Stock Options Trading: 7 Things New Traders Need to Know

Options trading is on the rise. According to a Yahoo Finance-Harris survey, nearly one-quarter of stock market participants buy and sell options. Options, of course, aren’t the same as stocks. They don’t represent ownership in a publicly traded company. Rather, options are tradable contracts that give you the right to buy or sell a stock at a specific price. Before jumping head-first into this alternative trading strategy, there are several things you should know about options trading.

1. Calls vs Puts

There are two types of options: calls and puts. Calls give you the right to purchase 100 shares of a stock at a specific price before the expiration date, whereas puts give you the right to sell 100 shares of a stock at a specific price before the expiration date. You can buy and sell both types of options through most brokers.

Buying calls and selling puts are considered bullish strategies. If you think the price of a stock will increase, you may want to buy calls or sell puts for that stock. Selling calls and buying puts, conversely, are considered bearish strategies. You can sell calls or buy puts if you think the price of a stock will decrease.

2. Premium

The premium is the amount of money for which an option sells. Like with stocks, there’s a buyer and a seller for each traded option. The premium represents how much money a buyer paid for an option.

When buying calls or puts, you’ll have to pay the premium. When selling calls or puts, you’ll earn the premium. Option premiums can fluctuate based on the market’s expectations of the underlying stock as well as the passing of time. As an option approaches its expiration date — options can expire anywhere from one day to several years after being purchased — it will lose its extrinsic value, resulting in a lower premium paid by buyers.

3. Strike Price

All options have a strike price. It’s the per-share price for which you can purchase or sell 100 shares of the underlying stock. A call with a $60 strike price means you can purchase 100 shares of the underlying stock at $60 each. A put with a $30 strike price means you can sell 100 shares of the underlying stock at $30 each.

Options don’t come with a commitment to purchase to sell the underlying stock. They simply give you the right to purchase or sell the underlying stock before the expiration date. The strike price represents the per-share cost of exercising an option. If you want to exercise an option, you’ll need to have enough money in your broker account to cover the cost of the option’s strike price multiplied by 100.

4. Selling Is Riskier

As a newcomer to this alternative trading strategy, you may want to stick with buying options. Losses for buying options are capped at the premium. You won’t lose more money on an option than the premium for which you purchased it. Selling options, on the other hand, can have unlimited downside.

If you sell naked calls and the price of the underlying stock shoots up, you’ll likely incur substantial losses. There are covered calls and naked calls. A covered call means that you already own 100 shares of the underlying stock, whereas a naked call means that you don’t own 100 shares of the underlying stock.

In either case, selling a call grants the buyer the right to purchase 100 shares of the underlying stock from you. But with a naked call, you’ll have to purchase the shares when the buyer exercises it. Assuming the price of the underlying stock goes vertical from the time when you sold the naked call to the time when the buyer exercised it, you’ll lose a substantial amount of money.

5. ITM vs OTM

Options can be classified as either in the money (ITM) or out of the money (OTM), depending on the strike price in relation to the underlying stock’s price. ITM calls have a strike price that’s lower than the underlying stock’s price. ITM puts have a strike price that’s higher than the underlying stock’s price. They are known as “in the money” options because they can be exercised at a favorable price relative to the underlying stock’s price.

ITM options have both intrinsic value as well as extrinsic value. In comparison, OTM options only have extrinsic value. The only value an OTM option has is the potential to become an ITM option before the expiration date. This time and the market’s overall expectations of the underlying stock is the option’s extrinsic value.

6. Automatic Exercising

Brokers will automatically exercise options immediately before the expiration date if they are ITM. Automatic exercising is a requirement set by the Options Clearing Corporation (OCC). The OCC requires brokers to automatically exercise ITM options on buyers’ behalf so that buyers don’t forfeit gains.

If you don’t have enough money in your account to cover the cost of purchasing 100 shares of an ITM option’s stock, your broker won’t exercise it. Instead, it will sell your ITM option on the stock market.

7. The Greeks

You should learn the Greeks if you’re planning to trade options. The Greeks consist of four primary mathematical measurements that reflect specific attributes of an option. Delta, for example, reflects the expected change in an option’s premium given a $1 increase in the underlying stock’s price, whereas gamma reflects how quickly an option’s delta changes.

Another Greek is theta. Theta reflects the sensitivity of an option’s premium to the passing of time. Some options will decrease in value more quickly than others during a given period. The degree to which an option’s premium is affected by the passing of time is measured in theta. The fourth main Greek is vega. Vega reflects the sensitivity of an option’s premium to implied volatility. The more sensitive an option’s premium is to implied volatility, the higher its vega will be.

Options trading isn’t for everyone. When compared to stock trading, it yields bigger gains and bigger losses. By learning the fundamentals, though, you can start trading options. Just remember to trade conservatively while investing no more than what you can afford to lose.