A Quick Guide to Buying Stock Options

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Options Trading Strategies: A Guide for Beginners

Options are conditional derivative contracts that allow buyers of the contracts (option holders) to buy or sell a security at a chosen price. Option buyers are charged an amount called a “premium” by the sellers for such a right. Should market prices be unfavorable for option holders, they will let the option expire worthless, thus ensuring the losses are not higher than the premium. In contrast, option sellers (option writers) assume greater risk than the option buyers, which is why they demand this premium.

Options are divided into “call” and “put” options. With a call option, the buyer of the contract purchases the right to buy the underlying asset in the future at a predetermined price, called exercise price or strike price. With a put option, the buyer acquires the right to sell the underlying asset in the future at the predetermined price.

Why Trade Options Rather Than a Direct Asset?

There are some advantages to trading options. The Chicago Board of Options Exchange (CBOE) is the largest such exchange in the world, offering options on a wide variety of single stocks, ETFs and indexes. Traders can construct option strategies ranging from buying or selling a single option to very complex ones that involve multiple simultaneous option positions.

The following are basic option strategies for beginners.

Buying Calls (Long Call)

This is the preferred strategy for traders who:

  • Are “bullish” or confident on a particular stock, ETF or index and want to limit risk
  • Want to utilize leverage to take advantage of rising prices

Options are leveraged instruments, i.e., they allow traders to amplify the benefit by risking smaller amounts than would otherwise be required if trading the underlying asset itself. A standard option contract on a stock controls 100 shares of the underlying security.

Suppose a trader wants to invest $5,000 in Apple (AAPL), trading around $165 per share. With this amount, he or she can purchase 30 shares for $4,950. Suppose then that the price of the stock increases by 10% to $181.50 over the next month. Ignoring any brokerage, commission or transaction fees, the trader’s portfolio will rise to $5,445, leaving the trader with a net dollar return of $495, or 10% on the capital invested.

Now, let’s say a call option on the stock with a strike price of $165 that expires about a month from now costs $5.50 per share or $550 per contract. Given the trader’s available investment budget, he or she can buy nine options for a cost of $4,950. Because the option contract controls 100 shares, the trader is effectively making a deal on 900 shares. If the stock price increases 10% to $181.50 at expiration, the option will expire in the money and be worth $16.50 per share ($181.50-$165 strike), or $14,850 on 900 shares. That’s a net dollar return of $9,990, or 200% on the capital invested, a much larger return compared to trading the underlying asset directly. (For related reading, see “Should an Investor Hold or Exercise an Option?”)

Risk/Reward: The trader’s potential loss from a long call is limited to the premium paid. Potential profit is unlimited, as the option payoff will increase along with the underlying asset price until expiration, and there is theoretically no limit to how high it can go.

A Quick Guide to Buying Stock Options

So you’ve decided to invest in the stock market. Congrats!

Now that you’ve come to this decision, you’re probably scratching your head, wondering which stock-buying strategy to use.

Not to mention, the stock language is pretty overwhelming. What’s strike price anyways?

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Well, this quick guide to buying stock options can help you out with that.

In it, you’ll learn:

  • 3 Basic strategies for buying stock options
  • Common stock market terms so you can speak Wall Street
  • And, a handful of know-hows when it comes to buying and selling stocks

Read on to learn more!

Common stock market terms you need to know

Options

Options are contracts that give investors just that—options. One of the options is buying the stock at a certain price by or prior to a specific time period.

If you want to get technical, this is a call option.

The other option is similar except, instead of buying the stock, you’re selling it. This is known in the stock market world as a put option.

Since these choices are options, you’re not obligated to do one or the other.

Strike Price

The “certain price” we’re talking about above is known as the strike price.

In other words, the strike price is a set price.

It’s also a key factor for investors to determine if they’re making a profit.

In fact, you can use it to determine your break-even point. This is the amount you would need to make to not loose money. But you also wouldn’t be making more.

Price Premium + Strike Price = Break-Even Point

Option Premium

The option premium is based on intrinsic and extrinsic value.

To better understand this, here’s an example.

You have a call option at a strike price of $50 per share. You have 100 shares (since this is the norm). The option premium is $6.

The option is currently trading at $54 a share. This is $4 above the strike price.

So, the $4 of the option premium is the intrinsic value. The $2 that is leftover is the extrinsic value.

Strategies for buying stock options

There are several stock option strategies. But, according to a Nasdaq article, some of the most common and straightforward strategies are these…

Wait until they’ve matured

Essentially you hold the call option until the contract is up. (Note: this is before it expires.) And then you trade it.

Trade before the contract is up

When TV shows and movies capture the stock market, they normally depict some form of this strategy.

Let’s say you have a call option that has a strike price of $40 per share. Recently, it’s risen to $60 per share. You expect this is the highest this share will rise. So, you trade it.

Which should bring you some profit (minus the premium and commission).

Allow it to expire

Perhaps the share you bought never went up or down. You’re still waiting but nothing is happening.

At which point you let it expire. You’ll have to pay the option premium and commission.

Advice for buying stock options

Here’s some universal advice when it comes to buying stock options:

  • Buy when they’re low; sell high
  • Think twice about risky stock options if you’re towards retirement. Yes, there’s potential big profit. But potential big profit loss.
  • Predict trends by studying filings
  • In general, think marathon, not sprints

How to Buy Stocks

Buying a stock — especially that first time you become a bona fide part owner of a business — deserves its own celebratory ritual.

But before we pick out shareholder party hats and rent a ticker tape confetti cannon, let’s review the specific steps for how to buy stocks.

Step 1: Open an online brokerage account

Opening an online brokerage account is as easy as setting up a bank account: You complete an account application, provide proof of identification and choose how you want to fund the account. You may fund your account by mailing a check or transferring funds electronically. (We have a full guide to opening a brokerage account here.)

How do you find a broker that’s worthy of your dough? Two things to consider when opening an account to buy stocks:

1. The cost of commissions: The commission is the fee a broker charges each time you buy or sell a stock. Finding a broker that charges low or no commissions will be most important to active traders — generally, those who place 10 or more trades per month. (Learn more about the ins and outs of stock trading.) Commissions can add up quickly if you’re trading regularly.

But all investors should consider costs, as they eat into your investment returns. In our analysis, we’ve found two brokers come out on top for commission-free trades:

  • E-Trade offers commission-free trading of stocks, exchange-traded funds and options. Read our full review of E-Trade.
  • TD Ameritrade was our pick for beginner investors, and also offers commission-free trading of stocks, ETFs and options. Read our full review of TD Ameritrade.

2. How much support you want. Consider the broker’s offerings of educational tools, investment guidance, stock-trading research and access to real, live humans via phone, email, online chat or branch offices. This is especially important for beginner investors, as you will want knowledgable customer service representatives available to answer your questions.

In our research, Merrill Edge stood out for investor resources and customer service: The broker offers investors a notably large selection of research about stocks and other investments, and its website is stocked with educational videos, courses and webinars. (Read our full review of Merrill Edge.)

To compare all of your brokerage options, review NerdWallet’s full list of the best brokers for stock trading, or use the search tool below to find the right match for your investing style. (Article continues below tool.)

Get the best broker recommendation for you by selecting your preferences

What do you want to invest in?
What do you want to invest in?

Investors who trade individual stocks and advanced securities like options are looking for exposure to specific companies or trading strategies.

Mutual funds and ETFs are typically best suited to investing for long-term goals that are at least 5 years away, like retirement, a far-off home purchase or college.

Beginners and long term investors often look to get exposure to whole markets and don’t have a preference on which type of securities to trade.

How much will you deposit to open the account?
How much will you deposit to open the account?

Some brokers have minimum deposit requirements, while others may require a minimum balance to access certain advanced features or trading platforms.

If a broker is offering a new account promotion, there may be a minimum initial deposit requirement to qualify.

How often will you trade?
How often will you trade?

If you’re trading frequently — more than weekly — you’ll want an advanced broker that has powerful platforms, innovative tools, high-quality research and low commissions.

Those who trade monthly or yearly will want a well-rounded broker with a user-friendly interface, helpful customer support and competitive pricing.

Who will manage your investments?
Who will manage your investments?

Robo-advisor services use algorithms to build and manage investor portfolios. For a very low fee, they’ll create a portfolio of ETFs based on your investing goals and risk tolerance, then rebalance it as needed. Many also offer tax-loss harvesting for taxable accounts.

If that sounds too hands-off for you and you want to manage your own investments , choose a self-directed account at an online broker.

What is most important to you?
What is most important to you?

Low Cost: Mutual fund/ETF investors want access to funds without commissions or fees; stock or options traders want low commissions and no added fees for inactivity, tools or research.

Platform: If you plan to trade frequently, you likely know what kind of tools you’ll use most and what you want out of a platform.

User interface: Tools should be intuitive and easy to navigate.

Premium research: Investing, particularly frequent trading, requires analysis. The broker should provide extensive information to help you select the investments for your portfolio.

Top research; two powerful trade platforms; educational content

cash credit with qualifying deposit

on TD Ameritrade’s secure website

Offers access to human advisors for additional fee.

of free management with a qualifying deposit

on Betterment’s secure website

Professional-level trading platform and tool.

0.25% reduction on margin loans. Tiers apply

on Interactive Brokers’s secure website

Step 2: Select the stocks you want to buy

Don’t let the deluge of data and real-time market gyrations overwhelm you as you conduct your research. Keep the objective simple: You’re looking for companies of which you want to become a part owner.

Warren Buffett famously said, “Buy into a company because you want to own it, not because you want the stock to go up.” He’s done pretty well for himself by following that rule.

Start with the company’s annual report — specifically management’s annual letter to shareholders. The letter will give you a general narrative of what’s happening with the business and provide context for the numbers in the report.

After that, most of the information and analytical tools that you need to evaluate the business will be available on your broker’s website, such as SEC filings, conference call transcripts, quarterly earnings updates and recent news. Most online brokers also provide tutorials on how to use their tools and even basic seminars on how to pick stocks.

To learn more about evaluating companies for your portfolio, see NerdWallet’s feature on how to research stocks.

Step 3: Decide how many shares to buy

Step 4: Choose your stock order type

Basic stock trading terms

Ask For buyers: The price that sellers are willing to accept for the stock.
Bid For sellers: The price that buyers are willing to pay for the stock.
Spread The difference between the highest bid price and the lowest ask price.
Market order A request to buy or sell a stock ASAP at the best available price.
Limit order A request to buy or sell a stock only at a specific price or better.
Stop (or stop-loss) order Once a stock reaches a certain price, the “stop price” or “stop level,” a market order is executed and the entire order is filled at the prevailing price.
Stop-limit order When the stop price is reached, the trade turns into a limit order and is filled up to the point where specified price limits can be met.

There are a lot more fancy trading moves and complex order types. Don’t bother right now — or maybe ever. Investors have built successful careers buying stocks solely with two order types: market orders and limit orders.

Market orders

With a market order, you’re indicating that you’ll buy or sell the stock at the best available current market price. Because a market order puts no price parameters on the trade, your order will be executed immediately and fully filled, unless you’re trying to buy a million shares and attempt a takeover coup.

Don’t be surprised if the price you pay — or receive, if you’re selling — is not the exact price you were quoted just seconds before. Bid and ask prices fluctuate constantly throughout the day. That’s why a market order is best used when buying stocks that don’t experience wide price swings — large, steady blue-chip stocks as opposed to smaller, more volatile companies.

Good to know:

  • A market order is best for buy-and-hold investors, for whom small differences in price are less important than ensuring that the trade is fully executed.
  • If you place a market order trade “after hours,” when the markets have closed for the day, your order will be placed at the prevailing price when the exchanges next open for trading.
  • Check your broker’s trade execution disclaimer. Some low-cost brokers bundle all customer trade requests to execute all at once at the prevailing price, either at the end of the trading day or a specific time or day of the week.

Limit orders

A limit order gives you more control over the price at which your trade is executed. If XYZ stock is trading at $100 a share and you think a $95 per-share price is more in line with how you value the company, your limit order tells your broker to hold tight and execute your order only when the ask price drops to that level. On the selling side, a limit order tells your broker to part with the shares once the bid rises to the level you set.

Limit orders are a good tool for investors buying and selling smaller company stocks, which tend to experience wider spreads, depending on investor activity. They’re also good for investing during periods of short-term stock market volatility or when stock price is more important than order fulfillment.

There are additional conditions you can place on a limit order to control how long the order will remain open. An “all or none” (AON) order will be executed only when all the shares you wish to trade are available at your price limit. A “good for day” (GFD) order will expire at the end of the trading day, even if the order has not been fully filled. A “good till canceled” (GTC) order remains in play until the customer pulls the plug or the order expires; that’s anywhere from 60 to 120 days or more.

Good to know:

  • While a limit order guarantees the price you’ll get if the order is executed, there’s no guarantee that the order will be filled fully, partially or even at all. Limit orders are placed on a first-come, first-served basis, and only after market orders are filled, and only if the stock stays within your set parameters long enough for the broker to execute the trade.
  • Limit orders can cost investors more in commissions than market orders. A limit order that can’t be executed in full at one time or during a single trading day may continue to be filled over subsequent days, with transaction costs charged each day a trade is made. If the stock never reaches the level of your limit order by the time it expires, the trade will not be executed.

Step 5: Optimize your stock portfolio

  • Make sure you have the right tools for the job. NerdWallet’s list of the best stockbrokers can help you identify the right brokerage account for you.
  • Be mindful of brokerage fees. These can significantly erode your returns.
  • Consider also investing in mutual funds, which allow you to buy many stocks in one transaction. Here’s our list of the best brokers for mutual funds.
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