Stock Options Trading - How it Works

By Rick Hendershot

Options trading offers a series of interesting and potentially profitable alternatives to regular stock trading. But before becoming involved in stock options trading it is very important to understand the basic concepts involved. Here is a partial list of some of the more important differences and similarities between regular stocks and stock options.

The most obvious similarities are that like stocks, options are securities. A "security" is broadly defined as an investment contract created when a person invests in a common enterprise with the hope of or anticipation of a positive return. Options can also be traded like stocks between buyers and sellers. And active trading takes place in a listed market.

Options differ from stocks in that they are "derivatives", which means that options get their value from something other than themselves - an underlying security. This derivative value means that options do not have the same voting or dividend rights that stocks have. Options are also time-limited while stocks are not. They expire after an agreed upon time, unlike stocks which do not.

A useful way to look at purchasing a stock option is to compare it to purchasing an insurance policy. Say for example you want to minimize the risk involved in the possibility that your house may burn down. You contract with an insurance company to pay you the value of the house if this should happen, and in return you pay a slight "premium" for this coverage. If the house is destroyed your investment is covered and the "option" is automatically exercised - you receive the payout as previously agreed.

Or perhaps even more to the point is the "security deposit" you put down when you want to secure a lease or rental agreement. Say you decide you want to rent a home for a family vacation. To "secure" that space - to have the property owner or manager hold it for you - you give them an agreed-upon non-refundable sum of money.

In return the owner of the rental property agrees not to rent it to anyone else for a specified period during which time you have the "option" of either confirming the rental by paying the full rental fee, or backing out of the agreement and forfeiting your security deposit.

A stock option is similar in the sense that you pay a relatively small premium to secure your right to either buy or sell a certain stock at an agreed-upon price within a specific period of time.

So, for example, say you want to buy the right to purchase 100 shares of stock ABC sometime before the end of October, for $25 each. This is called a "call option". You have reason to believe that the stock which is currently valued at $21 may go significantly higher within the next two or three months. In options trading jargon this is written "ABC October 25 Call".

To obtain this right you will have to pay a relatively small premium, the amount of which is set depending on various considerations. Let's say in this case the call premium is $2 per share. That means you will immediately have to pay $200 and will then have the right to buy that stock at $25 per share any time up to the termination date. If it is now August and the termination month is set for October, you will be able to exercise your option any time up to the third Friday in October.

If for example the stock should go to $30 sometime in September you could exercise your call option and buy the stock. It would only cost you $25 per share. After buying it you could then turn around and sell it back into the market at $30. Your profit would be $5 per share minus the initial premium you paid for the call option.

This is just one very simple example of how stock options work. As you can imagine, there are many different variations on this same basic principle, and anyone thinking of getting involved in online options trading is well advised to learn as much about those variations as possible.

There would not be as many people involved in trading stock options if it was not possible to develop a sound, profitable strategy. But there is considerable risk involved - especially for the beginner - and educating yourself on the ins and outs of option trading is undoubtedly the best way to minimize those risks. You should also find a good online broker with the best combination of low fees, comprehensive online resource materials, and helpful advice from real people who can assist you.

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