Traditional stock trading differs substantially from options trading. If you're looking to embark on the high-risk, high-reward adventure of buying and selling options contracts, there are a few terms and concepts you should familiarize yourself with before you get started. Get a sense of how trading options differs from traditional trading, what bid, ask, and bid-ask spread are, and the various types of orders you can place.
What Is Options Trading?
Image via Flickr by free pictures of money
In options trading, investors purchase contracts, based on an underlying asset's value, that give the buyer the right, but not the obligation, to purchase or sell part or all of the underlying asset within the confines of the contract. Options trading is highly time-dependent and often requires consistent check-ins while looking for a buyer or a seller.
The Difference Between Bid and Ask
Two important options trading terms are "bid" and "ask." A bid is the most amount of money a buyer is willing to spend on a contract while an ask is the least amount of money a seller will part with their contract for. It's very rare for bid prices and ask prices to match. Almost always, the ask price is higher than the bid price, leading to a disparity in the value of the contract.
The Bid-Ask Spread
The difference between the bid price and the ask price is called the bid-ask spread. This range can vary dramatically depending on factors like the liquidity of the underlying asset. The spread is factored into the price of the purchase, and the difference in bid and ask usually goes towards paying transaction or broker fees.
You can calculate bid-ask spread by per share dollar amount or percentage of the expenditure. To calculate the dollar amount, simply subtract the bid price from the ask price. To calculate the percentage, use this formula:
bid-ask spread (%) = (ask - bid) / ask * 100%
For example, if an investor is asking $20 per share and another investor offers $19, the bid-ask spread is $1. To calculate the percentage, plug the appropriate figures into the formula:
5% = (20-19) / 20 * 100%
Types of Orders
Investors can choose from five different types of orders when buying and selling options:
Market Order: In a market order, the contract is fulfilled at the market or prevailing price.
Limit Order: In a limit order, the purchaser sets a price at which they'll buy or sell their underlying asset, but no lower.
Day Order: In a day order, if the parameters of the contract are not met, the contract is canceled at close of business.
Fill or Kill: In fill or kill, the entire order must be immediately fulfilled or it's instantly canceled.
Stop Order: In a stop order, the contract activates when the contract's underlying stock reaches a certain amount or goes below it.
Options trading is complicated but can yield substantial returns much higher than traditional stock trading. Take the time to learn more about the nuances of options trading for best results.