3 Things You Need To Know About Options - InvestingChannel

3 Things You Need To Know About Options

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3 Things You Need To Know About Options

In response to our How To Research An ETF installment, a Juice reader named Stacy said she wanted to learn about options:

Simple steps to what to look for, HOW to do it, and so on.

If there’s something about personal finance or investing you’d like to learn, use the feedback link at the bottom of this email (or page) to get in touch with The Juice

There’s actually a ton to cover in Stacy’s request so we’ll break it out over several installments, starting today. We’ll save the basics for later. 

In this Juice, after providing the oft-repeated definition of a call and put option, let’s dig into some things you need to know before you even think about making an option trade.  

  • A call option is a contract between a buyer and a seller that allows the call buyer to purchase a certain stock at a certain price up until a defined expiration date.
  • The buyer of a put has the right to sell a stock at a set price until the contract expires.

We’ll focus on calls as we move through the things The Juice thinks you need to know. 

Time Decay 

If you learn nothing else about option trading, make sure you learn about time decay. It’s the concept that will sink or help you swim when dealing with options. 

When you buy a stock, you can literally wait forever for it to go up. If you purchase shares at $100 today and they drop to $50 in a month, you can sell or ride out the downside. Unlike options, stocks don’t have the aforementioned expiration date. 

As an option’s expiration date gets closer, the premium the option contract trades for decreases in value. Why? Because as the time to expiration decreases, investors are less willing to pay a premium that exceeds intrinsic value. Intrinsic value being the amount by which an option is in the money. 

To illustrate, a $10 call option on an $8 stock is out of the money by $2. A $10 call option on a $10 stock is at the money. And a $10 call option on an $11 stock is in the money, making its intrinsic value $1. 

Time value refers to the premium an investor is willing to pay over intrinsic value ahead of expiration. The more time there is for an underlying stock to move in the option investor’s desired direction, the greater the time value. 

Generally, you’ll pay more for a call option with a further out expiration date than you will for one less far out into the future. 

Trade The Premium 

To this end, when you buy a call, you do not need to exercise your right to purchase the underlying stock. In fact, investors often buy options without any intent to own the stock. Instead, they want to trade the premium. 

This is one area where the above discussion on time decay matters immensely. 

If you buy a call with a $6 strike price and April 2024 expiration on a $4.50 stock today, you might pay a premium of around $0.30. If tomorrow, the stock price increases to $5, the premium on your call option should also increase. You could sell your call and pocket the difference between the $0.30 you originally paid for the call and the new market price for the option contract. You profited from upside in the underlying stock without ever owning it. 

However, a move from $4.50 to $5.00 very close to option expiration will have little, if any impact on the premium. In fact, as option expiration date draws near, that premium will, in most cases, only be worth a few cents until it ultimately expires worthless. 

So, when you buy a call — or put — keep your eye on the expiration date and the move you need the underlying stock to make so you have time to profit from your option position. Thankfully, most trading platforms have simulators and calculators that do this math for you so you can visualize how the value of an option changes as the underlying stock moves and time passes.  

Do The Math On Covered Calls 

Many investors start with covered calls when trading options. See this Juice installment for some basics on covered calls, how they work and how you might use them. 

There’s math — sometimes lots of math — to do with most option trades. Same goes for covered calls. Even though the risk of losing money isn’t big, the risk of leaving money on the table is. 

If you sell a covered call with a $100 strike price on a stock you own, you must sell that stock for $100 if the party you sold the call option to exercises their right to buy it. If the stock ends up at $120, you still have to sell it for $100. 

The math you need to do is two-fold:

  • Consider the premium you received when you sold the call. If you received a $5.00 premium, your breakeven is $105 (the $100 strike price plus the $5.00 premium). 
  • Consider the price you paid for the stock you wrote the call against. If you paid $50, in this case, you profit all the way up to $105, for a gain of $55 per share. Sometimes, investors who want to sell a stock, write a covered call with a strike price that represents their target price for unloading the stock. 

Ultimately, when you write a covered call, you need to ensure you’re willing to sell the underlying stock and that the strike price you selected is one you’re comfortable selling it at. 

The Bottom Line: Options, even at the basic level, can seem confusing. And that’s because they are. It takes time to wrap your head around the things we outlined today. Going over the material multiple times and seeing examples as you advance your learning is the way to go. But it takes time. 

In coming weeks, we’ll tie option trading to everything from dividend stocks to ETFs (see today’s Trackstar top five for a preview) to retirement with real world examples. And we’ll consider options in and of themselves. Stick with The Juice and we’ll get you up to speed on options basics — and a little more — in no time.

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