Options Trading -- The Basics
Options Trading is another way to invest money in the Stock Market. We'll start with a definition of options -- also called stock options -- followed by a real life example. We'll look at the types of options, introduce some terminology, and end with a discussion of when Options would be a good investment choice. It is important to state here that options carry large risk and should only be traded after you thoroughly understand the risk.
What is Options Trading?
An option is a contract that gives the owner the right, but not the obligation, to buy or sell a security at a particular price on or before a certain date. Yes ..... this is a very theoretical, text-book type of definition. To make better sense of it, let's consider an example in the real world.
A Real Life Example
The entrepreneur in you is fired up again. This time you are convinced that a Car Wash is what you need to buy. After weeks of intense searching you find one that's for sale. Understandably, you're hesitant to make this purchase. Millions of doubts flood your mind. The price-tag of $200,000 is a substantial sum to borrow. You need more time to think, plan, and look at the business idea from every angle. But you don't want to lose this opportunity to buy either. If only there was some way you could reserve the right to buy this Car Wash at this price and still have 3 months to think it through..... You approach the seller and negotiate a deal that gives you an option to buy the Car Wash in three months for a price of $200,000. The owner agrees ... but there's one catch. You have to pay him $2,000 to buy this option. A couple of scenarios could arise in the next three months... - A big developer buys the land close to the Car Wash to construct a new shopping mall. All of a sudden, the value of the Car Wash skyrockets by 50%. The seller, cursing himself for entering the option deal with you, realizes that he is obligated to sell you his Car Wash for $200,000 even though it's now worth $300,000.
You stand to make a whopping $98,000 gain when you exercise your option to purchase the Car Wash. - You make a trip to the Car Wash with the intention of studying it in detail. The seller reluctantly shows you around. You notice all kinds of malfunctions in the equipment despite his best attempts to cover up. After leaving the Car Wash, you drive around the neighborhood and notice three more Car Washes within 1 mile.
You're now convinced that had you made the $200,000 investment instead of buying the option, you could have been in trouble. Big trouble! The $2,000 insurance policy saved you from a catastrophic business investment.
Tying it together ....
In light of the above Car Wash example, let's review our definition of Options/Options Trading again An option is a contract that gives the owner the right, but not the obligation, to buy or sell a security at a particular price on or before a certain date. In the Stock Market this security is typically a stock. Does the definition make more sense now?
Types of Options -- Calls and Puts
The Call Option gives the holder the right to buy the underlying security at a certain price on or before a certain date. You would buy a call option if you expected the price of the underlying stock to rise before the option expires. The Put Option is the right to sell the underlying security at a certain price on or before a certain date. You would buy a put option if you expected the price of the underlying stock to go down before the option expired.
Basic Options Trading Terminology
Strike Price (or Exercise Price) is price the underlying stock can be bought or sold for as specified in the option contract. Expiration Date is the month in which the option expires. All options expire on the third Friday of the month unless that Friday is a holiday. In that case the options expire on Thursday.
Options are identified a particular way -- by the month they expire, whether they are a Call or a Put, and the strike price. For example, an “AAPL July 117 Call” would be a call option on Apple stock with a strike price of $117 expiring in July.
Why Trade Options?
Speculation -- betting on the direction the underlying stock price is going to move. The versatility of options makes the direction immaterial .... the price could go up or down and you could still profit if you bought the proper type of option. Hedging -- similar in concept to the insurance policy in the Car Wash example above. It can be thought of as protection against a downturn in your stock investment. This makes more sense for large institutional investors. By hedging, your potential to profit is limitless, but your loss can be limited by buying the appropriate option.
In summary, we started with the definition of Options Trading, looked at a real world example to solidify this definition, reviewed Call and Put Options and discussed why we would trade options. Again, this is only a basic introduction to options.
Finally -- and this bears repeating -- options trading involves huge risk. Tread (or Trade) carefully! If you're looking to learn more on options trading, here is a great website that we recommend:
Safe Options Trading Income — Conservative Options Trading Techniques for Generating Income.
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