Options Trading Basics
A Door to the Lottery, Expensive Cars, Protecting Investments, and Creating Income
By Alex Johnson
By far, the most bewildering and intimidating concept for new traders seems to be stock options. Often beginner traders end up allured by the empty promises of penny stocks or bored by the sluggishness of blue-chips, yet somehow they end up feeling like a kindergartner pissing his own pants on the first day of school when options are brought up.
Trading Options is best for Traders who:
- Lack the virtue of patience
- Enjoy directional bets, with or against the market
- Want more control over the risk of their trade
- Seek protection from huge drops
- Seek huge returns via leverage
- Need approval from a disapproving dad
- Enjoy risk and want to make the most of it
If any of the above applies to you, it’s worth a shot reading on, and giving a couple contracts a try.
So what is an option
An option is a contract that gives the buyer the right to buy or sell 100 shares of an equity at a certain price, on a certain date. This concept makes options a commodity themselves. There are some terms we have to define before we completely understand option, but if you’re one of those people who struggles to read more than a paragraph; options can be most easily used as directional bets, as they give you leverage and the ability to make money on the stock whether it goes up or down. In simplest terms;
if you think the underlying stock will go up, buy calls!
If you think it’s going down, buy puts!
If you think it won’t move much, sell calls/puts to hopeful suckers.
Now, let’s move to an actual understanding, because in-depth understanding of options leads to unique and strong strategies that win over time.
Key Terms for Options Trading
A CALL CONTRACT – is the right to buy. Buying calls is taking a bullish position in its most extreme form.
A PUT CONTRACT – is the right to sell.
The underlying – is the stock that the option is covering i.e. AAPL, GOOG, AMZN
Strike Price – the price at which a put or call option can be exercised.
ITM (In the money) – In the money means that a call option’s strike price is below the market price of the underlying asset or that the strike price of a put option is above the market price of the underlying asset. Being in the money does not mean you will profit, it just means the option is worth exercising.
OTM (Out of the money) – a call option with a strike price that is higher than the market price of the underlying asset, or a put option with a strike price that is lower than the market price of the underlying asset.
ATM (At the money) – Strike price at the same price as the underlying
Expiration – Expiries for options are every friday of every week by standard, with exceptions such as every month, or every other day – depending on the underlying. SPY and SPX are great examples of very active option chains with expiries every other day.
Exercising an Option – Think of this as exercising your right to bear arms, only it’s your right to buy/sell the stock at the strike price. On the expiry date or any time before (with american options), an option can be, but doesn’t have to be exercised; meaning the holder of the option can use it to buy or sell shares of the underlying stock at the strike price.
For example, when AAPL was at 120 before its earnings report, Joe buys 10 FEB 17th CALLS at strike 127 for .60 , each. Now .60 cents is really 60 dollars each, because the contract is multiplied by 100 (the right to 100 shares). In total, Joe spends $600 dollars + commission on this trade. The next day, AAPL leaps to 130 upon great news. These same option contracts are now worth 3.50 each. $350 dollars per contract, times ten contracts is $3500 dollars. Joe Shmoe Yolo just turned $600 into $3500 dollars.
That same Joe later buys FEB 17th XOM calls at 90, hoping for similar results. However, XOM ends up never reaching anywhere close to the strike price, and the options expire worthless. Get it?
Now let’s get to understanding what determines the value of an option, as this will help you understand whether you’re screwing yourself over or getting a decent deal for your risk.