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 – but be warned, options trading is its own world, with its own jargon.
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.
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. In layman’s terms, when you’re trading options, you’re investing in an option to buy or sell a stock, rather than the stock itself.
Again, this is a form of derivative trading, and there are numerous options trading strategies that can be put to use, too. It’s not exactly the same as trading stocks, and is often more complicated. For that reason, investors should know what they’re getting into before trading options.
💡 Quick Tip: Options can be a cost-efficient way to place certain trades, because you typically purchase options contracts, not the underlying security. That said, options trading can be risky, and best done by those who are not entirely new to investing.
Options Trading Terms to Know
When it comes to options trading, these are some of the most important trading terms to understand.
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.
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
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.”
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, and it’s often described as “in the money” versus “out of the money.”
An option is in the money when the correlation between the strike price and the stock price is leaning in a buyer’s favor. Which way this movement needs to go depends on whether they have a call option or put option.
With a call option, a buyer 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 option buyer is in the money with a put option if the strike price is higher than the actual stock price.
Out of the Money
Being out of the money with call or put options means the option buyer 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.
At the Money
Being “at the money” is another scenario an options buyer 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.
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 down swings 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.
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.
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.
💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.
Pros and Cons of Options Trading
Options trading can offer both advantages and disadvantages for investors.
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.
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.
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.
Knowing the specific jargon and terminology used by options traders can help investors cut through the noise and make better decisions. Of course, if you’re uneasy or unfamiliar with options terminology, you’d probably be better off learning more before starting to make trades.
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