Reasons why options are harder to understand than traditional stocks:
Options can expire and their values fluctuate based off that fact.
- Imagine there is a stock that has been trading between $15 and $20 for the last 5 years. Someone offers to sell you a “CALL” option for a $25 “strike price” that expires in 2 days. The current price of the stock is $17 and the stock has never moved more than $.70 in a given trading day for the last 5 years. How much is option worth? Probably next to nothing unless there is something drastic in the news, but even then it is very unlikely the option is valuable because if there was that much speculation currently available, why would the stock be still at $17.
- Imagine there is a stock that has been trading between $15 and $20 for the last 5 years. Someone offers to sell you a “CALL” option for a $16 “strike price” that expires in 15 months. The current price is $15 (the 5 year low) and the stock has been going back and forth between $15 and $20 fairly frequently almost every month. How much is this option worth? A lot more. If you look at the chart and you are confident that the stock will at least make it to $18 at some point in the next 15 months. Assume the option is currently going for $1 a share – it might be a good investment, because you are fairly confident it is going to go up $3 a share.
- Expiration date comes and you didn’t use the option? Well it’s gone. There is no option anymore.
Most options are not actually executed.
- You buy the right to “CALL” (Buy) or“PUT” (Sell) a stock at a price, but usually where option traders realize gains and loses is when they sell the option itself. Say you purchased an option for $2 and it is now worth $2.35 – that is a 17.5% gain. Do people execute options? Absolutely, but imagine the option market kind of like a big trading card game for speculation.
Options do not move linearly and pricing is based off speculation as well as fundamentals.
- It is a combination of volatility, news, expiration date, and a lot more.
- Options gain and lose their value versus their “underlying stock.” What that means is if you have a option on AMZN (Amazon.com) and Amazon’s stock goes up – Your right to “CALL” (Buy) at a price would increase and vice versa for a “PUT” (Sell). But be warned if amazon stock goes up or down 2% that does not mean the option will go up or down 2% – there is no set formula for how the option moves, but generally it is a higher leveraged position, therefore if the stock moves up 2%, the option may moves up a lot more (It could be 10 – 50%+ depending on how leveraged the option is).
- Example: AMZN is trading for $100 when you purchase an option to “CALL” (Buy) Amazon at $105 that expires 5 months from now. Your option costs you $3.79. This means if the stock goes up to $200 within those 5 months – you could buy it for only $105 (and even sell it immediately to profit $95 per share). Back to the example, the next day the AMZN stock goes up to $103 a share. You still have the right to buy the stock for $105, but you wouldn’t because the stock is at $103 – you could buy amazon’s stock at the market for cheaper – BUT your option is more inciting. Before your option was $5 away from the current market prices – it’s closer to being “in the money”. Maybe that option is now worth $4.45 (+17.41%).
Options are highly leveraged securities – That can be Scary.
- The stock goes down 5%, your security might go down 35%. It can be hard to manage risk and/or take “pain”.
Option terminology can be new and very tough to grasp, especially when you get into different brokers.
- Want to buy an “butterfly” option? I did say this was the basics, but the point remains some of the terminology can be confusing. “Call” and “Put” are just the tip of the iceberg.