Stock Options Demystified

2 Mins read

For a lot of people, the stock market is an exciting place to turn idle savings into a possible revenue stream. Even people who are in no way financial experts are attracted to owning a few shares in big companies like Apple or Disney. Buying and holding onto those blue chips can make one feel connected to the slow-but-steady climb of the market. On top of that, the logic seems fairly simple: As a company’s numbers go up, so too should its share price.

Then, there are derivatives. To hear stock-talk about “options” and “futures” may sound familiar, but these financial products aren’t so clear-cut as the actual company shares they’re based on.

“Options add a whole new level to trading that lets you go beyond simple up-down vertical dichotomies,” explains CMT and self-taught trader Matt Choi. Matt Choi runs Certus Trading, a trading education company that offers courses in options and asset trading. “One of the beauties of options is you can now trade horizontally, tangentially to the basic movements of the underlying assets. It’s like 3D chess.”

Breaking Down Derivatives

They’re called derivatives because they derive their value from something else, most often stocks and bonds. This means that the price of a derivative depends on the price movement of its specific underlying asset, though not necessarily in the same direction or at the same magnitude.

Derivatives are also contracts. Unlike the trading of a stock or a bond, which is like a normal transaction between buyer and seller, an option is an agreement between two parties on what they can or must do in the future.

A futures contract is an agreement between two parties now to complete a transaction by some stated date at a given price. For example, I sell you the contract now to buy my wheat next September. The idea here is to lock in secure prices in case of any major ups or downs between now and harvest time.

Now we come to options. These contracts give the buyer the choice to fulfill the transaction — hence option. That is, if I buy an option’s contract, I can choose to buy (or sell) an asset within the timeframe of the contract. But, I don’t have to.

For example: You sell me an option that lets me buy your stock at $100/share (a “call” option). If before the contract expires, that share price goes up to $120, I’ll buy it (“call it in”). If it drops to $80, I’ll let my contract expire, and you get to keep the fee for the contract.

Options of strategies

The price of an option’s contract is a fraction of the price of the assets. This lets more people trade on big moves with less at stake.

But on top of that, “[t]hey provide controlled leverage for both short-term and long-term trading objectives,” states the Online Trading Academy, an education company which specializes in web-based trading. “Options are also a vehicle used by both financial institutions and individual investors to hedge their portfolio risk.”

In other words, if you’re looking to expand your financial acumen, don’t think of options as a replacement strategy to traditional stocks and bonds, but as a supplement, a buffer. Programs in advanced options trading are replete with options strategies to minimize overall portfolio risk, as well as for those ready for higher risk in order to gain higher return.

“Options greatly expand the buffet of financial offerings,” says Matt Choi.

Great news for those with extra savings just hungry to get to work.