How To Get Started In Options Trading, Part I
Overview
In this course, we will teach you what options are and the basic options strategies that can be used to take advantage of different conditions in the markets. This course is divided into three parts as follows:
In Part I, you’ll learn what options are along with the advantages and risks they offer to the astute trader.
We’ll continue to lay the groundwork in Part II, as we teach you how options are priced and how various factors affect the price of an option.
Finally, in Part III, we’ll go deeper and teach you the most basic options strategies and their behavior based upon the action in the underlying market.
Please understand that the objective of this course is to teach the basics of options trading. But because options are highly risky and the reality is that you can potentially lose some or all of your investment capital. Therefore, it is important that you not trade with real money until you receive a strong foundation in professional options strategies. Click here to learn these strategies from a successful professional options trader.
Let’s get started!
Options in one form or another are nothing new. They’ve been around for hundreds and perhaps thousands of years. Traders and investors can use options for hedging and speculative purposes. Options are known in the financial markets as “derivatives.” That basically means that their value is tied to or derived from the value of their underlying instrument. For example, the value of an option to buy Microsoft stock will be based on the price of Microsoft stock.
In the financial markets, there are options on individual stocks, various market indices, and futures contracts. In this lesson, we will focus on stock options, but most of the concepts are applicable to other types of options. So just what are options? Options are contracts between a buyer and a seller that gives the buyer the right to buy or sell something at a predetermined price on or before a specific date.
Let’s look at an example. Say that I want to buy a house and you want to sell your house. You’re asking $300K for your house. I (the buyer) really like the deal, but need to check elsewhere before I commit to buying your home for $300K. So let’s say that you decide to sell me an option that gives me the right to purchase your home at a stated price of $299K. And for selling me that right, I will pay you $1,000. Also in this contract, you state that this option will only be good for three months. If during the three-month period, I (the buyer) do not notify you (the seller) that I intend to exercise or use my option to buy your house at the stated price of $299K, the option expires worthless and ceases to exist.
In this case, I would have forfeited the $1,000 that I paid to you for the option. Meanwhile, you, the option seller, gets to keep the $1,000. Now let’s say that two months later, home prices in your neighborhood suddenly rose in anticipation of the building of a mega-shopping mall. In this case, your house is now worth $320K. Remember that I still have the right to buy your house at $299K. I can now either exercise my option or I can just sell it. I could exercise my option and purchase your house at the stated price of $299K and immediately sell it for $320K, thus netting a $20,000 profit ($320K – $299K – $1K). Or I can sell my option to someone else for at least $21K.
Advantages
Option trading has been increasing in popularity over the last few years as options provide traders with several advantages:
1. Leverage — Higher returns and lower cash outlay. Stock trading is expensive. In order to buy 100 shares of XYZ stock at $100 per share, you’ll need $10,000. Although this might not seem like a huge amount of money to some people, $10,000 might be a big sum for new traders. If XYZ moved up five points, you would make 5% on your money. With options, you can control or participate in the movement of a stock for a lot less money and earn a higher rate of return. If instead of buying the stock, you purchased an XYZ January 100 call, which gives you the right to buy 100 shares of XYZ stock at $100 on or before the January expiration date, you would have made over 250%!!! Now that’s leverage!
2. Flexibility/versatility — With stock, traders can be either bullish or bearish. With options, traders can be bullish, bearish or neutral. Options can be used by themselves or in conjunction with stock. Options can also be used in combination with other options to create many different risk/reward scenarios.
3. Predetermined risks — For option buyers, the most you can ever lose is the amount paid for the option. You know in advance how much you can lose.
Types of Options
There are only two types of options, calls and puts. Call options give buyers the right, but not the obligation, to purchase the underlying instrument at a specific price (strike price) on or before a specific date (expiration date). Put options give the buyers the right, but not the obligation, to sell the underlying instrument at the strike price on or before the expiration date. Just remember that buyers of options have all the rights and sellers have all the obligations. So on the flipside, call sellers have the obligation to sell the underlying instrument at the strike price to the call buyer if the call buyer chooses to exercise or use the option. Put sellers have the obligation to purchase the underlying instrument at the strike price if the put buyer chooses to exercise.
Back in the old days, there were no organized options markets. Options were traded over-the-counter. Each option contract was tailored to meet each party’s exact specifications. This made it difficult and cumbersome to find someone who wanted to take the other side of your trade. These days, most options are traded on an organized securities exchange such as the Chicago Board of Exchange (CBOE). The terms of option contracts are now standardized, which means that the terms of each contract is set or fixed. Option contracts have standardized contract sizes, strike prices and expiration dates. For stocks, each option contract covers 100 shares of stock. So if you bought a call option, you bought the right to purchase 100 shares of stock. Much like insurance policies, option prices are referred to as “premiums.”
You will often see option premiums being quoted as “10 1/2.” This does not mean that you can buy an option for $10.50. Since each option contract is for 100 shares of stock, you need to multiply the 10 1/2 by 100 to come up with the actual price of $1,050.00. In stocks, the number of shares available for trading is known as the “float.” In options, it’s known as “open interest.” The exercise price or strike price of options is the price at which the underlying instrument will be delivered if the holder/buyer of the option chooses to exercise. Strike prices are set at two-and-a-half-dollar intervals for stocks trading at $25 and under. For stocks between $25 and $200, strike prices are set at $5 intervals. Stocks trading over $200 have strike prices set at $10 intervals. Certain stocks trading between $20 – $450 also have strike prices set at two-and-a-half dollar intervals. The expiration date of an option is the date that the option expires or ceases to exist. All listed stock options expire the third Friday of the month. Options also have maturities from one to nine months. There are also long-term options called Leaps. Leaps have maturities of up to three years.