How Do I Play Stock Options?

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Option prices fluctuate with the stock market.
Option prices fluctuate with the stock market. (Image: stock market analysis screenshot image by .shock from Fotolia.com)

Stock options are contracts that give the owner the right but not the obligation to buy 100 shares of a security at a predetermined price on a specific date. These contracts are available for a variety of price levels and expiration dates. Options are very volatile and are considered to be among the riskiest investments available. However, if you have a conviction for a time frame in which a stock will appreciate or depreciate, it is possible to profit using options.

How to Trade Options

View the option chain. This is a table that displays calls and puts for each expiration date. Calls are contracts that increase in value when the underlying stock increases in value. Puts appreciate in value when the underlying stock depreciates in value.

You can view the chain by entering the ticker symbol for the stock into your broker's search function. The ticker symbol is an abbreviation for the stock, used by your broker to identify the security.

Determine the strike price you wish to use. The strike price is the price the underlying stock must reach for the option to become profitable. When the underlying stock price breaches the strike price, the option is deemed to be "in the money."

The more in the money the stock price moves, the greater the value of the option. Until it reaches this price, the option is considered to be "out of the money." Strike prices are available in incremental values so that you can determine the specific price level you wish to buy.

For example, stock ABC is currently trading at $50 per share, and has strike prices at $45, $48, $50, $52, and $54.

Calls at $45 and $48 are in the money and therefore profitable. Calls at $50 are "at the money" and will become profitable if the stock rises above $50. Calls at $52 and $54 are out of the money and not yet profitable.

Puts at $45 and $48 are out of the money. Puts at $50 are at the money, and puts at $52 and $54 are in the money.

Select the expiration date. Options are typically offered by the month. The contracts expire on the third Friday of their respective month. The further out the expiration date is, the more value the contract will hold, because of the probability that the stock price will reach the strike price by that date. This concept is referred to as time value, which erodes as time passes and the stock does not advance towards the strike price.

Using the same example as Step 2, if ABC is at $50 now and you believe it will be above $55 by March, choosing to buy 5 calls at $54 for March could be a very profitable trade if your beliefs were realized.

Place the order. Once you have determined the number of contracts you wish to buy, the strike price, and the expiration date, you are ready to place the order. Using the example from Step 3, if the calls with a strike price of $54 were trading at $2 each, the calculation for the total cost of this trade would be as follows:

5 contracts for 100 shares each at $2:

5 x 100 x $2 = $1,000

This trade would cost $1,000, plus commission.

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