How Do Options Actually Work?
With a basic understanding of what options are and the risks involved, it is time that we take a deep dive into how options work. In this chapter, we are going to cover an example that is closely modeled to how you would trade options in the real financial markets. It is important to note that when trading options, not only do we have to take note of the price of the asset, but we also have to pay attention to the time frame, or the expiration date. By the end of this section, you should grasp the details of how trading options really works.
The most common form of underlying asset an options contract can cover is stocks, or equity, therefore for this example we will be using options on stock price.
Preface- The date is July 1st, and the stock price of ChocoMart, our fictional company, is $15. The cost for a September $20 Call is $2. This means that the option will expire on the third Friday, always the case for expiration of options, and you have the option to BUY the share for $20, recall what is “call” option.
You did a great deal of research on the stock and believe that the price can spike above $20 in 3 months, and went ahead and purchased a contract of 100 shares. The total cost of this transaction is $2 cost x 100 shares = $200.
Note that you should only do it IF you expect the price to go above $20. Otherwise, the contract is useless. Assume that the market price is $19 at the end of the 3 months. There is no reason to exercise the contract to buy at $20 because you can get it for lower at the market price. If this is the case, you lose your initial investment of $200 in contract cost, and of course the commission paid to the broker.
Let’s say now within the first 4 weeks, the stock price rose to $24 and the cost of a contract is now $5, which is up from $2 because of the increased demand for this option. You now have 2 possible courses of action:
1. Trade Out, or Close the position – This means you sell your options to another buyer at $5. Therefore, your profit is ($5 x 100 shares) – ($200 initial investment) = $300
2. Exercise the Option – This means you exercise the option by actually purchasing the stock. You can either sell the stock immediately at market price for profit or you can choose to hold the contract for longer if you expect the stock price to rise even more! If you sell it immediately, your profit is ($24 market price x 100 shares) – ($20 buy price x 100 shares) – ($200 initial investments) = $200
Note that if the market price is at $21, you are in fact still at a loss. This is because you have to factor in the initial investment of $200. Therefore, the breakeven point for this investment would be $22.
In reality, most traders choose to close their position instead of exercising because of bigger profit margins and also because they want to cash in the profits as fast as possible.
How To Trade Options
Why Trade Options?
Calls and Puts
Types of Options Orders
Valuation of Options
Choosing The Best Options Broker
Leverage in Trading Options
Mistakes Options Traders Make