What are options?

An option is a contract to buy or sell a stock, usually 100 shares of the stock per contract, at a pre-negotiated price and by a certain date.

Just as you can buy a stock because you think the price will go up or short a stock when you think its price is going to drop, an option allows you to bet on which direction you think the price of a stock will go. But instead of buying or shorting the asset/stock outright, when you buy an option you’re buying a contract that allows — but doesn’t obligate -hence option — you to do a number of things, including:

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• Buy or sell shares of a stock at an agreed-upon price (the “strike price”) for a limited period of time (by the "expiration date")

• Sell the contract to another investor.

• Let the option contract expire and walk away without further financial obligation.

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Why use options?

Investors use options for different reasons, but the main advantages are:

• Speculation and Trading

• Hedging or protecting an investment from price decline.

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Language of Options

Like most professions, trading has its own language. Sounds confusing to the unknowing, and the ones that are speaking it can sound like really really smart people. They're not. once you learn the jargon and language of a profession, you take the mystery out of it - 

 

Here are the Basics to Get you Started -

Call: An option contract giving the buyer the right, but not the obligation, to purchase a stock at some time in the future. This would be the equivalent of Going Long, or Buying. Ie You're Bullish On the Stock

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Put: An option contract giving the buyer the right, but not the  obligation, to sell a stock at some time in the future. This would be the equivalent of Going Short, or Selling, Ie You're Bearish On the Stock

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Note - At no time during the process of Options Trading do you ever need to actually own the stock itself. When trading options, you only need trade the options contracts themselves, never the actual underlying stocks.

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Expiration: The date on which an option contract automatically expires; the last day an option may be exercised. 

In-The-Money: The state of an option contract in which it has a positive value if exercised. 
 

At-the-Money: The point at which an option's strike price is the same as the current trading price of the underlying commodity.

Out-Of-The-Money: The state of an option contract in which it has no intrinsic value.

Premium: The payment an option buyer makes to the option writer for granting an option contract. The cost of the option

Time Value: That portion of an option's premium that exceeds the intrinsic value, reflecting the probability that the option will move into-the-money.

 

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Example Of A Call Option

 

Lets Say it is September 12, 2018. Microsoft is currently trading at $111.00, and over the next few months I expect the price of Microsoft Stock (MSFT) to go up over $125. In fact, I am certain that this is going to happen, so certain, that I am willing to make a bet on it. 

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I have $1,000.00 to invest and that would allow me to buy 9 Shares of Microsoft 

(9 * $111.00) = $999.00 (excluding broker trade fees of course)

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My prediction comes true and just a few months later Microsoft is trading at $128.00. 

(9 * $128.00) = $1,107.00

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!!!  Victory  !!! My $999.00 is now worth $1,152.00 and I have earned a not too shabby $108.00 (excluding broker trade fees, gotta pay the piper)

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My Return On Investment (ROI)

ROI = (Total - Principal) /  (Principal )

ROI = ($1,152 - $1,000) / ($1,000) = 15.2%

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Not too shabby for two months of work.

 

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Now lets say i know how to use Options and I want to make that same bet. 

I look up the price of a a CALL (Long Bet) on Microsoft with a strike price of $125.00 (i.e. the Price that I think Microsoft is going to Beat).

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Option Format Sample:

Ticker     Expiration Date

Strike Price     Type of Option

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MSFT   Nov 16 '18

$125.00   Call

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This OPTIONS Contracts are currently selling for $.66 (Wow That's Cheap. But Wait!)

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When you buy options, you deal in lots of 100. The actual price to buy one contract will be $.66 * 100 = $66.00. Having $1,000 we can afford 15 contracts costing us a total of $990.00

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The Price of MSFT does what we expect and goes up to $128.00.

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The OPTIONS Contracts that we purchased above, on November 15, 2018 would be worth:

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Contract Value = (Contracts Purchased) * (# of Shares MSFT per Contract) * (Current stock Price - Strike Price)

Contract Value = (15) * (100) * ($128 - $125)

Contract Value = (15) * (100) * $3 = $4,500.00 !!!

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Now lets remember that we spent $990 on the contracts so our total profit is:

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PROFIT = Contract Value - Initial Investment

PROFIT = $4500 - $990

PROFIT = $3,510 !!!

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My Return On Investment (ROI)

ROI = (Total - Principal) /  (Principal )

ROI = ($4500 - $990) / ($990) = 354%

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This is a an example of the leverage that OPTIONS trading can offer you in your trading, without actually borrowing money from an investment firm (Margin).

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It has to be noted - that you can sell that option anytime between the date you buy it and the expiration date. If the price of MSFT stock randomly spiked up $10 per share on October 1, 2018. You could sell it off to another speculator on the market and collect your profits. 

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It has to be noted - SCREAMED - that once the option Expires - it is worthless. In the above example, if you went to sell that OPTION on November 17, 2018, it would be completely worthless 0$. 100% Loss.

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Example Of A Put Option

Same as above but in reverse. hehe

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more detailed example coming soon.

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How to start trading options

In order to trade options, you’ll need a broker. There are many brokers to choose from, and a few good ones would include:

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• E*TRADE - Best for options overall. [THIS IS THE BROKER THAT WE CURRENTLY USE]

• Interactive Brokers - Lowest commissions.

• TD Ameritrade - Best options tools.

• TradeStation - Well-rounded offering.

• Charles Schwab - Best for order types.

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Pitfalls and Challenges

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Choosing the date of expiration for an option can definitely be a difficult task for a newer trader. When starting out, keep in mind the following factors that can help you choose an expiration date to improve your chances of success:

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- Your trading style

- Upcoming earnings/dividends

- How much risk you can tolerate (Closer to Expiry, Higher the Risk....But ...Higher the Risk should allow for a higher reward)

- Stock Prices are subject to random price swings due to: Negative News, Bad Earnings Reports, Good Earnings Reports, Wars, Weather, etc)

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