When it comes to stock trading, there are two main approaches; you can either buy a stock and sell it when it increases in value, or you can short a stock and take your profits as the price of the stock drops. In both cases, you are dealing with transactions of actual shares of a company’s stock. Stock options, which are a slightly different type of security asset, are more concerned with the control of a company’s shares instead of actual ownership. Let us take a look at the core nature of a stock option.
The definition of an option in its truest form is as follows: a buyer of an option buys the right but not the obligation to buy or sell a specific stock at a specific price, on or before a specific date. That, of course, is a very textbook definition that can be unpacked as follows. When you are normally trading, you are buying and selling actual shares of a company’s stock; however, when you trade options, you are buying and selling the right to purchase those same shares. If you own an option that grants you the right to purchase a company’s shares, you can purchase the shares in question as long as your option contract is still active. However, you do not have to purchase the stock as you can let your option or your right to purchase them expire as option contracts are only good for a limited amount of time.
For the most part, we trade options the same way we trade stocks. For example, when you are buying a stock long, you have the expectation the price will go up over time. The same purchase and hold strategy in the world of options would be buying a call. If the price of the stock goes up, then the demand for the option with the right to purchase the stock will go up as well. Let us take a look at a previous Etsy trade, which we covered in our Foundations blog on Buying Long and Selling Short. In this long trade, Etsy’s stock went up in price, and we exited the trade with a profit of $84.25.
However, if we had purchased a call option that provided the holder of the option the ability to purchase Etsy stock at $41.27 per share, don’t you think that right to purchase would be worth something to someone when the stock is currently sitting at 42.96 and going higher? Yes, it would, and that is what you trade to someone else, the right to purchase the Etsy stock at a cheaper rate then what it is going for on the open market.
It may seem buying a stock long and buying a call option are the same thing, and in a way they are as they operator off the same principle, if the stock goes up, you will make a profit with both trades. However, where they differ is by the amount of leverage you can have over a company’s stock. In the Etsy trade above, we purchased fifty shares of Etsy at $41.27 per share. That means for us to open the trade, we needed to have $2063.50 in our account.
However, we could have purchased one call option contract for pennies on the dollar, which would have given us influence over one hundred Etsy shares instead of just fifty. This ability to have control over more shares of a company with less capital is a great way to trade in the marketplace with a smaller dollar account, which in turn keeps the possible risk of financial loss to a minimum.
Join us next week, where we dive deeper into the world of options. And if you wish to learn more regarding this topic, please consider signing up for our Foundations of Stocks and Options class, which you can do here. Thank you!