33 Options Explained
Welcome to the Financially Free Journey podcast where I aim to dispel the seemingly complex topic of personal finances, money management, debt, savings, investing and even retirement. This podcast is designed to help you feel empowered by increasing your knowledge so you can flex your money muscles!
Wow- what a week… I have been picking up recording and putting out more content for all of you in the last couple weeks. I have done several episodes in a row specifically about in investing because I posted on social media and asked for the top money questions my followers had. I received over 300 questions related to investing so I have been trying to answer those questions and answer as many of you as I can!
Just know that I really appreciate your support and I love answering your questions. Another way you can submit questions is by emailing the podcast at firstname.lastname@example.org…I will make sure to link the podcasts email in the show notes so you all can access it easy.
And as always, you know I would love for you to go rate and review the podcast, it really helps the show out!
Ok so the last few episodes were really broad stock market and investing based. Today I am going to get into some specific concepts around options.
Lets first cover what options are exactly. You may have heard terms like calls, puts, premiums, strike prices, bear, bullish, spreads or straddles. These are all option terms and honestly, when I was first learning about options I felt like I was learning a new language. The terms and jargon used when it comes to options is just one of the complex aspects.
Options can help you as an investor manage your risk and options can be used to manage risk at any level of investor. I will do my best during this episode to explain options as simply as I can so you can walk away from this episode with a basic understanding of the concept and see if options are right for you!
Ok, so what are options exactly? An option is a contract to buy or sell stock at a pre-negotiated price and by a certain date. Each option contract typically represents 100 shares of a stock.
Similar to how you can buy a stock if you think the price will go up or short a stock if you think the price will go down, an option allows you to bet on which direction you think the price of a stock will go…but instead of buying or shorting the asset outright, for example buying 100 shares of a stock, when you buy an option you are buying a contract that will allow you to buy those 100 shares for the price that is pre-determined on the contract. Good thing to note here is that when you buy an option contract it doesn’t require you to buy the 100 shares but gives you the option to exercise the contract and buy the shares.
When you buy an option it also doesn’t obligate you to buy gives you the option to buy or sell shares of a stock at the agreed upon price, you can also sell the contract to another investor or let the option expire and walk away from the option all together.
Now that we have gone over WHAT options are, let’s now touch on why people use options. The main advantages to using options is first of all, you don’t have to completely buy the asset, meaning, you don’t have to front the cash to buy 100 shares of a stock and hope that you made a good buy. You can simply buy the contract for the premium price and if the stock doesn’t move in the direction you had hoped, you are just out the premium versus the price of 100 share of stock.
Another thing that options does is it allows you as the investor time to see how things play out in the market. Also, as I had mentioned earlier, an option protects investors from downside risk, locks in the price and doesn’t obligate you to actually buy the asset.
For example, if there is a company that you have been following and you think their stock price is going to rise, a call option gives you the right to purchase shares at a specific price at a pre-determined later date. If your prediction was correct, you get to buy the stock for less than it is selling for on the open market. On the flip side, if your prediction doesn’t pan out, your lose is limited to the price you paid for the contract or aka the premium.
Another popular scenario with options is protecting stock positions you already own. Lets just say you own a stock and your worried about the short term volatility wiping out your investment gains. To hedge against losses, you can buy a put option that gives you the right to sell your stock at a predetermined price at a later date. In the situation, lets say the price of the stock does unfortunately tank, the option limits your losses and the gains from selling help offset some of the overall lose on the stock position.
Selling calls is typically done against stocks that you already own and you are attempting to create income from the position by profiting the premium aka contract price that was paid to you. Let me give you a specific example of trading to give you a better visual as to how this works exactly:
Let’s say that you own 1,000 shares of Walmart and those shares are trading at $125. You sell 10 calls at a strike price of $150 for $2 each. Each option contract represents 100 shares so the sale nets you $2,000. Basically, if Walmart in this example goes above $150, you must sell the position or buy back the options. If Walmart does not climb above $150 by the expiration date on the option contract, you can hold onto the shares that you own and pocket the $2,000 that was paid to you for the contract. Owning the shares of the stock takes the risk away from this strategy.
[WE ARE GOING TO TAKE A QUICK BRAKE AND WHEN WE COME BACK WE ARE GOING TO TALK ABOUT HOW YOU GET STARTED WHEN IT COMES TO TRADING OPTIONS SO DON’T GO ANYWHERE]
Ok now let’s talk about HOW you start trading options.
In order to trade options, you are going to need a broker and a brokerage account. It’s important to look into the costs associated with having a brokerage account as well as details like minimum capital required to start trading options at that firm.
A couple of firms that have received good reviews online for trading options are:
These firms don’t require a large capital balance in your brokerage account prior to starting to trade options. I have provided this information in the show notes as well so you can go back later and look into these different firms and what will work best for you.
Now that we have reviewed the WHAT and HOW when it comes to options, I am going to go ahead and answer some of the questions you all submitted about options.
#1: Why is option trading considered “risky”?
This is a great question. As with all investing, options are risky when you do not know what your doing. A lot of people will jump in and start trading options without really knowing the basics and can find themselves in a real bind. Depending on the type of options you are trading, you can find yourself in a situation where you have UNLIMITED LOSS potential. Yes, you heard me correctly. You can be in a situation where the amount of money you lose is unlimited.
Selling what’s referred to as “naked calls” creates unlimited liability.
Risk is really increased when you start getting into something you don’t really understand. When buying stock, it’s more straight forward- you buy the stock, hold into it and sell it when you have seen the price move in a favorable direction. On the other hand, options have more moving parts and you have to be an active, involved investor to be successful with trading options.
#2: When trading options, do I have to wait till the expiration date to sell if my contract is already profitable or in the red?
This is a very common misconception when it comes to trading options. A lot of people think you have to hold the option contract until the expiration date before you do anything which isn’t true.
So for example, lets say you have a 6 month option contract but its already profitable after 1 month, what do you do? You can take the profit on the contract at any point in time during the duration of the contract. This is another example as to why you have to be an active and involved investor when it comes to trading options.
#3: What is the maximum amount of money I can lose when I buy options?
When it comes to BUYING options, you can never lose more than you paid for the contract, aka the premium. Lets say your bullish on a stock, buy the contract but the stock ends up bearish, you will not lose more money than the contract price. On the flip side, let’s say you bought the stock outright in this same situation…well your risk exposure is a lot greater, right?
Lets just quickly recap what we went over today..we talked about what options are exactly, how to start trading options and answered a few of the top options questions that have been submitted to me. If you have any questions about options that you would like to have answered, just send them to the shows email which is @email@example.com.
And as always, go rate and review the show and follow us on Instagram @financiallyfreejourney where I post daily tips and motivation to help you on your financially free journey. Until next time!