The Basics of Options Trading – Lesson 1

Let’s start by defining Options. Stock Options are probably the most misunderstood of all stock trading actions.

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

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