The stock market holds many opportunities for average people to get a nice return on their investments. However, many people find that understanding how to invest in the stock market can be confusing. They leave the job up to their financial adviser and cross their fingers. Don’t be one of those people. Instead, options trading is a great way to get started investing in the stock market.
What Are Options?
An option is essentially a binding contract that gives the purchaser the option to buy or sell a stock in the future at a specified price. The options agreement itself doesn’t include the ownership of any stock. It just includes the option to exercise the future buying or selling of a particular stock.
Terminology You Need To Know
Simple options trading for beginners can seem overwhelming to start with until you understand the terminology. You’ll need to know what these terms mean to assess potential options that are available for purchase. These terms include all of the following:
This is the agreed-upon price that you can buy or sell a stock in the future. Depending on the specific options contract that you purchase, the strike price indicates different options. When it comes to a call option, the price which you can buy the stock in the future is considered the strike price. A strike price for a put option states the price a stock can be sold for in the future.
The premium is simply the purchase price of the options contract. It’s based on various factors, including the stock’s current price, the volatility of the market, and the expiration date of the option. Realize that the premium is typically expressed in terms of per single stock. Most options contracts are for the purchase of 100 shares of stock. So, you’ll need to multiply the premium price listed by 100 to get your total premium for that option.
Each option contract that you enter into will have a specified expiration date. This is the date listed on the option in the marketplace. You can exercise the call or put options contract at any point up through the expiration date. The expiration date of an options contract can vary greatly from weeks to even years.
This is the asset that the rights to buy or sell are being sold for. The underlying asset could be a stock, index, commodity, currency, or futures. To keep things simple when you’re first starting out in the options market, it’s best to stick to traditional stocks as your underlying asset.
American Vs. European Option Styles
While you may think that all options trading is the same, that’s not the case. There is a major difference between American options trading and European options trading. As you learned above, with American options trading, you can exercise your option up through the expiration date. With European options trading, you can only exercise the options contract on the day of its expiration. This makes the European options market much trickier than the American options market.
You may hear people refer to an option in terms of moneyness. This can be a bit confusing at first, so we’re going to break down the three major categories of moneyness. These include an option being in the money, out of the money, or at the money.
In The Money Options
When a call option is in the money, it’s the current stock price is above what the strike price of the agreement is. This means you can exercise the contract by buying the stock at the lower price and reselling it today at a higher price. On the reverse side, when a put option is in the money, it’s the current stock price is lower than the strike price. This means you can buy a stock at a low price today and exercise your contract to sell it at a higher price.
Out Of The Money Options
In regards to a call option, it’s out of the money when the current stock price is lower than what the strike price is. When dealing with a put option, this means the current stock price is actually higher than your strike price. If you exercise either option contract, you will lose money.
At The Money
As you can probably guess at this point, this is when the current stock is equal to the strike price of your options contract. At this point, you don’t earn or lose money on your option.
Understanding the basics of options trading can do wonders for allowing you to invest your money. After you understand the terminology above, you can better decide what options contracts are going to be best for your investment strategy.