In order for you to purchase an option someone has to be willing to sell it to you.

Why would someone be willing to give you the opportunity to purchase stock at a known price for a period of time? Especially when no one knows what the price of the stock may do between now and expiration. The stock could soar and the seller of the option would have to make good on the contract at a loss.

The reason people sell options is pretty much the same reason people buy them. They are speculating that the underlying asset is going to move in their favor or not move at all before the expiration date.

You, as a buyer pay a premium for the option. The seller gets this premium credited to his or her account and if the contract expires worthless, the seller keeps the premium.

Let’s show an example from both sides.

First as a buyer.

ACME Industries is trading at $40 today. You think that it’s undervalued and will increase in price before the expiration date next month.

You check the options price tables and notice that you can purchase a $40 strike contract for next month’s expiry for $2. This means you would pay a premium of $2 over today’s closing price.

You think this is a good deal so you purchase one contract with an expiry three weeks out for a $40 strike price for $2 per share. Remember option contracts are traded in multiples of 100 shares so the premium you paid is $200. This goes straight into the account of the seller never to be seen again.

You could have bought the stock today for $40, but you decided to pay the premium to have the option instead.

Now you can see that you’ve actually paid more for the option to buy the stock than you would have if you had purchased the stock outright.

Consequently, the stock would have to increase in price to $42 to hit your breakeven point. If the stock does not increase in price above $42 before the expiration date there is no point in exercising your option and the contact would expire worthless.

This is the premium you pay to have the option to buy the stock at $40 for three weeks.

The purchaser would win in this case because he or she already has your $200 in their account.

But let’s say ACME posted the quarterly earnings in the second week of the contract and the stock soared to $47. Now you have a profit and can exercise your option which would require the seller to supply you with 100 shares @ $40 which you can turn around and immediately sell for $47. Now you have made $7 per share minus the cost of the option $2 per share = $5 per share times 100 shares or $500. Not bad for two weeks non-work huh? :)

Now let’s take a look at it from the seller’s point of view.

Keep in mind this is just the opposite of the buyers situation. Let’s say you’re the seller.

You decide to sell a contract for 100 shares of ACME at a $40 strike price for $2 with an expiry three weeks out.

A call buyer purchases the contract from you.  Unlike the buyer who has the option of exercising the contract, you have the obligation to supply the 100 shares of ACME at $40 any time during the next three weeks. The ball is in the buyers court. If the buyer decides to exercise the option you must supply the shares.

If you don’t own the shares you must buy them at the current market price regardless of what that is and turn them over to the buyer.

But taking the above example let’s say the stock only moves to $41.50 at expiration. the buyer has no reason to exercise the option because he or she already has $42 into it. ($40 strike plus the $2 option)

So in this case you just made $200 for doing absolutely nothing! As long as the price of ACME stays below $42 for three weeks you, as the seller, have nothing to worry about. The buyer lost his $200.

But now let’s look at the other example from above.

The stock price goes up to $47 and the buyer exercises his option and you must supply him or her with 100 shares of ACME at $40. If you already owned the stock you would just sell 100 of your shares to him or her.

If you don’t own the stock, you must buy it at $47 per share and then sell it to him or her at $40. Your loss as a buyer in this case is $7 times 100 shares minus the premium you already have been paid. So 7 X 100 = $700 – $200 = $500 loss.

All of this just goes to illustrate that when the buyer wins the seller loses and vice versa.

By now you should understand there are two basic types of options contracts, calls, and puts. You should also know that one can buy or sell either of them.

So….

You can buy calls.

You can sell calls.

You can buy puts.

You can sell puts.

This seems a little complicated when you think about all the combinations you could enter into, but stick with it and it will become clearer. :)

In the next lesson we’ll reinforce calls with a couple more examples.

Until next time, happy trading!

Trader X

Click here to move on to Lesson 4

Calls and Puts.

A call gives the holder the option to buy an asset at a certain price within a specific period of time. Calls are just like having a long position on a stock. Buyers of calls hope that the price of the stock will increase before the option expiration  date.

A put gives the holder the option to sell an asset at a certain price within a specific period of time. Puts are just like  having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

Notice the use of “asset” above? The reason I didn’t use stock is because options aren’t always on stocks. You can also use options with indexes and other derivatives.

Don’t let the word derivatives scare you. A derivative is just the underlying asset that gives an option it’s value. A derivative could be a stock, an index, or any other underlying asset that can be traded on the options market.

For now just remember that calls are the option to buy and are entered when one thinks the underlying asset will increase in value.

Puts are the option to sell and are entered when one thinks the underlying asset will decrease in value.

The nice thing about options is you can combine calls and puts to profit regardless of which way the market moves.

Next we’ll look at trading options in a little more detail.

Until next time, happy trading!

Trader X

Click here to go to Lesson 3

Options are in reality very simple to understand. It’s the advanced ways of trading options that take a little more concentration to understand fully.

Stock Options are simply the right to buy (calls) or sell (puts) a stock at a pre-determined price (the strike price) within a stated period of time (a variable length of time representing the life of the options contract, usually 30, 60,  or 90 days, but sometimes even longer). Options normally expire the Saturday following the third Friday of every month. For 2010 you can find the expiry calendar here.

All this means is, as an option buyer, you have the right (not the obligation) to buy or sell the underlying stock at a predetermined price, at any time before the option expires.

It should be noted that this last point depends on the overall “style” of option, “American style Options”  allow the contract holder (option purchaser) to exercise the option at any time during the life of the option contract. “European style Options” only allow the option to be exercised at the end of the option contract (called the expiration date).

The two styles have nothing to do with geography as “American  style Options” are the most popular on both sides of the big pond.

Options are normally based on 100 shares of the underlying security. This is where they get their leverage.

Let’s use Calls as an example because they are usually the easiest to explain and understand.

When you buy a call option you are buying the option, not the obligation, to purchase 100 shares of the underlying stock at a pre-defined price (called the strike price). Simple as that. You have the option to buy stock at a price that you agreed to when you purchased the call option anytime before the expiration of the options contract (we’re going to always assume “American style”).

The amount you pay is called the premium and is paid to the seller to initiate the options contract.

The price for options (premium) varies based on the length of the contract and the strike price, but can be 10% or less than the underlying stock.

For example, you buy a call against IBM with a current value of $100. This gives you the option to buy 100 shares of IBM at a strike price. The option contract cost varies with the strike price. In this case, since you’re buying the right to purchase the stock (a call option), the price of the contract will go down as the strike price goes up. You may have to pay $15 a share with a strike price at $101, but only $10 a share with a strike price of $110.

See how that works? If not, don’t worry, keep reading and it will become clear within the next few posts.

Why would you buy a call option instead of just buying the stock outright?

There are a couple main reasons.

1. Options have built-in leverage. This means you can control up to 10+ times (or more)  the number of shares with the same amount of investment as you would if you bought the stock outright.

2. Depending on the strategy, options have a built-in control of risk. 

Let’s create a fictitious example.

You spot a stock that you think is under-valued at $50 a share. You could buy 100 shares of this stock for $5000 and wait for it to rise in price. But what happens if you were wrong and the bottom falls out of the stock? Say it dropped to $20 in a week. You could sell it at $20 (for $2000) for a loss of $3000. Ouch.

To make matters worse, let’s say the stock rebounds to $65 a week later. You have already sold for a loss. Double ouch.

Now let’s look at the same example using options. Let’s say the option price for the same stock at a strike price of $50 was $5. You could buy an options contract at $500 and still control 100 shares of the stock.

Now the difference is you have the right, but not the obligation, to purchase 100 shares of the stock at $50 any time up to the expiration date of the options contract. Let’s say that the expiration date is 4 weeks out from the time you purchased the contract.

Ok so the stock falls to $20 in the first week same as before. At this point all you have lost is the purchase price of the option which was $500. You certainly wouldn’t buy the stock at $50 when it’s only worth $20 right? But you’ve still got 3 weeks left on your option so when it takes off and hits $65 the next week you exercise your option and purchase the stock at $50 and immediately sell it at $65 for a $15 X 100 (shares) $1500 profit. Subtract the $500 you paid for the option and you’re left with $1000 in profit (less broker fees).

Or, even better, since you have two weeks left on your option, you could put in a trailing stop loss and let it ride hoping for even higher profits. If it falls below the trailing the stop loss level you’ll still end up with a nice profit automatically. If it goes even higher your stop loss will move up for greater profits all the way up to the contact’s expiration.

So, as you can see, in this case you have limited downside risk with unlimited upside potential profits.

One of the big differences between buying stock outright and buying options contracts is you always know what your risk is with the options contract. You can never lose more than you paid for the contract. Whereas if you buy the stock outright and the stock goes into a freefall you could potentially lose your entire investment.

Another big difference is the leverage with options. Using the example above, you would have to come up with $5000 to purchase the stock outright. Buying the same amount of the same stock using an option you would only have to come up with $500. This leaves you with more capital to invest in other options, or other areas of your portfolio.

And perhaps the most important difference between purchasing stocks and using options is with certain options strategies you can profit whether the underlying stock goes up or down!

We’ll talk about that more in the following posts.

Until next time, here’s to your successful trading!

Trader X

Click here to go to the next lesson.

So they are exactly reversed from the order you should read them. To get around this, and to make it easier for you to get them in the right order, I have numbered the lessons.

If you follow the lessons in numbered order you will find the lessons will make much more sense.

Start with The Basics of Options Trading and then move on to the numbered lessons.

I have tried to put a link to the next lesson at the end of each post to make it even easier to follow along.

Once all the lessons are posted I will go back and re-date them so they show up in the correct order. I’m only doing this for those of you that happen to start the lessons before I’m finished posting them. :)

I hope this helps and if you have any suggestions or questions along the way just drop me a comment and I’ll try to answer as soon as possible.

Good luck with your trading and all that you do.

Trader X

Click here for the first lesson – The Basics of Options Trading