A Quick Guide to Buying Stock Options

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Options Trading Strategies: A Guide for Beginners

Options are conditional derivative contracts that allow buyers of the contracts (option holders) to buy or sell a security at a chosen price. Option buyers are charged an amount called a “premium” by the sellers for such a right. Should market prices be unfavorable for option holders, they will let the option expire worthless, thus ensuring the losses are not higher than the premium. In contrast, option sellers (option writers) assume greater risk than the option buyers, which is why they demand this premium.

Options are divided into “call” and “put” options. With a call option, the buyer of the contract purchases the right to buy the underlying asset in the future at a predetermined price, called exercise price or strike price. With a put option, the buyer acquires the right to sell the underlying asset in the future at the predetermined price.

Why Trade Options Rather Than a Direct Asset?

There are some advantages to trading options. The Chicago Board of Options Exchange (CBOE) is the largest such exchange in the world, offering options on a wide variety of single stocks, ETFs and indexes. Traders can construct option strategies ranging from buying or selling a single option to very complex ones that involve multiple simultaneous option positions.

The following are basic option strategies for beginners.

Buying Calls (Long Call)

This is the preferred strategy for traders who:

  • Are “bullish” or confident on a particular stock, ETF or index and want to limit risk
  • Want to utilize leverage to take advantage of rising prices

Options are leveraged instruments, i.e., they allow traders to amplify the benefit by risking smaller amounts than would otherwise be required if trading the underlying asset itself. A standard option contract on a stock controls 100 shares of the underlying security.

Suppose a trader wants to invest $5,000 in Apple (AAPL), trading around $165 per share. With this amount, he or she can purchase 30 shares for $4,950. Suppose then that the price of the stock increases by 10% to $181.50 over the next month. Ignoring any brokerage, commission or transaction fees, the trader’s portfolio will rise to $5,445, leaving the trader with a net dollar return of $495, or 10% on the capital invested.

Now, let’s say a call option on the stock with a strike price of $165 that expires about a month from now costs $5.50 per share or $550 per contract. Given the trader’s available investment budget, he or she can buy nine options for a cost of $4,950. Because the option contract controls 100 shares, the trader is effectively making a deal on 900 shares. If the stock price increases 10% to $181.50 at expiration, the option will expire in the money and be worth $16.50 per share ($181.50-$165 strike), or $14,850 on 900 shares. That’s a net dollar return of $9,990, or 200% on the capital invested, a much larger return compared to trading the underlying asset directly. (For related reading, see “Should an Investor Hold or Exercise an Option?”)

Risk/Reward: The trader’s potential loss from a long call is limited to the premium paid. Potential profit is unlimited, as the option payoff will increase along with the underlying asset price until expiration, and there is theoretically no limit to how high it can go.

A Quick Guide to Buying Stock Options

So you’ve decided to invest in the stock market. Congrats!

Now that you’ve come to this decision, you’re probably scratching your head, wondering which stock-buying strategy to use.

Not to mention, the stock language is pretty overwhelming. What’s strike price anyways?

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Well, this quick guide to buying stock options can help you out with that.

In it, you’ll learn:

  • 3 Basic strategies for buying stock options
  • Common stock market terms so you can speak Wall Street
  • And, a handful of know-hows when it comes to buying and selling stocks

Read on to learn more!

Common stock market terms you need to know

Options

Options are contracts that give investors just that—options. One of the options is buying the stock at a certain price by or prior to a specific time period.

If you want to get technical, this is a call option.

The other option is similar except, instead of buying the stock, you’re selling it. This is known in the stock market world as a put option.

Since these choices are options, you’re not obligated to do one or the other.

Strike Price

The “certain price” we’re talking about above is known as the strike price.

In other words, the strike price is a set price.

It’s also a key factor for investors to determine if they’re making a profit.

In fact, you can use it to determine your break-even point. This is the amount you would need to make to not loose money. But you also wouldn’t be making more.

Price Premium + Strike Price = Break-Even Point

Option Premium

The option premium is based on intrinsic and extrinsic value.

To better understand this, here’s an example.

You have a call option at a strike price of $50 per share. You have 100 shares (since this is the norm). The option premium is $6.

The option is currently trading at $54 a share. This is $4 above the strike price.

So, the $4 of the option premium is the intrinsic value. The $2 that is leftover is the extrinsic value.

Strategies for buying stock options

There are several stock option strategies. But, according to a Nasdaq article, some of the most common and straightforward strategies are these…

Wait until they’ve matured

Essentially you hold the call option until the contract is up. (Note: this is before it expires.) And then you trade it.

Trade before the contract is up

When TV shows and movies capture the stock market, they normally depict some form of this strategy.

Let’s say you have a call option that has a strike price of $40 per share. Recently, it’s risen to $60 per share. You expect this is the highest this share will rise. So, you trade it.

Which should bring you some profit (minus the premium and commission).

Allow it to expire

Perhaps the share you bought never went up or down. You’re still waiting but nothing is happening.

At which point you let it expire. You’ll have to pay the option premium and commission.

Advice for buying stock options

Here’s some universal advice when it comes to buying stock options:

  • Buy when they’re low; sell high
  • Think twice about risky stock options if you’re towards retirement. Yes, there’s potential big profit. But potential big profit loss.
  • Predict trends by studying filings
  • In general, think marathon, not sprints

The Complete Beginner’s Guide to Investing in Stock

How Owning Shares of Companies Can Help Build Wealth

Image by Theresa Chiechi © The Balance 2020

History shows that investing in stocks is one of the most profitable ways to build wealth over the long term. Nearly every member of the Forbes 400 list of the wealthiest Americans got there because they own a large block of shares in a public or private corporation. Learning to invest wisely and with patience over a lifetime can yield a portfolio far outpacing the most modest income.

What Stock Is

A share of stock—sometimes called security or equity—is legal ownership in a business. Corporations issue stock to raise money and it comes in two varieties—common or preferred. Common stock entitles the stockholder to a proportionate share of a company’s profits or losses. Preferred stock, meanwhile, comes with a predetermined dividend payment. There’s more that distinguishes the two types of stock.

How to Make Money Investing in Stocks

An increase in stock price and dividends are two ways to profit from owning and investing in stock. Because these accumulate over time, just one year’s investment in the right company—if held for 30 years—can yield a solid return.

“The real money in investing will have to be made—as most of it has been in the past—not out of buying and selling, but out of owning and holding securities, receiving interest and dividends, and benefiting from their long-term increase in value.” said Benjamin Graham, father of value investing. This practice has created millionaires.

How to Find Stocks for Your Portfolio

Investment ideas can come from many places. Ask your family members what products and services they are most interested in—and why. Look at trends in the world and companies that are in a position to benefit from them. Stroll the aisles of your grocery store with an eye for what is emerging. You can also seek guidance from professional research services such as Standard & Poor’s and ValueLine. Many online sources also exist for investment ideas.

How to Buy Stocks

You can buy stock directly using a brokerage account or app. Other options exist for those who are employed—either a 401k plan or a 403b plan if you work for a non-profit. Then there’s the IRA—be it a Traditional IRA, Roth IRA, Simple IRA, or SEP-IRA account. You can also set up a direct stock purchase plan or dividend reinvestment plan (DRIP). Each type of account has different tax implications.

How to Choose a Stockbroker

The two types of brokers are full-service and discount brokers. Full-service brokers tailor recommendations and charge higher fees, service charges, and commissions. Once an account is set up, a discount broker can allow you to do it yourself at minimal cost through their website and offers support online, by phone, or in a branch when needed. The cost of buying continues to decrease with the introduction of apps. Apart from cost, a distinguishing factor is the research provided.

Why Stock Prices Fluctuate

News events and earnings reports can change the perceived value of a company. Because the stock market functions as an auction, prices sometimes need to adapt for a trade to occur. When there are more sellers than buyers, the price will go down. Alternately, a stock that has more who want to buy than sell will experience a price increase. Buyers and sellers can be individuals, corporations, asset management companies, or others. Price fluctuations can be dramatic in just one day.

Stock Market Capitalization (and Why You Should Care)

A stock’s market capitalization (cap) is its true value, the sum of the total shares multiplied by price. It has more meaning than the share price because it allows you to evaluate a company in the context of others of the same size in its industry. You can use a market cap as a filter to screen for companies to balance your portfolio. A small-cap company with stock capitalization of $250 million to $2 billion shouldn’t be compared to a large cap, which ranges from $10 billion to $100 billion. Market capitalization influences your investment returns.

Why Stocks Split

A stock split is when a company increases its total shares and is frequently done on a 2-for-1 ratio. So, if you own 100 shares of a stock priced at $80 per share and worth $8,000, after the split you’ll have 200 shares priced at $40 each, and still worth $8,000. Stock splits occur when prices are rising in a way perceived to deter smaller investors. They can keep the trading volume up by making it easier for a larger buying pool to trade. If you invest in a stock, expect to experience a stock split at some point.

What You Should Know About Stock Prices

A $50 stock can be more expensive than an $800 stock because the share price means nothing on its own. The relationship of price-to-earnings and net assets is what determines if a stock is over- or under-valued. Companies can keep prices artificially high by never conducting a stock split, yet without having the underlying foundational support. Make no assumptions based on price alone.

Dividends 101

Dividend investing refers to portfolios containing stocks that consistently issue dividend payments year-in and year-out. These stocks produce a reliable passive income that can be especially helpful in retirement. Dividend reinvestment is a way to accelerate portfolio growth. Still, you can’t judge a stock by its dividend price alone. Sometimes companies will increase dividends as a way to attract investors when the underlying company is in trouble. Dividends are taxable.

Why Investors Like Blue-Chip Stocks

Blue-chip stocks are popular because they typically have a decades-long track record for earning. “Blue chips” derived their name from Poker, where the most valuable playing chip color is blue. Shareholders like them because they tend to grow dividend rates faster than the rate of inflation meaning the owner increases income without having to buy another share. Blue-chip stocks are not flashy, but they have solid balance sheets and steady returns.

Investing in Preferred Stock

Preferred stock is very different from shares of the common stock most investors own. Holders of preferred stock are always the first to receive dividends, and in cases of bankruptcy will be first to get paid. However, the stock price does not fluctuate (up or down) the way common stock does. Preferred stock is a hybrid of common stock and bonds.

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