Options trading can help stock market investors leverage their investment capital and maximize their returns
Options are derivative financial instruments that can be applied to different investment vehicles such as stocks, ETFs, bonds, currencies, commodities, and cryptocurrencies, among others. Considering the importance of options in a stock market investment strategy, understanding their basic characteristics can be helpful for investors to complement their investing strategies.
While options trading is an extensive area of knowledge, the information in this article is expected to serve as an overview of the topic, addressing only the essential characteristics of stock options.
Options are not company shares but contracts that investors can buy or sell for a given price (called the premium), which, once bought, give the buyer the right to buy or sell a given number of stocks at a fixed price (called the strike price) within the time frame agreed on in the contract. As such, their price is based on the expected market value of the underlying security at a predefined time in the future.
Options have an expiration date, ranging from a few days to up to three years. If no action is taken within the options’ validity period, then the options become void. After their expiration date, options cannot be exercised or traded; whatever value they had will be lost at that time.
While the term contract reflects the nature of options, in practice there are no contracts to read or documents to sign when placing buy or sell orders. The terms and conditions of those trades are presented and electronically signed during the account setup process, when an investor opts in to options trading.
Once purchased, the holders of options contracts usually sell their options when their value reach a price that enables them to make a profit. Selling the options held is the most common occurrence, since their volatility enables investors to profit from their price variation without the need to buy the underlying stocks. Investors may also choose to exercise them anytime if they want to own the underlying stocks.
There are two main types of options: option calls and option puts. People can sell and/or buy each of these types. A more detailed explanation of calls and puts can be found in this article.
If an investor wants to buy (exercise) the underlying stock at the agreed strike price, there are two styles: American and European. American-style option holders can exercise their right to buy the underlying stocks early, from the moment they own the option until its expiration date.
With European-style options, investors may exercise their right to buy the underlying stocks only during the option’s expiration day. Stock options offered by U.S. stockbrokers are American style.
Standard options are traded in packages of 100 shares per contract. Unlike stocks and ETFs, where investors can buy any number of shares of a company or basket, or fractional shares in some cases, options traders buy numbers of contracts instead, and each contract can be sold or exercised separately.
The ability to trade options is normally not enabled by default when people open their stock brokerage accounts; they have to be indicated in the preferences or explicitly requested. Once options are enabled, there are different access levels. The one that allows buying option calls and option puts is level 2.
One type of options calls that may be helpful to know for those with a long investing timeframe is LEAPS, which refers to deep-in-the-money long-term option calls, also known as stock substitutes. They allow people to secure the purchase of stocks at a prearranged strike price (i.e., when they want to buy the market dips) and pay part of their cost when purchasing it, and the rest at a later time, like in a year or two. The premium paid offers the convenience of splitting the payments for the ownership of stocks over time.
Investors anticipating market downturns can also consider option puts, which can help them hedge their portfolios if stock prices decline, or profit from the price drops if they correctly anticipate such trends.
When considering stock options, it is crucial to understand that this type of trading involves significant risks and is not suitable for all investors. Since they are derivative products, before engaging in options trading it would be important to understand how the underlying securities in the stock market work.
Prior to buying or selling options, investors are encouraged to read a copy of the document “Characteristics and Risks of Standardized Options,” from the Options Clearing Corporation (OCC), also known as the options disclosure document, which explains the characteristics and risks of exchange-traded options.