The Most Foreign Stock Market Term Known: Options Trading.
Well, if stocks are a foreign language to some, imagine what options are to those same people? Not many people understand options trading, nor do they care to understand what the action enatials. Yet, I’m here today to tell you how profitable this trading action can be, but risk is much more higher. How can I trade options and make adequate returns? What are options? When do they expire after purchasing? All will be explained throughout this blog.
Firstly, let's examine the two forms of options that are commonly traded on the secondary market: Calls and Puts. When one purchases a call option, they are purchasing the right to buy 100 shares at the expiration date. When one buys a put option, they are purchasing the right to sell 100 shares at the expiration date. For example, if one wanted to buy an Apple contract right now, they would look at the current stock price. $APPL is trading at $131.10 per share, and with a call option, you’re betting the stock will increase. When a call option is “In the money”, or ITM, that is when the stock price exceeds the strike price, price where one purchased the call at. ITM for put options would be when the strike price exceeds the stock price. These terms are important because they show us why sometimes it is more beneficial to buy a call option, rather than purchasing the underlying asset, a share itself.
How much do options cost me? Well, there are three determinants when factoring the price of said derivative: Time to expiration date, underlying stock price, and volatility. Time to expiration date is interesting due to the fact that it is almost the opposite of what most would expect. The further the expiration date is in the future, the more expensive it is. Similar to insurance, it is more expensive due to the fact that a lot can occur to move a stock’s price within that time period. That being said, 120 day options are the most expensive, in this example, while the lower the amount of days to expiration, the less expensive it becomes. This is known as “Time decay”. It makes sense if we think logically though. Why would an option be expensive, when it has 10 days to its expiration date? The amount of time would certainly elicit a cheaper price.
How the heck can I trade options without losing my mind and money? Options trading is different for everyone, and while I don’t claim to be a God amongst men when it comes to this derivative, I can explain the measures I look for and see if they will work for you. Firstly, I look at the overall state of the economy. I look to see what is occurring within said stock I want to purchase an option on. For instance, the beginnings of the pandemic was certainly a great time to purchase puts, as the market was decreasing each day. Another significantly imperative measure is the volatility. On most stocks, we can find how volatile they have been in historical terms. This measure helps examine how much the market price will increase or decrease based upon its history. And that’s it for today. While there is much more to understand about options, I may discuss them in part 2 blog coming soon. Keep an eye out for it.