Options Trading Basics

• Introduction to Options Trading
• Understanding Option Contracts
• Types of Options
• Basic Options Trading Strategies
• Risks and Benefits of Options Trading

• Introduction to Options Trading

  Options are superior investment tools that offer accelerated returns and reduced capital requirements. While some view options as risky, they serve as insurance to protect invested capital. With understanding, options can help investors increase capital at above-average rates compared to traditional assets. Furthermore, options limit potential losses to the initial purchase price plus fees, unlike stocks. By understanding options, individuals can make informed decisions about their suitability.

  An option is a financial instrument that offers a right to purchase or sell an asset at a certain price on, or before, a predetermined date. It is commonly used by investors to minimize the downsides of other asset classes they own and to take advantage of short-term movements in efforts to trade a market ranging from bullish to bearish. Options are flexible tools that appeal to active investors, but before intending to trade options, a basic understanding of what options are is very essential.

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• Understanding Option Contracts

  To trade stock options successfully, you must know what exactly is an option contract and the amount of information that is needed to give you the ability to be successful in option trading. An option contract represents 100 shares of the underlying stock. For example, if you are buying an option giving you the right to buy IBM at $5 per share, you would be buying an option on 100 shares of IBM. So the total cost of the contract would be $500. A key factor that is often overlooked by those who are new to stock option trading is that of understanding how the Greeks can be used as an important tool to guide trading strategy. Greeks are a set of risk measures that evaluate the sensitivity of an option’s price to several factors. The main factors are stock price, time, and volatility. By knowing how these factors can impact an option, the trader can make better-educated decisions on which options to buy or write, and which hedging strategy is the most suitable for the given option.

  Understanding stock options and how to best use them for your gain can be a very involved and intricate process. This is because options have characteristics that are far different from those of the underlying stock and there are several option-based strategies that an investor can take up to either maximize their gains or hedge their current position. For this reason, it is very important to be constantly expanding your knowledge on beginner’s options trading. Knowledge can be obtained from a variety of sources including financial books, going to classes/seminars, and speaking to experienced options traders. A combination of these methods will ultimately give you the best chance to understand options on a higher level.

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• Types of Options

  Call options
  – A call option gives the holder the right to buy the underlying security.
  – To buy a call, the investor must pay an option premium.
  – The premium (price) is determined by several factors.
  – The call is said to be “in-the-money” when the current price of the underlying is above the strike price. If the stock is selling at a price higher than the strike price, the call is said to be “out of the money.”
  – A call option is said to be “at-the-money” when the current price equals the strike price.
  – The call seller must sell the security to the call buyer at the strike price if the buyer chooses to exercise the call.
  – The call buyer has the right to buy the security. If the call is exercised, the call buyer will buy the security at the strike price.
  – The upside on the call option is unlimited. The option buyer has leverage on the stock price. They can earn more profit with the limited amount of the premium.
  – The option seller’s profit is limited to the amount of the premium, but their risk is unlimited.

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• Basic Options Trading Strategies

  Now look back at the two transactions that can be made with an options contract, to buy or to sell. Similar to other investments, a person can buy and sell options. All of the strategies that are presented involve buying and selling options of the same underlying asset and type. These are called debit and credit spreads because when you buy an option, money is taken (debit), and when you sell an option, money is received (credit). A person can also buy a call or put and then sell it before the expiration. This is also a strategy that involves taking a small loss to avoid the possibility of a bigger loss or to make a small gain. This is similar to insurance.

  Knowing that there can be only one of two possible actions with the option contract, buying and selling the contracts can be used to develop other strategies.

  1. Exercise an out-of-the-money option to acquire the underlying asset at less than its current market value.
  2. Offset the option to close out the position to avoid any further loss or exercise the option if it becomes profitable to do so.
  Two basic things can happen with the options contract: to exercise the contract and take delivery of the underlying asset, or secondly, the contract can be offset in the market before expiration. This may sound a little confusing, but it will make more sense once the concepts are explained.

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• A stock option is a contract to buy or sell a stock at a fixed price until a specified date. Buying an option is a bullish bet on the stock while selling a call option is a bearish bet. Options are versatile and can be conservative or speculative. They are popular among investors looking to test their investment skills.

  Options are trading tools that allow you to hedge bets in the stock market or make new ones. You can have opposing positions on the same investment, like when buying or selling a home. Buying a home is bullish as you expect its value to rise while shorting a stock is bearish, but risky. Shorting involves selling an investment and hoping to buy it back later at a better price to profit from stock price declines.

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