shorter contracts will change value faster (and more dramatically) than their longer-dated counterparts.
“What Does It Mean If an Option Is In/Out of the Money?”
The ‘in/out of the money’ concept circles back to our discussion of strike prices.
Let’s say stock XYZ is trading for $50, but you think it could hit $60 by the end of the month.
If you buy a $60 call, that contract is out of the money because the underlying stock isn’t trading at or above $50 (yet).
Now let’s say you were right — two days later, XYZ is trading for $62.
At that point, your $60 call would be in the money. The stock increased beyond your strike price.
“What Does It Mean to Exercise an Options Contract?”
Now, let’s return to our hypothetical XYZ trade…
If the contract’s about to expire and your $50 strike is in the money, you have two choices…
The first choice is to sell the contracts outright. This is the simplest and most common way to lock in gains without any confusion.
Your account will be credited the difference between the premium you paid to put the trade on and the premium for which you sold the contracts.
This is what I do 100% of the time.
But there’s another choice, which is to exercise the contracts…
If you choose to exercise, you’ll need to purchase all of the shares that the contract represents. Remember that each options contract represents 100 shares of the underlying stock.
That means to exercise just one of your XYZ $50 calls, it would cost $5,000. You can imagine how expensive this can get if you have 10, 50, or 100 contracts.
So if you truly love the stock and want to own the shares beyond the life of your options contract, know that exercising is a choice you have.
But whatever you do, make sure you have the capital in your account required to purchase the underlying shares. If you don’t, you could risk receiving a margin call — and potentially blowing up your entire account.
“Can I Trade Options on Any Stock or ETF?”
The short answer is no. Stocks only have options attached if market makers believe there’s enough liquidity, or demand, to support derivatives on the name.
So pretty much any blue-chip or index-held stock will have options.
On the other hand … smaller, newer, or less liquid stocks often won’t have any options offered at all.
This is why my options-trading strategy focuses on volatile stocks in hot sectors. These names are almost always liquid enough to warrant an options chain.
To Be Continued…
That’s not all, folks!
Tomorrow, I’ll continue going through a variety of questions I continually receive from students.
Don’t miss it, because the one question you’ve been afraid to ask could get answered tomorrow!