Trading stocks can help investors build wealth over time. But for investors interested in more advanced investment strategies, options trading might be worth looking into.
When an investor trades options, they aren’t trading individual shares of stock. Instead, they’re trading contracts to buy or sell stocks and other securities under specific conditions.
Beyond this, there are a number of important options trading strategies investors commonly use when trading options.
In order to effectively deal in options, an investor might also want to familiarize themselves with certain lingo.
Related: 6 real questions about investing— answered
Image Credit: DepositPhotos.com.
First – Understand What You Are Trading
Before learning the trading terms, it helps to have a firm grasp of what options trading is and what it involves.
Here’s a simple option definition from the Securities and Exchange Commission (SEC): “Options are contracts giving the purchaser the right to buy or sell a security, such as stocks, at a fixed price within a specific period of time.”
In other words, you’re investing in an option to buy or sell a stock, rather than the stock itself.
Image Credit: DepositPhotos.com.
Options Trading Terms to Know
When it comes to options trading, these are some of the most important trading terms to understand.
Image Credit: DepositPhotos.com.
1. Call Option
A call option is an options contract that gives the purchaser of the option the right to buy shares of a stock or another security at a fixed price. This price is called the “strike price.”
When an investor buys a call option, the option to buy is open for a set time period. The expiration date is the date when the call option is voided, though some options positions are automatically closed or exercised if they are in the money. Standard options contracts are no more than 90 days.
Image Credit: ipopba / iStock.
2. Put Option
A put option gives a purchaser the right to sell shares of a stock at the strike price by a specified day.
When getting to know puts and calls definitions, it’s important to remember that each one has:
- A strike price
- An expiration date
Image Credit: DepositPhotos.com.
3. Strike Price
With a call option or put option, the strike price is one of the most important trading terms to know.
In a call option, the strike price is the price at which an investor may buy the underlying stock associated with the contract. In a put option, the strike price is the price at which they may sell the underlying stock.
The gap between the strike price and the actual price of a stock determines whether an investor is “in the money” or “out of the money.”
Image Credit: SlavkoSereda / iStock .
4. In the Money
When discussing stock movements, it’s typical to think in terms of whether a stock’s price is up, down or flat. With options, on the other hand, there’s different language used to describe whether an investment is paying off or not.
An option is in the money when the correlation between the strike price and the stock price is leaning in an investor’s favor. Which way this movement needs to go depends on whether they have a call option or put option.
With a call option, an investor is in the money if the strike price is below the stock’s actual price. Say, for example, you place a call option to purchase a stock at $50 per share but its actual price is $60 per share. You’d be up, or in the money, by $10 per share.
Put options are the opposite. An investor is in the money with a put option if the strike price is higher than the actual stock price.
Image Credit: ipopba/ iStock.
5. Out of the Money
Being out of the money with call or put options means an investor doesn’t stand to reap any financial gain from exercising the option. Whether a call or put option is out of the money depends on the relationship between the strike price and the actual stock price.
A call option is out of the money when the strike price is above the actual stock price. A put option is out of the money when the strike price is below the actual stock price.
Image Credit: Алексей Белозерский/ iStock.
6. At the Money
Being “at the money” is another scenario an investor could run into with options trading.
In an at-the-money situation, the strike price and the stock’s actual price are the same. If the buyer of the option sells the option, they can make or lose money. If they exercise the option, they will lose money because of the premium paid.
Image Credit: Antonio_Diaz / iStock.
7. Volatility Crush
When trading options, it’s important to understand stock volatility and how it can impact trading outcomes.
Volatility is a way to track up or downswings in a stock’s price across trading sessions. Implied volatility is a way of measuring or estimating which way a stock’s price might go in the future.
A volatility crush happens when there’s a sharp decline in a stock’s implied volatility that affects an option’s value. Specifically, this means a downward trend that can detract from a call or put option’s value.
Volatility crushes can happen after a major event that affects or could affect a stock’s price. For example, investors might see a volatility crush after a company releases its latest earnings report or announces a merger with a competitor.
Image Credit: NicoElNino / iStock.
8. Bid/Ask Price
When trading options, it’s helpful to know how bid and ask prices work.
The bid price is the highest price a buyer is willing to pay for an option. The ask price is the price a seller is willing to accept for an option.
The difference between the bid price and ask price is known as the spread.
Image Credit: Chainarong Prasertthai / iStock.
9. Holder and Writer
Other trading terms investors may hear associated with options are “holder” and “writer.”
The person or entity buying an options contract may be referred to as the holder. The seller of an options contract can also be referred to as the writer of that contract.
An option is exercised when the buyer chooses to invoke their right to buy or sell the underlying security.
Image Credit: Pinkypills / iStock.
Pros of Options Trading
- Lower entry point: Unless an investor is able to purchase fractional shares, purchasing individual stock shares with higher price points can get expensive. Investing in options, on the other hand, may be more accessible for investors with a limited amount of money to put into the market.
- Downside protection for buyers: If the stock’s price isn’t moving in the direction a buyer anticipated, they don’t have to exercise their option to buy. This can limit losses.
- Greater flexibility: An investor has control over exercising the option to capitalize on the stocks rise or fall accordingly. An investor could exercise an option to buy and keep the shares, or buy and then resell them. Or they could choose not to exercise their option at all.
Image Credit: DepositPhotos.com.
Cons of Options Trading
Options trading can be risky for sellers. Trading stocks is risky, but trading options have the potential to be more so for investors on the selling end of a contract.
An investor might end up being out of the money on an options contract, but even that doesn’t determine the extent of the loss. The risk comes from the selling of uncovered puts and calls.
Image Credit: g-stockstudio/iStock.
The Takeaway
Trading options can be appealing to investors who think an asset’s price will go up or down, or who want to attempt to offset risk from assets that they own. But before an investor engages in options trading, it’s a good idea to get familiar with put and call definitions and other options trading terms.
Learn more:
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
SoFi InvestThe information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.3) Digital Assets—The Digital Assets platform is owned by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, http://www.sofi.com/legal.Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.Stock BitsStock Bits is a brand name of the fractional trading program offered by SoFi Securities LLC. When making a fractional trade, you are granting SoFi Securities discretion to determine the time and price of the trade. Fractional trades will be executed in our next trading window, which may be several hours or days after placing an order. The execution price may be higher or lower than it was at the time the order was placed.
Image Credit: g-stockstudio / iStock.
