Beginning with Options Trading

by Investing School on April 1, 2009

Most people view options trading as a very risky way to invest but little did people know that options were first developed in the 1970 to mitigate investment risks.  When it’s done right, options can be a powerful way to accomplish protection, both on the up and down side.

Call and Put Options

There are two basic kinds of options, a call option (sometimes referred to as calls) and a put option (sometimes called puts).

Call Option Explained

When you buy a call option, you are buying the right to purchase an underlying asset.  In the case of options for equities, you can trying to obtain the rights to buy a contract at a certain pre-specified price, known as the strike price.

Options are measured in contracts, with each contract equal to the rights to 100 shares.  For example, if I buy 10 call option contracts of stock XYZ at a strike price of $30, it means that I obtained the right to buy 1,000 shares of XYZ at $30, no matter what the share price of the stock is.

Put Options

Puts on the other hand is just the opposite.  Buying puts equates to buying the right of selling that stock at a certain strike price.  Buy 10 contracts of put option of XYZ at a strike price of $30, and you can sell 1,000 shares of that stock even if XYZ falls to $0.

Other Options Terms

Expiration Date – All options have a date in which they expire.  In any option contract, you are buying the right to exercise your option within a certain period of time.  The longer the expiration is from the current date, the higher the probability that the options will be in your favor and therefore the higher the price of the contract.

Premium – The price of the contract is what’s known as the premium, because you are effectively paying a premium to obtain the right to purchase the security.

In and Out of Money Options – When a option contact is considered “in the money”, it means that you can exercise the option right away to make money.  For example, a call option with a strike price of $48 would be in the money if a stock is trading at $50 per share because you can exercise the option for a gain.  Therefore, any call options with a strike price that’s lower and any put options with a higher strike price than the current share price of the security is in the money.  Every other options contract are out of money, but the premium is usually lower on those as well obviously.

A Simple Options Strategy

A popular and simple strategy with options is what’s known as “buying put protection”.  For example, you can buy stock XYZ at $50 a share and buy put options with a strike price of $50.  If the stock goes up (as you thought it would), your gain would be the difference in share price x the number of shares you have – the premium of the put contract.

However, if XYZ’s price drops, you will be underwater with your XYZ holdings but you at least have some protection through your put contract because you can still sell some shares at the strike price of $50.  In effect, the put contract acted as an insurance for you, reducing your risk on the downside.

What Options Mean for Us

When you get into it, option contracts can be much more complicated than what I’ve described above.  However, options can be a great way to supplement your investing strategies.  While it may be more advanced than just buying a share of a stock, it is not impossible to learn and one that I encourage you to look into (even if you don’t plan to buy or sell options).

One final word of caution.  Make sure you understand that options expire and are deemed worthless after the expiration date.  If you forget that, you can lose all your capital in a hurry.

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{ 1 comment… read it below or add one }

Frank March 1, 2011 at 7:18 pm

Great walk through on basic terminology.


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