Options trading is a popular investment strategy that involves buying and selling contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specific price before a specified expiration date. In this article, we discuss the reasons why someone might get involved in options trading, including the ability to earn regular income from their shares, insurance against a collapse of the stock, and the ability to make arrangements to purchase shares at attractive prices. We also provide an example of how options can be used to speculate on a stock’s potential earnings during earnings season, and how they can be used to profit no matter which way the stock moves.

What are options?

An option is basically an agreement on the underlying shares of stock. It’s an agreement to exchange shares at a fixed price over a certain timeframe (they can be bought or sold). The first thing that you should understand about options is the following. Why would someone get involved with the options trading in the first place? Most people come to options trading with the hope of earning profits from trading the options themselves.  But to truly understand what you’re doing, you need to understand why options exist, to begin with.

There are probably three main reasons that options on stocks exist.

The first reason is that it allows people that have shares of stock to earn money from their investment in the form of regular income. So, it can be an alternative to dividend income or even enhance dividend income. Then you can sell options against the stock and earn income from that over time intervals lasting from a week to a month, generally speaking. Obviously, such a move entails some risk, but people will enter positions of that type when the relative risk is low.

The second reason that people get involved with options is that they offer insurance against a collapse of the stock. So, once again, an option involves being able to trade shares of the stock at a fixed price that is set at the time the contract is originated. One type of contract allows the buyer to purchase shares, the other allows the buyer to sell shares. This allows people who own large numbers of shares to purchase something that provides protection of their investment that would allow them to sell the shares at a fixed price, in the event that their stock was declining by huge amounts on the market. So, the concept is exactly like paying insurance premiums. It’s unclear how many people actually use this in practice, but this is one of the reasons that options exist. The way this would work would be that you pay someone a premium to secure the right to sell them your stock at a fixed price over some time frame. Then if the share price drops well below that degree to price, you would still be able to sell your shares and avoid huge losses that were occurring on the market.

The third reason that I would give for the existence of options is that it provides a way for people to make arrangements to purchase shares of stock at the prices that they find attractive, which aren’t necessarily available on the market. So, there is a degree of speculation here. But let’s just say that a particular stock you are interested in is trading at $100 a share.  Furthermore, let’s assume that people are extremely bullish on the stock and they are expecting it to rise by a great deal in the coming weeks. Maybe, it’s earnings season. During earnings season, stock can move by huge amounts. But before the earnings call, nobody knows whether the stock is going to go up or down or by how much it’s going to move. An options contract could allow someone to speculate and set up a situation where they could profit from a huge move upward without having actually to invest in the stock. 

So, in that situation, if the stock declined instead, they wouldn’t be out of much money. Just for an example, let’s say they buy an options contract that allows them to purchase the shares (of the stock currently at $100) for $102, and the option costs two dollars per share. So, the stock would have to go to $104 or higher to make it worth it.

Typically, options contracts involve 100 shares. So, if the speculator bets wrong, the most they would be out would be $200. 

Let’s just say, after the earnings call, the share price jumps to $120. The speculator can exercise the option, which means they buy the shares at $102 per share. Then they can sell the stock on the market at the price of $120 per share. Taking into account the investment to buy the options contract, that basically leaves them with the sixteen $16 dollars per-share profit. Now, you might say well why didn’t they just buy the shares that $100 a share? The reason is if they did that, they would actually be exposed to the stock to the fullest extent possible. Like we said, earnings calls can go both ways. Just recently, Netflix announced that they lost subscribers. In after-hours trading alone, the stock lost $43 per share. So, in our little example, we could say that the stock dropped instead of gaining, let’s say to $80 per share. In that case, our speculator would’ve been in a major point of pain had they actually purchase the shares ahead of time. By doing the option instead, they set themselves up for profit while only risking a $200 loss. And it turns out that there are strategies you can use with options to profit no matter which way the stock moves. So, I didn’t want to get too far ahead of ourselves, but an experienced options trader would have set up a trade designed to earn profits either way.