How to Trade Options
Apr 12, 2012, 2:26 pm EDT | By Beth Gaston Moon. InvestorPlace Contributor
With any options strategy you implement, you can make the holding as big or small as you like. It’s really up to you, your investment goals, and your risk tolerance.
It’s also important to remember that when you purchase options. the price quoted will be per share and not per contract. You will need to do the simple calculation below to determine the actual price.
When you purchase an options contract. you pay a premium for the privilege that goes along with holding that contract; you’re not paying for the full value of a stock. For instance, if you wanted to commit some of your investment capital to Google (GOOG), you’d be paying in the neighborhood of $625 a share. Buy 500 shares and that investment is the equivalent of a piece of real estate!
We’re not saying you can’t play the market that way, but it isn’t the only way and it might not be the BEST way. And it’s certainly not the least expensive way. But there’s a way to play Google — and thousands of other stocks — with a much smaller initial investment AND with the potential return that can equal and oftentimes even SURPASS (on a percentage basis) what the traditional stock investor might experience. Options can open the doors to a wider variety of equities and ETFs for lower-capitalized investors that might not otherwise be able to have triple-digit stocks in their portfolios.
Options At the Money, In the Money, Out of the Money
When gauging the price of the options, these three terms — at the money, in the money and out of the money — will come into play. You can
tell which options are which simply by looking at their strike prices (and the price of the underlying stock).
An option is “at the money” if the strike price is the same as the market price of the underlying security. For example, if Google is trading for $620 and you hold a January 620 option, you are “at the money” (whether you own a call or a put).
A call option is “in the money” when the strike price is below the market price of the underlying stock. For a put option, it’s the opposite; a put is “in the money” when the strike price is above the market price of the underlying stock.
For example, if you buy Google January 620 call options now and two weeks later Google is trading for $623.00, then you are in the money by $3.00. It’s simple math: $623.00 stock price minus the $620 strike price equals $3.00. Similarly, a January 625 put would be in the money by $2.00, taking the difference between the strike price and the stock price.
A call is “out of the money” when an option’s strike price is above the market price of the underlying stock. Again, for a put option, it would be the opposite, or when the strike price is below the market price of the underlying stock.
If you had bought the January 620 call options a few weeks ago and now Google is trading for $618.10, then you would be out of the money by $1.90 ($618.10 – $620 = -$1.90). The January 615 put, meanwhile, would be out of the money by $3.10 ($618.10 – $615 = $3.10).
Take a look at the chart below for more examples:
Now let’s talk about how an option’s price is determined.