Ready to learn about options? In this article, we’ll walk you through some of the basic terminology and strategies surrounding options.
How to understand options
Ever go to book a plane ticket, but you’re not 100% sure you’re going to be able to take that trip? Prices look good, and you don’t want to risk them going up, but you’re not quite ready to put $500 down to reserve your seat, yet.
Some airlines will offer you something called a “flight hold,” which reserves your right to purchase your ticket at the current price, no matter how much the price increases in the future. Some of these holds last up to two weeks, and they cost a fraction of the price of a ticket.
Flight holds offer customers a choice: a small amount of money now to lock in a purchase price for later. Options do something similar.
For options, it’s a similar concept, but this time with stock. Buying an option gives you the right to buy or sell stock (usually 100 shares at a time) at a particular price — even if that price changes for the general public.
Options terminology
Like any new corner of the market, options come with their own set of vocabulary words. To get a sense of what everyone’s talking about when engaging with options, the following terms are a good place to start:
Call: An options contract that gives the buyer the right to buy shares at a particular price
Put: An options contract that gives the buyer the right to sell shares at a particular price
Spread: A combination of two or more options for the same stock. This can be a combination of calls, puts, or both
Strike price: The price at which the buyer of a contract can exercise their right to buy or sell shares
Premium: The price you pay for the contract
The Greeks: The measurements of change which are used to help determine the market price of an option
Out of the money: An options whose strike price that the underlying security has failed to reach
In the money: An option whose strike price has already been surpassed by the current stock price
Expiration date: The date at which the option expires
How do options work?
So, how does one actually make — or lose — money, using options?
In the simplest terms, it all depends on the direction that you expect the market to move. This will determine what kind of option you decide to purchase and, in turn, how you make (or lose) money.
The first way is through calls. A call is the right to buy shares at a particular price. When you purchase a call, you are expecting the price of the shares to go up. For example, you might buy a call with a $100 premium that reserves your right to buy shares at $10. If the price then goes up to $15, you’d make about $5 for each of your 100 shares — $500 — minus the original cost of the option ($400 profit).
The second way is through puts, which reserve your right to sell shares at a particular price. Let’s go back to our previous example. If you reserve the right to sell your shares at $10, and the price goes down to $5, you’re once again making about $5 per share — $500 — minus the original cost of the option (again, a $400 profit for a $100 option).
The last way to trade options that we’ll address is called a spread, and it involves investing in two, or more, options at once. There are many types of spreads, almost all of them with funny names (verticals, butterflies, condors, straddles, strangles, rolls, and more). Typically, you’ll buy two options, which can help protect against risk or change the likelihood of profit given various price movements.
In all these cases, your losses are (usually) limited to your premium(s)*. However, that isn’t always the case in the wider world of options trading.
What are uncovered options?
There are many places where you can trade “uncovered” options, which means that you don’t own the underlying shares or options contracts that would cover the short margin risk of holding those contract. In this case, there’s the chance that you would have to shell out a lot of money if the stock moves the wrong way — even more than the value of the equity in your account — which could lead to a “margin call”.
As you can imagine, this type of options trading can make people wary against options as a whole. The rewards can get extremely high — but so can the risks.
But that doesn’t mean that uncovered options are a bad choice for experienced traders. For some, that risk/reward factor might be what they’re looking for in an investment. However, for now, we don’t offer this type of options trading on eToro — meaning those new to options don’t need to worry about this level of risk (though all options carry some level of risk).
How to use options as a hedge
There are a lot of ways that you can use options to enhance or construct your portfolio. One of the more conservative ways is to use options as a hedge.
Despite their reputation as a high risk/high reward investment, options can actually help limit your risk. Beyond the fact that generally the most you can lose is your premium*, many people actually use options as a way to offset a loss on a stock investment.
For example, say you bought 100 shares of a stock. You think it’s going to go up (which is why you bought the shares in the first place), but you’re just not sure. You could easily buy a put which covers the same amount of shares, at a strike price not too far off from the current trading price. That way, if the price of the stock — and therefore your entire stock investment — does drop, you’ll still make some money because your put could still be profitable. In the end, you might still lose a little, but it won’t be as much as you would have lost with just the stock investment.
Conclusion
If you consider yourself a speculative trader, or you like being a little more hands-on with your portfolio, you might want to consider adding options to your investing strategy.
While options are extremely varied and can be extremely risky, eToro’s options trading experience was designed to simplify the way you trade and limit the amount you might lose*. That doesn’t mean that options are for everyone, though. In fact, you’ll need to fit a certain investor profile in order to start trading options on our platform. (You can learn more about that here.)
To explore options on eToro, click here.
*There are certain edge cases in which you may be exposed to greater loss than your initial investment. Although these instances are rare, they can occur.
This communication is for information and education purposes only and should not be taken as investment advice, a personal recommendation, or an offer of, or solicitation to buy or sell, any financial instruments.
This material has been prepared without taking into account any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or a packaged investment product are not, and should not be taken as, a reliable indicator of future results.
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