How do options work?

If you’re new to trading, you’ve probably come across a lot of words that don’t seem to make a lot of sense. Are you interested in options? If so, you’re in luck. RWIBrokers.com has put together this article to help you understand how options work, options examples and more. 

Options Defined 

If you’re trying to figure out if trading options is right for you, you should first understand what options are. An options explanation can turn into something complicated very quickly, so let’s simplify. As with most investing products, an option is a contract. It is exactly how it sounds. This specific type of contract gives you the right to buy or sell an asset at a specific price by a specific date. It’s essentially a contract that is giving you the option to follow through. 

How Do Options Work? 

Again, as with most investment products, you’re going to want to determine the probability of the future prices of certain assets. You can assume that the more likely it is that something will happen, the more expensive a related option would be. 

The basic steps of trading an option are:

• Identify the asset you want to buy or sell.
• Enter a contract to determine a premium, cost and expiration date.
• If you’re the buyer, you pay the premium cost.
• Monitor the asset and decide whether you want to follow through on the contract to buy or sell. 

Here are some key factors to understand about options:

• Options are typically sold in increments of 100. So you should be sure to multiply the premium of your contract by 100 to get the total cost of your option. Also multipliers of 10, 1000 and even 10000 occur, please check the financial information of a option before you buy the product so you won’t be surprised.
  
• The more time you have in your contract, the more valuable your option could be. This is because the more time there is, the more chance there is for the price to change.
• If you’re the buyer of an option, you are not obligated to go through with buying. However, you will not get the premium back if you choose not to follow through. The only risk to entering the options contract is losing the amount you spent on the premium. So be sure you’re comfortable with losing the cost of your premium if it comes to that.
• On the other hand, sellers may be required to make good on the options contract to sell. Sellers have greater risk and can lose much more than the cost of the options contract premium. 

Types of Options

If you want to trade options, you’ll need to understand the different types of options. Even though the options we talk about below seem like they’re related to geography, understand that geography has nothing to do with it. 

American options: These options can be exercised at any time between the date you purchase your option and the expiration date that is set on your option. This option type typically has a higher premium since it is allowing you to exercise your option at any time.

European options: Unlike American options, European options can only be exercised as the expiration date gets closer. 

Exotic options: This type of option offers more variation. The payment structure and expiration dates can be different than the American or European options. If you’re looking for a more customizable option, this is what you’ll probably want to look for. 

You’ll also need to understand the difference between call and put options:

• A call option gives you the right to buy a stock. 
• A put option gives you the right to sell a stock. 

Call Option Example 

You might be asking “how do call options work?” Let’s say there’s a new business opening up in your town. It seems like it’s going to be a profitable business with a lot of potential. You’re considering offering to buy the business with the hopes of getting in at the start of something big. Of course, this is a risk on your part. 

Even though the business shows a lot of potential, there’s no way to know how things will turn out. This is where call options would benefit you. If you could buy a call option on the business, you could offer to purchase the business at $500,000 sometime in the next 5 years. 

Now, the current owner of the business would want to know you’re serious. So imagine that they would require a down payment of $50,000. If this were an options contract, that down payment would be referred to as the premium. The premium is the price of the option contract. 

Now let’s fast forward 2 years. The business is booming, and it is now worth closer to $1 million. You decide at this point that you want to go ahead and exercise your option to purchase the business for $500,000. You can do this even though it is less than the current value of the business because you locked in the price with your down payment. 

Put Option Example 

You might want to have an option to sell your asset at a set price if you fear that your asset’s worth might plummet. This will allow you to protect yourself from losing a larger amount of money. 

So how do put options work? Let’s say that you fear that your stock in Apple is about to become much less valuable. So you decide to take out the option to sell it, just in case. It’s currently trading at $3,000, so you decide to take out the option to sell it at $2,700 at any time in the next 3 years. 

You’ll have to pay the premium, let’s say that’s $300 in this case. So if you decide not to sell, you’ll lose this $300 but you’ve probably gained much more by keeping your stock. If you’re right and the stock plummets, you can sell it for the $2,700 you locked in, even if it’s only selling at $2,200 when you sell it.

Best Options Brokers 

If you want to trade options, you’re going to need to find a broker. There are lots of brokers out there, but not all of them have the capability to trade options. Even if they do, you’ll want to consider if the trading platform is geared specifically for trading options.