“What is an option?” This may be a question you’ve asked yourself before. If so, options trading might be a suitable investment for you!
An options contract offers the buyer the opportunity to buy or sell the underlying asset depending on the type of contract they hold. Unlike futures, the holder is not required to purchase or sell the asset if they decide against it and make sure not to have “auto assign” turned on at expiration, or you risk automatically being assigned shares under the right circumstance. Check with your broker for specific details on this. Each contract will have a particular expiration date by which the holder must exercise their option.
Before we jump right in, a misnomer to dispel is that there aren’t options available for penny stocks. Considering the PennyStocks.com namesake, a quick search reveals that Yes, even some penny stocks have options and trading basics apply no matter the underlying asset’s price (more on this below).
Option prices can vary depending on certain factors, such as:
The strike price: A set price that a contract can be bought or sold when exercised is known as the strike price. These are the different price levels of the underlying asset.
Underlying asset: The underlying asset is the security that options are based upon.
Expiration date: This is the date until which the contract is valid. However, options only exist for a set amount of time, called an expiration cycle. An options contract will either be “in-the-money,” “at-the-money,” or “out-of-the-money,” depending on the strike price compared to the price of the underlying asset.
In-the-money for a basic Call option purchase is when the underlying asset’s price is at or above the strike price. In-the-money for a basic Put option purchase is when the underlying asset’s price is at or below the strike price. At-the-money is when the underlying asset’s price is at the nearest strike price, and out-of-the-money is when the underlying asset’s price is below (basic Call) or above (basic Put) the strike price of your option.
What Are You Doing With Your Options Contracts?
An options contract offers the buyer the opportunity to buy or sell the underlying asset depending on the type of contract they hold. Unlike futures, the holder is not required to purchase or sell the asset if they decide against it. Each contract will have a specific expiration date by which the holder must exercise their option.
The options contract offers buyers two types of options concerning rights that can be acquired with varying options contracts: Call options give buyers options in relation to purchasing stocks at a stipulated time in the future. In contrast, Puts offer them options regarding selling a certain amount of shares they own at a particular time in the future.
Why Look For The Best Options To Buy
While we’re just going over basic calls and puts in this article, investors and traders will look for the best options to buy for various reasons. For starters, purchasing options will give you a way to control more shares with less capital than buying stocks outright. They also offer leverage, which comes in handy when you’re looking to amplify your profit potential. Many day traders will use options to capitalize on quick moves in the market.
You can also use options to protect against any downside risk in your current holdings. For example, let’s say you have a significant position in a stock you plan to hold for a long period. If the stock market becomes increasingly volatile, your stock may get impacted as most did early in 2022. Assuming you weather this volatility and hold on during the big price swings, you can still make money using options. Buying puts in a bearish market is one of the ways to do this. While your core holding may have lost some value, your options strategy might help weigh out the loss in value with the opportunity to make money with put options in the short term.
On the other hand, let’s say the same scenario holds, and your stock drops to a significant support level. You might buy call options near the money or in the money with the expectation that the share price rises. If it does and assuming your expiration date is far out, you could secure your lower price “now,” see how things go in the market, and if share prices remain elevated, execute your option and take ownership of shares at the lower strike price.
You Can’t Forget About The Risks
Like all investment vehicles, you can’t ignore risk. Options are inherently volatile. Just as they can amplify gains, losses can happen quickly. With all options that you “buy to open,” you risk losing 100% of your investment. For example, if you bought Call options in a stock way out of the money and on the expiration day, the stock is nowhere near your strike, you’re likely to be in a position to have a worthless contract.
You also have to account for time decay. The further out you are from your expiration date, the less it is a factor. However, there are a few caveats to that. The first and likely most confusing for some is best shown through the following example:
You purchase a $40 strike call option, expiring in 2 weeks, and it costs you $2 or $200 per contract. The underlying asset is trading at $35, and on the day you purchased your Call, the price spikes from $35 to $39, and you hold. Your contract price jumps 50%, so your position at $39 is now worth $3 or $300 per contract (but remember, you held). The price then drops back to $35, and later that same day, it bounces back to $39. But instead of your option contract being worth $300, it’s worth $250. Time decay has just played its part.
Other Risks With Options Trading
There are other risks when it comes to more advanced trading strategies. When you “sell to open” a position, you also have the potential for significant losses. Similar to shorting, your loss isn’t limited to 100%. If you Sell a Call, you’re betting the underlying asset’s price will drop. Some investors will do this through a process called “selling covered calls.” They sell the contract and collect a premium as a stock’s price declines. If the option is at or below the stock’s current price, you will receive more premium. You would also need to own at least 100 shares of stock to sell a covered call against it.
More On Covered Calls
Whenever you sell an option, there’s a risk. But with covered calls, the risk may go beyond the option itself. Let’s say you sold a Call option at a $40 strike price that expires in 2 weeks. If the underlying asset finishes the day on expiration above $40, you will need to deliver 100 shares of that stock to the purchaser of the option. Therefore, the max loss on a Covered Call option is whatever the stock’s purchase price was, less the premium received for selling the option.
We briefly touched on some advanced options strategies like selling covered calls. However, for the most part, we mainly discussed some options basics. Buying basic calls and puts to play off of a potential up or downside move in share price can be a way to hedge, make money, or protect against losses in all markets. If you are brand new to trading penny stocks or options, the best step to take after you learn is practice. Using a trading simulator can help. We’ll continue this with more discussion at a later date on advanced options strategies, so stay tuned.