The Facebook Inc. (Nasdaq: FB) IPO hype was bigger than Superbowl week for NFL fans but with complaints about Zuckerberg’s “hoodie” and even the ticket scalpers in Germany quoting shares out at $74 just minutes before FB stock was set launch. Probably the most exciting action FB stock had on Friday was its crashing of the quotation system due to the large rush of order cancellations and order changes. Now that FB is trading after an underwhelming 0.61% IPO gain at $38.23, traders cannot wait to get their hands on the options contracts and begin option trading Facebook stock which are due out on May 29th.
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FB Stock Chart:
So, How Do You Trade Options?
In this “Options Trading: How To Trade Options” tutorial, we will cover the basic principles of Option Contracts. Why are options so profitable? Many stock investors consider a position in stock options as proxy ownership of a stock with higher leverage and less money required to purchase it. Rather than purchasing a stock if your long or shorting a stock and having to purchase it before a certain date, options trading lets you bet on the stock price going down, or up without having to actually purchase the stock.
Basically, an option is a contract to purchase which you can buy from someone or sell to someone. As the option holder, your responsibility depends on whether you’re the one buying or selling. Before getting into the responsibility aspect of options, these are some of the main characteristics of an option contract:
• An option contract is based on some underlying stock like Facebook
• An option contract always has an expiration date
• An option contract always has what’s called a Strike Price
• An option contract can be either a Call or a Put
So, an option is a contract, a contract which allows the owner the right, but not the obligation, to trade the underlying stock. One option contract is good for 100 shares of the underlying stock. So, buying a Facebook option gives you the right to trade 100 physical shares of FB stock.
An option contract will always have an expiration date which enforces a time frame to make the trade. Option contracts expire at the close of the third Friday of the contract’s expiration month. So, if you buy a Facebook option with an May 2013 expiration month, you have until end of trading day May 17, 2013 to trade those 100 physical shares of FB stock.
Now the option contract will have a specified strike price to it. The strike price is referring to the price of the stock not the option contract itself. So, for example, you could buy a Facebook option for May 2013 where the strike price is $39. That would give you the right, but not the obligation, to trade FB stock at the Strike Price of $39/share.
Calls versus Puts
If you buy a Facebook Call Option, you are have the right, but not the obligation, to buy 100 shares of FB stock at $39/share. If you buy a Facebook Put Option, you are given the right, but not the obligation, to sell 100 shares of FB stock at $39/share. So, which one do you choose? Call or Put?
The choice of which type of option to purchase depends solely on your personal belief on how FB stock will behave before the contract has expired. In our example, it is May 17, 2013. So, you have to ask yourself, “do I think FB stock will be above or below $39/share on May 17, 2013?” Since the expiration date is in the future, you can’t really determine FB stock price with any certainty, but you could make an educated guess.
If you think FB stock will be above $39/share, you would purchase a Call Option. Why? Because a Call Option will give you the right, but not the obligation, to purchase 100 shares of FB at $39/share. Now, picture FB stock does really well and on May 17, 2013, it is trading at $51/share. If you were to exercise your right, you will buy 100 shares at $39 and sell 100 shares at $51. You’ve just made a $1,200 profit: The difference between $51 and $39 multiplied by 100 shares.
So, what if the Contrarian Investor in you thinks FB stock will be below $39/share on May 17, 2013? Well, then you want to purchase a Put Option. Why? Because a Put Option will give you the right, but not the obligation, to sell 100 shares of FB stock at $39/share. Picture FB stock is trading at $25/share on May 17, 2013. Well, if you exercise your right under a Put Option, you will buy 100 shares of FB stock at $25 and sell 100 shares at $39. Do the math and you’ve just made a $1,400 profit.
In Summary, a Call Option gives you the right, but not the obligation, to buy low while a Put Option gives you the right, but not the obligation, to sell high. Purchasing the option contract gives you that right which means that the person selling you the contract is the one who is actually giving you that right.
When you exercise the Call Option from the example above, you are actually purchasing those 100 shares from that person at the strike price of $39 and selling those same 100 shares on the market at $51. If it was a Put Option, you are purchasing 100 shares from the market at $25 and selling those 100 shares to that person at the strike price of $39. In both cases you are buying low and selling high!
Note: When buying and selling the stock is mentioned above, it’s not exactly correct. Your brokerage firm is doing the buying/selling of the stock and giving you the net profit in your trading account. That’s is what is referred to as an Option Assignment. Expect that your brokerage firm charges you a small fee for handling the transaction.
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Option Premium
So, how much does it cost to buy an option contract? The price will depend on two factors:
- How close the current market price is to the strike price, and
- How much time is left before the option expires
These two concepts are called Intrinsic Value and Time Value.
A Call Option is believed to have intrinsic value if the current market price is above the strike price. Generally speaking, the price of the option increases by $100 for each $1 increase in the price of the underlying stock above the strike price. The rest of the option price is the Time Value.
Note: When you see a price quote for an option, typically, you will see the price divided by 100. So, if the option will cost you $390 to purchase, it will be quoted as $3.90. It’s quoted like that because, as noted above, one option controls 100 shares.
For example: Picture the price of the FB $39 May 2013 contract is $3.90. If the current date is March 15, you still have 9 weeks until expiration plus the current market price is $41. That means approximately $2.00 of the option is intrinsic while $1.90 is the time value. For a Put Option, the Intrinsic Value would be based on how much lower the market price is relative to the strike price.
Time Decay
A very important factor to understand when trading options is the decay of time. Imagine the price of the FB stock in our previous example remained at $41, but it got closer to May 17. As the expiration date gets closer, the Time Value decreases and on May 17, the option will be worth $2.00 because the Time Value is now $0. The Intrinsic Value doesn’t decay, just the Time Value. Remember that you bought a May $100 option which means you have the right to buy at $39 and sell at $41.
Buying and Selling Options
All the above was based on the assumption that you hold the option contract until the expiration date. You not only do not have to, but may not want to. In the real world, many investors do not buy and hold option contracts that long. If there is an increase in the price of the option they bought, most will sell the option and book their profit.
With Intrinsic and Time Value under consideration, knowing that as time proceeds, the decay in Time Value will decrease the value of your option, the only way to make money is for the underlying stock to move in your favor. Back to the example of the Facebook May $39 Call option, the option premium, the amount you paid to purchase the option, will decrease as you get closer to May 17. But, if FB stock’s market price increases as well, the decay in time value may be offset. How?
Picture it like this; what are the chances that FB stock will trade at $39 or better if you have 2 weeks to go and the price is already at $38.75? Now, ask yourself, what are the chances if the price is currently $36. You can most likely guess by now that the closer the market price is to the strike price, the more the option is worth. So if you bought the option for $3.90 when FB was trading at $34 and the next day it went to $36.22, that option will be worth more (lets say $4.80). Now, you can wait and see what happens on May 17th, but, if you just wanted to take advantage of a short term price swing, you can book your profits right now and run.
In our example, you made a profit of $90. That is ($4.80 – $3.90) * 100.
Buyer Beware
Up to now, these are pure facts about options. You have to be extremely careful when trading options. People often tout the upside to options investing while playing down the risks involved. Just like with penny stocks with the opportunities to make huge profits, the chances of you realizing tremendous losses are just as great..if not more.
Even the best options traders and brightest investment professionals cannot predict price movement, especially over the short term. They get it wrong just as often as they get it right. At the end of the day, options trading is meant to add another dimension to your entire investment strategy, so be careful not to get wiped out as soon as you enter the option world. It’s best to start out playing less than 10 options at a time. If you find you’ve made some money doing it, then you can risk more capital.
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