Options trading volume has surged in recent years thanks to more retail traders entering the market. The options market can be complicated and it's not one for the faint of heart. However, it can pay off when done properly.
In the video above, Interactive Brokers Chief Strategist Steve Sosnick and Yahoo Finance's Jared Blikre explain some of the options trading basics in Options 101.
For more expert insight and the latest market action, click here to watch this full episode of Yahoo Finance Live.
Editor's note: This article was written by Stephanie Mikulich
Video Transcript
[AUDIO LOGO]
JARED BLIKRE: A new generation of retail traders is flocking to options trading As an alternative to plain vanilla stock investing. But the options arena can be complex to maneuver and there are also pitfalls to avoid. So we're starting off with the basics in Yahoo Finance's options week 101. And this is sponsored by Tastytrade.
And now joining us to break this all down is Interactive Brokers Chief Strategist Steve Sosnick. Steve, thank you for joining us here today. And let's start with a very simple definition here. This is a stock option definition, financial contract that grants the buyer the right, but not the obligation, to buy or sell a stock at a predetermined price within a specified period of time. Just tell some of the important aspects of this for us.
STEVE SOSNICK: Well, it's important to remember, Jared, that it is a right, and that's where the word "option" comes from. As opposed to, let's say, a futures contract or actually buying the stock where you're obligated to own that underlying security. As a result, the price tends to be lower. But the very important parts are you have to get that target price correct, because there's a predetermined price, and you have to get the time frame correct.
So there's a lot of-- it's a little bit-- it's much less of an outlay, but you really have to get everything just right for it to work out for you.
JARED BLIKRE: All right. With that we have calls, and we have puts. Calls are the right to buy a stock. Put is a right to sell. But that's if you're long. If you're selling the stock, it's a little bit different matter. And for the newer investors, we're probably going to be thinking about buying calls or puts there, right?
STEVE SOSNICK: Yeah. Most people start off by buying-- by buying options outright. There are a lot of people who do end up writing options, particularly covered calls. I know you'll get to that later this week.
JARED BLIKRE: Tomorrow, actually.
STEVE SOSNICK: I'm not going to-- I'm not going to-- I'm not going to front run the next guest, but so what happens is but it's typical to think in terms of buying them to begin with. And again, it's a fairly limited outlay compared to the price of the stock usually to either speculate about whether it's going to go up over that period of time or whether it's going to go down depending on the contract.
JARED BLIKRE: You find risk, a concept we're going to come back to. So the structure of a call option here, first of all, one option equals 100 shares. And then we have a couple of different things, maybe you can go through and outline the importance of each one of these things.
STEVE SOSNICK: Yeah. So when you see the price of an option, you have to multiply that by 100. So if you see it at trading at $1.50, your outlay is actually going to be $150 because it conveys the right to buy 100 shares. One contract buys 100 shares. The expiration date is predefined. So you're buying the March 190 calls on Apple.
JARED BLIKRE: So you have weekly and monthly expirations there.
STEVE SOSNICK: And even dailies for certain ETFs and index options. But we'll stick here to the weeklies and the monthlies for common stocks. But you do specify your date when you buy it and you specify your strike. So the expiration date and the strike. And when you and when you go to look at the quote, that gives you the premium.
JARED BLIKRE: And that's what you're paying if you're buying it.
STEVE SOSNICK: Exactly. So so you so you pay that premium. And especially if it's an out-of-the-money option, meaning that if it's a call, the price is above the strike-- the strike price is above the current price or put, the strike is below, that is pure premium there is no intrinsic value to that option. It's just really what you're paying for the right to speculate on the stock price over that period of time--
JARED BLIKRE: So important to say that premium can just disappear 100%. That's something that you're just outweighing from the beginning there.
STEVE SOSNICK: Premium does-- premium-- there's few guarantees and options. And one of them will be that there is no premium left on expiration date. It's either going to be in the money or it's going to be out of the money. And this chart shows you that.
JARED BLIKRE: So we have a-- first of all, this is for an Apple 190 call. And this is a typical profit and loss chart, so get used to this. We're going to be showing a lot of these. And in this example, this is the 190 strike, and it's $3.50 per share. But maybe you can kind of break down the structure of this.
STEVE SOSNICK: So if you're paying $3.50, so this little red line means that if it closes below 190, you lose all 350. You have to get it up and above 193.50 for you to even break even. On the other hand, though, the advantage, the appeal of options is you could see how fast that line accelerates. So if you get above that 193.50 hurdle, the strike price plus the premium paid, that can accelerate very quickly. And that's the appeal that keeps people trading in options.
JARED BLIKRE: And another thing is I look here, the red line, it never goes any lower no matter how much the strike or how much Apple price-- share price decreases, you're only going to lose that fixed amount.
STEVE SOSNICK: That's true. It's very defined risk the important thing, though, to keep in mind is most options expire worthless. So it is important to realize that-- you're kind of given that up in a lot of instances.
STEVE SOSNICK: You are giving that up.
JARED BLIKRE: On average.
STEVE SOSNICK: And on average, it is speculation. And I think, unfortunately, some people treat it almost as gambling, and gamblers don't win most of the time. So you do want to use your defined risk, but you need to use it intelligently.
JARED BLIKRE: Good point there. The house tends to win, and that involves writing, but we're going to cover that later in the week. For now, just go through-- let's go through some of the benefits here because we have leverage, hedging. We talked about defined risk. So maybe you could talk about leverage and hedging a little bit.
STEVE SOSNICK: Well, sure. Well, the leverage part was in that graph before because we mentioned that it needed to get past $190, $350.
JARED BLIKRE: Right in here.
STEVE SOSNICK: If you got to $197, well, that option is worth $7, and then you've doubled your money. So there's your leverage. So it's hit or miss to a certain extent. And when you hit, you can hit big. And that, I think, again, tends to be a little too appealing sometimes to people.
JARED BLIKRE: Yeah, we saw that in 2021.
STEVE SOSNICK: Exactly. Hedging, on the other hand, tends to be-- if you're long a stock, and you want to protect yourself on the downside, you may want to purchase a put. There are other ways to generate income, which, again, you'll get to with writing. With writing calls, that's hedging. And so there's-- so the whole point of options was really not as a tool for speculation but as a tool for risk management to transfer risk and to allow hedging between different parties who wanted to-- some wanted to assume risk. Some wanted to lay off risk.
JARED BLIKRE: Very good. We've got less than a minute, so we've got to go over a couple of the risks here. Leverage can work for you, can work against you. Also, options are complex. And then time decay, we didn't talk much about that. Maybe you could just address time decay with the little bit of time.
STEVE SOSNICK: Time decay is--
JARED BLIKRE: We're experiencing it now.
STEVE SOSNICK: Time decay is one of the most unrelenting features of option trading. As I mentioned, the guarantee-- I can only guarantee you that there will be no premium on expiration, and that does dissipate as the time goes by. The longer you have for the trade to work out, the higher the premium of the option. As you get closer and closer, that premium declines.
The risk, by the way, with trading very short term options is that premium really decays very quickly. It's not linear. It's an exponential function. Sorry, for getting too mathy, but--
JARED BLIKRE: That's all right.
STEVE SOSNICK: It's-- but you fall off a cliff as you get close to expiration.
JARED BLIKRE: We really thank you for appearing on day one of Options 101 week here. Steve Sosnick, thank you.
