Have you ever been taken aback by the sheer amount of jargon used to describe options trading? You're not alone. That's why explaining options simply is so important.
Other than learning the terminology, you'll want to understand the fundamentals of options trading in the simplest terms.
What is an options contract—in the simplest terms?
Long story short, an options contract is a financial tool.
This tool allows you to buy or sell an individual stock. So, how is it different from regular trading?
In regular trading, you must pay market value at the time the transaction goes through. That's why investors might put a "stop-loss" on their order, to ensure that their trade doesn't go over a certain price. However, in options trading, you get the chance (i.e. the "option") to buy or sell a stock at a particular time and price.
Of course, that price isn't set in stone. An options contract holder can't predict or manipulate a stock on their own. The stock might not reach the price that you predicted. If it doesn't, your contract can expire worthless and you lose the premium you paid for it. That's why options trading is largely considered to be riskier than regular trading.
Note: Options contracts aren't always dependent on stocks. You can also set up contracts based on cryptocurrency or gold and other commodities. For our purposes, we'll stick with stocks.
The options trading process, step by step
Let's go through the basics, from when you buy the contract to when you exercise it:
- Set the strike price for the options contract. The strike price is the price you're aiming for by the option's expiration date, which can be higher or lower than the current market value. If you're aiming higher, that's a call option. If you're aiming lower, that's a put option.
- Set your expiration date for the contract, which is when you hope the stock will hit the strike price.
- You pay a premium for the contract. Brokerages require you to buy at least 100 contracts at a premium of $0.50 each.
- In the U.S., you can exercise your contract at any point up until the expiration date if it reaches the strike price. Once you exercise it, you sell it to another options trader for the cost of the premium plus the stocks.
- If the stock doesn't reach the strike price before the expiration date, you might wind up with a worthless contract. In this case, you're out of the premium and the value of the stock.
How to know if you're ready to trade options
Understanding options trading in simple terms is the first step, but it isn't the be-all-end-all. Responsible brokerages require investors to take a quiz to prove their knowledge of options trading. The process carries more nuance and, ultimately, more risk than traditional buying and selling of stocks. It can be a lucrative financial instrument, but it isn't one to mess around with if you don't know what you're doing.
Consider using a brokerage that requires a quiz before you start options trading (like Schwab or E-Trade). Let the experts serve as a gatekeeper for your own fiscal wellbeing.