Option trading provides many advantages over other investment vehicles. Leverage, limited risk, insurance, profiting in bear markets, each way betting or market going nowhere are only a few. But let's look at a couple:
One thing to note before we go on is that the buyer of an options contract pays an amount, known as the premium, to the option seller. An option seller is also known as the writer of the option. The option premium is simply the amount paid for the option - but there is more about this under the Pricing link.
When you buy an option contract from an option seller, you aren't actually buying anything - no asset is actually transferred until the buyer chooses to exercise. It is just an agreement where the buyer has the option to decide if the transfer is to take place. But the option contracts value is determined by the underlying asset - Microsoft Shares as an example.
Options give the buyer the right to buy a number of shares of the underlying instrument from the option seller. The amount of shares (or futures contracts) to buy is determined by;
The contract multiplier (also called contract size) is different for most classes of options and is determined by each exchange. In the US, the contract size for options on shares is 100.
This means that every 1 option contract gives buyer the right to buy 100 shares from the option seller.
So, if you buy 10 IBM option contracts, it means that you have the right to buy 1,000 IBM shares at expiration if the price is right (10 x 100).
Note: In other countries such as Australia, the contract multiplier for stock options is 1,000, which means the every option contract you buy entitles you to 1,000 underlying share contracts. So pay attention to the contract specs before you begin option trading.
This also means that the price of the option is also multiplied by the contract multiplier. For example, say in the above you purchased 10 options contracts that were quoted in the marketplace for 15c, then you would actually pay the seller $150.
This is a crucial concept to understand. If you go out and buy 5 IBM share options for 15c that have a Strike Price of $25, then you will;
In this case, your initial investment of $75 has given you $12,500 exposure in the underlying security.
Option trading is very attractive for the small investor as it gives him/her the opportunity to trade a very large exposure whilst only outlaying a small amount of capital.
Say you bought a $25 call option for $1 while the underlying shares were trading at $26. If the market rallies to $27 the option must at least be worth $2 because you can exercise your right at $25. So, even though the shares only went up 3.8% you DOUBLED your money because you can now sell back the option for $2.
Penny stocks are also known to carry this type of risk/reward profile. Penny Stocks are companies that have very low share prices. You can buy some stocks for as little as 10c. It is much more common for a penny stock to trade from 10c to 20c than it is for Microsoft to trade from $25 to $50!
For this reason penny stock trading is becoming very lucrative for online speculators. They can still trade the stocks outright as well as making massive returns if they are correct about their view on market direction.
The only drawback with penny stocks is trying to pick which stocks to buy. I'm not that familiar with trading penny stocks, however, I know of a great site that provides stock picks for penny stocks every two weeks - <penny stock affiliate link>. They have a free trial, so you can see for yourself whether penny stock trading is for you or not.
Penny stocks can be risky though - there's a reason why they're so cheap, nobody wants them! So, be careful to act on the right information.
One of the biggest advantages option trading has over outright stock trading is to be able to take a view on market direction with limited risk while at the same time having unlimited profit potential. This is because option buyers have the right, not the obligation, to exercise the contract for the underlying at the exercise price. If the price is not right at the time of expiration, the buyer will forfeit his/her right and simply let the contract expire worthless. Let me give you an illustration.
Remember our initial example of Peter buying a Microsoft Call option? Here are the details of that trade provided with the appropriate jargon;
Underlying: MSFT
Type: Call Option
Position: Long (i.e. bought the contract)
Strike Price: $25
Expiry Date: 25th May
At the time of the trade, Microsoft shares (the Underlying) were trading around $30. The Call option contract had been valued and was trading at $6.5 - known as the premium, but more on this under option pricing models.
So, from the above information we can conclude that after the 25th May, if Microsoft is trading above $31.50 we can make a profit on this.
Why $31.50? Because we paid $6.50 for the right to have this option in the form of a premium to the option seller. This means we must consider this in our profit estimate. Therefore we add the option premium to the strike price to determine our break even point.
If Microsoft shares are trading at $40 by the 25th May, then we will elect to exercise our right to Call the shares from the option seller. Then we will be assigned Microsoft shares at the exercise price of $25, which is the same as if we actually bought Microsoft shares for $25.
Note: If we exercise our right and take delivery of the shares, this means that we will have to pay the full amount for the shares. So, the number of option contracts bought multiplied by the contract size multiplied by the exercise price. If you are planning to hold onto option contracts until expiry and take delivery, make sure you have the cash!
But, they are now trading at $40 at the stock exchange! So, you have Microsoft shares in your trading account with a purchase value of $25, yet they are trading at $40. So, you can sell them at $40 and make $8.50 per share.
Why $8.50? Remember the premium we paid? We have to consider that with our profit estimate.
Think about what happens as the underlying price continues to rise. You continue to make more and more money once the stock price has exceeded the strike price.
But what about the downside risk?
Let's imagine at expiration Microsoft shares are trading below our exercise price of $25 at, say, $20. Will we decide to exercise our right and take delivery of the shares and pay $25 per share? No way, because they're only worth $20.
So, we will just do nothing and let the option contract expire worthless.
What have we lost though? We lose the premium that we paid to the seller, which in this example was $6.5. That's it. A lot less than if the stock plummeted and we lost our entire investment.
What about if there is a stock market crash and Microsoft Shares are trading at $5 at the time of expiration? The same as if the shares are trading at $20 - nothing. We just let the option contract expire worthless and lose our premium - $6.5.
Can you see now how this type of strategy gives you the best of both worlds - both limiting your risk and at the same time leaving you open to make unlimited profit if the market rallies?
Not all option strategies have this payoff benefit. Only if you are buying options can you limit your risk. For option sellers, this is the reverse - they have unlimited risk with limited profit potential.
So, why would anybody want to sell options? Because options are a decaying asset, which you can read more about under the Time Decay section.
Another reason investors may use options is for portfolio insurance. Option contracts can give the risk averse investor a method to protect his/her downside risk in the event of a stock market crash.
One example of this is called a Protective Put. You can read more about option trading strategies under the Strategies link.
PeterOctober 6th, 2014 at 5:33pm
Hi Ken,
No. Once you sell the option back to the market your position is now flat and you have no option nor obligation.
You only have the obligation to sell stock when your position in a call option is "short".
kenOctober 4th, 2014 at 1:24pm
If I purchased a call option and decided to sell it back to the market for a profit, am I now obligated to sell stock to whomever bought back the call option from me should they choose to exercise it?
PeterJuly 21st, 2014 at 6:23pm
Hi Kenny,
Yes, you can exercise the option as it is in-the-money. Or, you can sell it back to the market just prior to expiration; if the stock is trading at $31 then the option will be trading at least $6.
KennyJuly 21st, 2014 at 4:25pm
In your above example, If
Underlying: MSFT
Type: Call Option
Position: Long (i.e. bought the contract)
Strike Price: $25
Expiry Date: 25th May
MSFT shares (the Underlying): $30
Call option Contract: $6.5
If the Price closes on expiration day at $31.00, can I still exercise my option to reduce losing the entire option amount??
$31.0 - [$6.5 + $25.0] = -0.5 or (-$0.5 / $30.0 =- 1.167%) as opposed to letting the contract expire worthless and losing compared to an equity investment of (-$6.5 / $30.0 =- 21.67%)??
CharmineJune 13th, 2012 at 8:46am
Thank you so much for your explanation. It helped me a lot.
PeterMay 23rd, 2012 at 6:33pm
Hi Mike,
The strike price won't change: it is fixed and part of the contract. If the stock price increases, however, and you would like to profit without exercising then you can simply close out the position by selling the same number of contracts back to the market - just like you would do if you were long a stock position and wanted to close it by selling.
MikeMay 23rd, 2012 at 3:12am
Hi Peter,
If I will use TDA for options trading and wants to buy a call option but doesn't want to exercise it due to limited fund, what should i do to sell it and make profit if the strike price increases?
PeterMay 23rd, 2012 at 1:17am
Buying/selling to open means establishing a new position i.e you were flat before placing this order.
Buying/selling to close means that you have a position (either long/short) and the order that you are placing will offset your position to make you flat.
These are terms that are often used in platforms offered by brokers to clients who trade electronically.
MikeMay 22nd, 2012 at 11:55pm
Thanks Peter.
What do you mean by buy to open, buy to close, sell to open/close?
PeterMay 22nd, 2012 at 10:42pm
Hi Mike,
No need to be sorry, it's a fair question.
The answer is $680: Contracts x Contract Size (or Multiplier) x Market Price.
The standard contract size for options on stocks is 100.
MikeMay 22nd, 2012 at 10:40pm
Im still confused and sorry for asking these questions.
Example money in your account: $500
Say you want to buy 10 AAPL at 565 weekly calls 0.68. How much money do you need in order to buy 10 calls? is it $6.8 (10 x 0.68)
PeterApril 19th, 2012 at 8:34pm
Yes, you can certainly sell it back in the market to close it out. The price, however, will be USD 20 (the market price) not the strike price of USD 10.
NingApril 19th, 2012 at 7:43pm
Thank you Peter! Suppose the strike price is Usd10 and maket price is Usd20, could i sell the optiton at Usd10 to other buyers directly?
PeterApril 19th, 2012 at 6:31pm
Hi Ning,
No, the contract size is standard and set by the exchange. If you don't have the funds to exercise you can simply close out the position prior to expiration to realize your profits.
NingApril 19th, 2012 at 4:09pm
Hi Peter,
since you mentioned the contract size is 100 shares, could i buy only 50 shares when executing the call option contact supposedly i am short of money?
PeterFebruary 29th, 2012 at 6:45pm
If an option is trading at its' intrinsic value then it will be in-the-money and have a delta of 1. This means that for every 1 point move the stock makes the option will gain/lose 1 point.
Say the stock is trading at $25 and you buy a $23 call option for $2 (at intrinsic value). If the stock trades up to $26 your option will now be worth $3.
So, for a 4% move in the stock you've made a 50% return on your option position.
That is the only reason I can see for buying an in-the-money option close to expiration: leverage on your investment if you're right about the stock move.
MarcusFebruary 29th, 2012 at 5:11pm
Peter,
What's the incentive on buying a contract at it's intrinsic value? I mean if a contract is about to expire within a few days, a person can:
A) Sell the contract
B) Buy/Sell the shares at the strike price.
Why do people buy contracts close to the expiration when they could just buy 100 shares of that stock out right?
PeterFebruary 28th, 2012 at 6:49pm
No worries, glad you like the site!
MarcusFebruary 28th, 2012 at 1:07pm
Very useful website.
I initially couldn't figure out why EVERYONE doesn't trade options. I thought the premium (say $5) was only $5 for 100 shares of stock. (Who wouldn't pay $5 for the option to control 100 shares of a company??) The $5 is actually per share, so your risk is $500 which makes more sense.
Anyways just wanted to say thanks for clearing that up for me and hope this helps other new investors.
PeterJanuary 10th, 2012 at 3:44pm
Hi Scarlett,
No, you don't have to own the stock before trading in options.
ScarlettJanuary 10th, 2012 at 7:39am
Hi, the information is very useful. Thank you for this. I have one question: Do I have to own certain stock before I can buy the contract of Put Option for that stock?
PeterDecember 28th, 2011 at 4:00pm
Hi Patrick, yes, you can simply sell out of the options prior to expiration if you do not want to exercise and take delivery of the stock.
By the time the option reaches expiration the option will be trading at its' intrinsic value and hence there shouldn't be any difference in profits between the two scenarios.
PatrickDecember 27th, 2011 at 11:59pm
Hi. I know this question has been asked several times, but I'm not sure I've read a definitive enough answer to feel comfortable pulling the trigger on a call option buy. I want to purchase a boatload of call option contracts but will not have the cash to exercise the option at expiration. Do I just sell prior to expiration to avoid this? And is there any difference in profit between the two scenarios (selling option before expiration and exercising option at expiration)? Thanks!
PeterNovember 13th, 2011 at 11:32pm
Hi Jon,
Yes, you are correct with that example - your return is 9,900%.
At that point you can walk away with no more obligation. Your sell order on the option just closes the original long (purchase) position. Much like if you buy 100 shares and then go and sell 100 shares. After the sell you will have 0 shares. You would only have exercise risk if you sold the option without having an open long position first.
When you sell back the option, another participant (the buyer) will be on the other side.
Let me know if anything is unclear.
JonNovember 12th, 2011 at 3:28am
Peter I have a bunch of questions that I just can't seem to find a clear answer for.
Let's say I buy 1 (American) call option with a $10 strike for 10 cents with no intention of ever exercising it. The underlying stock is announced to be bought for $20 and it immediatley goes from $8 to $20. The call option I bought is now worth $9.90 (after subtracting my premium)). This means I just made a profit of 99X my original investment, like a 9,900% gain. What I orginally paid for the option was $10 (.10x100). I sell the option for a profit of $990 (20-10.10=9.90, 9.90*100=990).
Can I just walk away after that with my profit?
Doesn't my sale of the call option that I previously bought count as a closing transfer and its not possible for someone to exercise the call option I just sold and force me to deliver?
I believe that just selling a call option is a type of short position so you would have the obligation to deliver if the buyer exercised, but it's not a short position when I sell an option that I already bought instead of just selling a call option outright?
I just want to make sure that if I sell a call option that I previously bought for a profit, I have no obligations whatsoever and can just leave the market with my profit. Since I wouldn't have enough money to buy hundreds or thousands of shares outright, but I have enough to buy options and I believe many people sell options that they couln't cover if exercised. And i'm also unclear on whether my call option gets bought by someone or just ceases to exist and the open interest will decrease?
PeterAugust 9th, 2011 at 5:56pm
Yes, you will make a loss on the shares as the buyer won't exercise unless the stock is higher than the strike price. However, it doesn't mean that you will have a total loss as you still have the premium received when you sold the option, which you will offset against the loss on the shares.
kanchanAugust 9th, 2011 at 9:53am
So that will be a loss to me right? Because I don't have the shares ...
PeterAugust 7th, 2011 at 7:36am
If it's a call option then you will have to sell the stock at the strike price to the option buyer. If it's a call option then you will have to buy the stock at the strike price from the option buyer.
kanchanAugust 6th, 2011 at 7:52am
And what if the person to whom I am selling the option exercises the option?
PeterJuly 26th, 2011 at 6:17pm
No, you don't have to buy it back - you can leave the position open until the expiration date. If the call option is out-of-the money then, yes, you will just keep the premium as your profit. However, if the option is in-the-money then you will be required to sell the stock at the strike price (but still keeping the premium already received).
kanchanJuly 26th, 2011 at 12:46pm
Hi,
If I sell a call option, do I have to buy it back in the market? Or can I wait utill it is expired and have the premium as my profit?
PriteshJune 3rd, 2010 at 12:27am
Fundamentally...
There is only 1 reason to BUY options:
It provides insurance...
(If you are thinking of making unlimited profits from options, then you have to very accurate about where the price of the underlying security will move, which is difficult; unless you are a real EXPERT)
There is only 1 reason to SELL options:
It's value depreciates over time.
(The above line is critical, when it comes to making option trading strategies.)
PeterMarch 21st, 2010 at 7:14pm
The $5 is multiplied by 100 at the time you purchase the option. So when you first buy the option it will cost you $500.
On expiration day, you can do either;
a) sell the option back in the option market, which should be trading around $10. This means you will make $500 in profit.
b) exercise the option. This means you will have to take delivery of the stock at the strike price of $20 for a total cost of $2,000 and then you can sell back the stock in the market at the market price of $30. You will receive $3,000 for selling the stock, subtract the $2,000 you paid for the stock and also the $500 you paid for the option means a profit of $500.
ShashankMarch 20th, 2010 at 12:16pm
Say I decide to buy a single call option with a strike price of $20 and a premium of $5. At the time of expiration the stock is trading at $30. Is the premium ($5) going to be multiplied by 100 if I decide to exercise the option, or will it just be $5? What would my profit be if I decided to exercise the option?
PeterDecember 28th, 2009 at 4:01am
Hi Chris, difficult to know for sure as it depends on the delta of both options and also how the implied volatility of the options changes as the stock has rallied. The delta on the $2.5 strike is of course higher but so is the premium so the net return may on fact be lower than the gain on the $5 strike. You are also, as you say, taking on more risk with the $2.5 strike than the $5 strike. So if you expect a substantial move in the stock then the $5 strike might be the better alternative.
You could exercise, sure, but only if you want to continue being long the stock. If you just want to profit from the option you can sell it before it expires in the open market without having to take delivery of the stock.
ChrisDecember 25th, 2009 at 12:21am
Say a stock is currently $4.5 and I'm trying to decide between two call options for this stock. Option (A) has a premium of $2.25 with a strike of $2.5. Option (B) has a premium of $0.25 with a strike of $5. Now tell me if the following sentence is correct please. I can make more profit off of Option (A) because I will start to turn a profit when the stock increases above $4.75 (rather than at $5.25 for Option (B)) but I will be taking on much more risk b/c of the $225 premium (assuming I bought one contract) if the price drops below $2.5.
Another question from the last example: If I chose Option (A) and on expiration day the stock has fallen to $4.00, should I now exercise the option to buy 100 shares for $2.5 and then immediately sell those 100 shares for $4 each? This way I make $150 from exercising the option which will help offset the money lost from the premium. So in the end, I only end up losing $75 ($225-150=75) from purchasing option (A).
Thanks and sorry if this is explained somewhere else and I overlooked it.
PeterOctober 4th, 2009 at 6:33am
Hi Ben,
If the stock is trading at $11 at the expiration date then you have no buyers to sell to as the option will be worthless and you will still incur the $2 loss. If you don't have enough cash to exercise the option then you just lose the $2, however, in this case you would not exercise even if you did have the money because you would exercise to sell the stock at the strike of $10 when the stock is trading at $11 and lose an extra $1 on top of the $2 you have given away by buying the option.
Hope this makes sense.
BenOctober 2nd, 2009 at 2:58pm
Hi Admin,
Lets say I buy an option for a company A with a strike price of $10, the premium cost $2 and the current market price is at $11. On the expiration date, the market price is still at $11. If I let it expired, I will lose $2. What do I need to do to minimize the lost? Do I have to exercise the contract and sell back at the market price so the lost will only be $1? Can I sell back the option right on the expiration date? Is anyone will buy the option with the expiration date on the same day? What happen if on the expiration date I don't have enough money to exercise the contract? what is the best options for me to do?
PeterJuly 15th, 2009 at 7:50am
Exactly. Either that or the trader might be selling the call together with another option as part of an option strategy.
Jerry KelleherJuly 15th, 2009 at 6:00am
Why would someone sell a call with a strike price of $25 when the un derlying stock is trading at $26? Is it because the price of the option would exceed the difference between the stock and the strike prices?
PeterApril 26th, 2009 at 6:51pm
Hi Dan,
Yes, the proceeds from the sale go back into your account. If the proceeds from the sale were more than what you spent on the option, then it is a profit.
danApril 25th, 2009 at 1:23pm
I have an call option on a stock thats 20 @ share. the stock goes to 30@share. I sell the option and the difference in price is put in to my account? Is that correct?
PeterMarch 25th, 2009 at 4:52am
Hi Doug,
Yep, you can get in and out of your position any time you like up until expiration. About your second question...it depends on the stock and how far out the expiration date of the option is...longer dated an option the less volume there will be. However, most optionable stocks have option market makers who are there to provide liquidity so you won't have a hard time getting out of a position...especially if it is close to the expiration date.
DougMarch 24th, 2009 at 3:35pm
Hello I have a couple questions. Lets say buy a call option for $1 and the stock is trading at $21 at that time. Right before the expiration date the stock is trading at $30. I want to take advantage of this gain but I don't have enough money to pay $2100. Can I just sell the option before the expiration date? And if I can, I see there isn't much volume in options so is it easy to get in and out like high volume stocks?
AdminMarch 24th, 2009 at 4:00am
The price is quoted in the market at $6.50. However, each contract represents 100 shares of the underlying asset. When the trade actually takes place each 1 unit you purchase will actually cost you $650.
framonfMarch 23rd, 2009 at 10:55am
Hello Admin,
i have doubts on this: the premium we pay on the option contract ( in our example amount of $6.50) is considered to be valued for 100 shares or each premium price $6.50 will be summed times 100 shares = $650 ?
AdminMarch 16th, 2009 at 5:33am
Yep, you can sell back at any time provided there is a market there - i.e another buyer to sell to. You may not necessarily "cash in" as the price of the option at day 40 may be less than your original purchase price.
MikeMarch 10th, 2009 at 1:49pm
Sorry if this was asked before but am I right?
If I bought a call option contract on Dell with a strike of $20, today, and time to expiry of 120 days and the stock price is $9. Say after 40 days the stock price rises to $15 (still below strike), can I cash in on day 40? (i.e. sell back that call option)? If yes, does that hold for a put contract too?
AdminMarch 5th, 2009 at 3:37am
Hi Paul,
That's right. You can trade in and out of options before expiration and take advantage of the leverage options provide, however, if you decide to exercise and take delivery of the underlying asset then you will need enough in your account to cover purchasing the stock.
Paul J SnyderMarch 1st, 2009 at 6:22pm
I have never traded options but would like to start. My question is this. If you purchase on option and decide to excercise the option, do you have to purchase the shares of stock in the open market? If so, it seems like you would have to have quite a bit of money in your trading account.
AdminJanuary 29th, 2009 at 5:01am
Hi Sean,
If you exercise the option then you are assigned stock at a purchase price of $25 (the strike price). If the stock is trading at $31.50 and you sell the stock that you now own, then your profit is $6.50. But you've already spent $6.50 buying the option, so net you've broken even.
Make sense?
SeanJanuary 28th, 2009 at 11:53pm
If the $6.50 premium is for the contract, and if the underlying is trading for $31.50, can't we exercise at $25 and gain $6.50 X 100, which is 99 times more than the premium? Thus, our break even point is actually when the underlying is trading for $25.065... Am I missing something?
AdminJanuary 21st, 2009 at 3:50am
Per option contract.
GranadinoJanuary 20th, 2009 at 6:30pm
Is the premium (In this case $6.50) calculated per share or per option contract?
AdminDecember 8th, 2008 at 3:25am
Hi Yash,
Yes, if you're long a call option that is in the money and allow it to expire, your broker will automatically exercise your option into shares provided you have the funds in your account.
YashNovember 23rd, 2008 at 8:10am
In case of fall in stock price its possible to just sit on the contract and let it expire and lose just the premium, is the applicable in the event of a climb in stock price as well or are you obliged to buy the shares beyond the expiry date.
AdminNovember 7th, 2008 at 6:00pm
Hi Alvin,
You won't be able to exercise without sufficient funds available. If you wanted to profit from a call option right before expiration you would just sell back the contract in the option market to realize the profit.
AlvinNovember 6th, 2008 at 12:04pm
How can I exercise the call option without the cash in my account? Can transfer the contract?
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