Trading Stock Options | Investing for Beginners
- Stock options allow you to buy or sell stocks at a predetermined price.
- Stock options work when an investor wishes to buy shares at a lower market price, they will buy a contract that gives them the chance to buy shares at a preset price by a specific date.
There are numerous ways to invest your money to grow your wealth, such as through the stock market, index fund, or real estate investing. However, there is also another popular option called stock options. Trading stock options is more advanced than buying and holding or day trading stocks.
What are stock options?
Stock options are when an investor is given the opportunity to buy or sell multiples of 100 of a stock at a preset price. When an investor decides to buy a stock at a predetermined price, it is called a “call option.” On the other hand, if an investor chooses to sell a stock at a preset price, it is called a “put option.”
What are the differences and similarities between a stock market and an options trading investor?
Stock market investing and options trading have many differences but, there is one main similarity: Buy low and sell high.
A day trader makes his money from buying and selling stocks at different times of the day, hoping to sell at a higher price than what they purchased the stock for. The difference in price multiplied by the large volume of shares bought helps obtain a sufficient return. On the other hand, an options trader cares about the price of a stock in a couple of days, weeks, months, or even years.
Day and options traders have different methods of determining whether or not to purchase a stock or option. For example, a day trader has a more reactive approach to buying and selling as when major news gets announced, they then decide whether they should buy or sell a stock.
On the contrary, options traders use forecasting to help them determine the stock price a couple of days in advance. Therefore, using forecasts alongside other financial statistics will help them decide whether the stock is good to buy using options and provide them with an above-average return in the long run.
American vs. European style trading options
Now that the types of stock options are covered, it’s time to distinguish the different styles of stock options. The first type that is predominantly used is “American.” The American style allows the investor to purchase or sell the stock at any time before and up to the expiration date. On the other hand, the “European” style is less common and allows the option to be exercised only on the expiration date.
Here is an example of stock options American vs. European style:
As of 12/27/2021, the price of Tesla Inc. (NASDAQ: TSLA) is $1097.71. If an investor felt that Tesla’s price was going to the moon, they might purchase 100 shares of it at a price determined by the Black Scholes Formula. The formula helps determine an accurate predetermined price for the purchase or selling of a stock.
For an investor to put in a put/call option, they must pay a premium. For this situation’s sake, let’s assume the predetermined price is $1,200 and the expiration date is 01/03/2022. Once the predetermined price has been set, alongside the expiry date, the investor has until the expiration date to exercise the option.
What happens if the investor exercises the option?
See the infographic below for a visual of the result if the investor excises the option.
What happens if the investor doesn’t exercise the stock option contract?
Suppose by 01/03/2022, the value of Tesla’s stock is $1150; at this point, the investor now has two options. The first option he has is to let the option expire, and the only money they lose is the amount used to pay for the option, which is the original $3,000. The investor’s second option is to purchase the stocks at the predetermined price.
If the investor were to do this, they would lose money as the predetermined price is higher than the current price. The amount of money lost would be $8,000 ($115,000 - $120,000 - $3,000) as the investor would purchase the shares at a higher than market price and then sell them at a lower price.
How do corporations use stock options?
The competition for large corporations is high, and to attract the best employees, these companies offer incentive stock options (ISOs) to their employees as part of their pay. These employee stock options allow the employee to purchase company shares at a discounted price. The shares to be purchased at a discounted price are not given immediately to the employee. Instead, there are stock options vesting schedules that detail when and how many shares will be available to be purchased by the employee at the predetermined price.
Image Credit: Matej Kastelic / Shutterstock.com
Furthermore, once the shares have been purchased, the employee could sell the shares immediately, for a quick profit, or they could hold onto them for a period of time in hopes of it rising in price and making long-term capital gains on their investment. If the employee chooses to sell their shares immediately or up to 12 months after purchase, the profit made from the sale of the shares will be taxed at regular income tax rates.
However, if the employee chooses to hold onto the shares for an extended amount of time, they will receive better tax treatment. For example, once these investments are held onto for at least 12 months and are two years after the grant date, which is the day these stock options are given to the employee, then whatever gains made on this investment will be subject to lower tax rates.
What platforms allow you to trade stock options?
If you wish to start trading stock options, there are four leading platforms that allow stock options while having the necessary resources to do so, such as:
- E*TRADE is ideal for investors who want to become familiar with options trading.
- TradeStation is more convenient for those investors who understand and utilize advanced financial statistics when deciding on their next investment.
- TD Ameritrade is viewed as one of the best trading platforms; investors use it due to its unique, smooth layout.
- Schwab offers some of the best resources available to both day and options traders. However, this trading platform is ideal for experienced investors.
The main benefit of stock options is that it has a high room for profit if appropriately done via mastering the craft. In addition, stock options help more seasoned traders exponentially increase their net worth in a shorter period because stocks are purchased in large quantities at discounted prices if the trade goes through.
However, it is essential to keep in mind that higher risks always need to be taken on with higher rewards. Therefore, do not practice this type of trading until you are confident in your abilities as an investor.
What are your thoughts on options trading? Share your thoughts with us in the comment section below.
Disclaimer: The information explained in the article should not be considered as investing advice. CapWay provides general information and is not a financial advisor. Always do your research before investing in any stock.
Main Image Credit: Shutterstock.com