MANY people want to learn how to trade Options but are not sure where to start.
That is because the amount of information out there can be overwhelming, and it is hard to find the right resources to help you avoid making costly mistakes.
Here are two common challenges:
- Firstly, there are too many different strategies, terms, and technical jargon to learn before you get started.
- Secondly, most courses are either too basic or too advanced, and they don’t really give you the information to help you succeed in Trading Options for income.
Don’t worry if you are not an expert, yet.
Keep reading and we will show you the basics that you need to know about Options trading — How it works, Why traders do it, and What options are involved?
What are Stock Options?
Stock options are traded similarly to stocks. However, the implications are very different.
A stock option gives the owner the right to buy a specific number of shares of the company stock at a pre-set price, known as the “exercise” or “strike price,” for a fixed period of time, which are valid until the expiration date.
An option contract comes in lots (groups) of 100 shares, where each contract represents 1 lot or 100 shares.
Call options allow the option holder to purchase an asset at a specified price before, or at a particular time.
Put options are opposite of Calls in that they allow the holder to sell an asset at a specified price before or at a particular time.
- You may sell the option for a profit or loss, any time before the contract expires.
- Your losses are limited to the total price that you paid for that options contract known as the premium.
- To break even, you must be able to sell the options for more than what you paid, or exercise options that allow you to cover the cost of your premium.
*NOTE: Options are very sensitive to changes in the price of the underlying stocks. Because option prices change quite rapidly, owning them requires that you spend a significant amount of time monitoring price changes in the stock and the option.
Understanding Call and Put
Call and Put options are examples of stock derivatives where their value is derived from the value of the underlying stock. When you purchase an options contract, you’re said to be long in the contract.
A long Call contract is a bet that the stock price will go up, whereas a long-Put contract is a bet that the stock will go down.
For example, a Call option goes up in price when the price of the underlying stock rises. And you don’t have to own the stock to profit from the price rise of the stock.
Four main components of a Stock Option
- The Strike Price — This is the price at which your underlying asset can be bought or sold if the option is exercised.
- The Expiration Date — This is the last day that your option is valid. After this date, the value of your option is zero because the contract no longer has an enforceable aspect.
- Time value (TV) — This is equal to the option premium (current market price) minus the option’s intrinsic value. After the expiration date, the time value of the Options is zero.
- Intrinsic value (IV) — This is the price of the underlying asset for delivery on the settlement date of the options. You can also express the time value of an option as Premium – IV = TV.
The price you pay for a Call option depends on many factors two of which include the duration of the contract (the longer the duration, the more you pay) and how far the current price of the stock is from the strike price of the contract.
You can own as many Call options contracts as your broker allows.
Buying a Call
A Call is a contract that gives the owner the right, but not the obligation to buy 100 shares of a stock at a fixed price, called the strike price, on or before the options expiration date.
Assume that you buy a June $120 Call option (the option expires on the third Friday of June). The strike price is $120. If the stock price reaches $120, the value of the contract increases $100 for each $1 increase of the stock. So, if the price of the stock moves from $120 to $135, the value of the option increases by $1,500.
If the price of the stock goes above the strike price and you want to buy the 100 shares, you can exercise the option and buy the 100 shares for $120 per share, no matter the current value of the stock.
On the other hand, if the value of the stock goes down, the price of the option goes down, and you could hold, or sell it at a loss.
Here’s what a Call buyer may do:
- Take profit. Sell option at a profit if the stock price rises above the strike price.
- Lose part of the purchase price. Sell option at a loss if the stock price does not rise.
- Lose all of the purchase prices. Let option expire and take a loss if the stock price does not rise.
TIP: The buyer may also sell the contract to another person before the expiration date at the market price for that contract.
Buying a Put
A Put option is a contract that gives you the right, but not the obligation to sell a stock at its current price.
The price you pay for a Put option depends on the duration of the contract (the longer the duration, the more you pay) and how far the current price of the stock is from the strike price of the contract.
If you buy a Put with a strike price of $50, you can sell 100 shares of the stock to the Put seller when the stock price falls below $50. So, if the stock falls to $30, you can sell it for $50, and the seller is then obligated to buy the stock at $50 even though the current price is $30 — not a good deal for the Put Seller.
How does a Put Option Make Money?
As with a Call option, you don’t have to own the stock, but if you do, the Put acts as a hedge – if the stock price goes down, the value of the Put goes up so you are hedged against the downside.
- Put options is In The Money when the stock price is below the strike price at expiration.
- A Put option goes up in price when the price of the underlying stock goes down.
- A Put owner profits when the premium paid is lower than the difference between the strike price and stock prices at option expiration.
- The owner can also sell the Put option to another buyer prior to expiration at fair market value.
PUT as a form of insurance
Buying Puts is a more conservative way of betting on a stock declining in price.
- If you own a stock, you may buy a Put as a form of insurance. When the stock falls in price, the Put rises in price and helps offset the paper decline in the underlying stock.
- If you don’t own the stock but think that it will go down in price, you may buy the Put to profit from the decline in the stock prices.
- If the stock price declines, the value of the Put rises and you can sell the Put for a profit.
- If the stock increases in price you may sell the Put for a loss.
*NOTE: Put buying is different from selling short. With a Put option, your only liability is the price you paid for the Put. With a short sale, you have an unlimited downside liability if the stock goes up.
Here’s what a Put buyer may do:
- Sell option at a profit if the stock price declines. Take profit.
- Sell option at a loss if the stock price does not decline. Lose part of the purchase price.
- Let option expire and take the loss if the stock price does not decline. Lose all of the purchase prices.
Is Options Gambling?
Contrary to popular belief, options trading is a good way to reduce risk. And if you know how to trade wisely, trading in options is NOT gambling, but in fact, a great way to reduce your risk.
Here’s how to Trade Options in 4 Steps:
1. Open an options trading account. Before you can start trading options, you’ll have to prove that you know what you’re doing.
2. Pick which Options to buy or sell.
3. Predict the Option strike price.
4. Determine the Options time frame.
Here are some common terms when it comes to Options trading:
- Expiration date — Date up until which an option contract is good
- Strike price — Contracted price by which the contract can be exercised.
- Option premium — Cost associated with purchasing or selling an option made up of intrinsic and extrinsic values.
- Intrinsic (in-the-money) value – The value between a stock option strike price and the underlying stock’s price.
- Extrinsic value – The value paid on a contract based on external factors of time and volatility.
- Implied volatility — The expected or forecasted volatility in a stock over a certain number of days.
ABOUT WEALTH MENTORS
Wealth Mentors offers a step-by-step program that teaches everything from beginner techniques all the way up to complex strategies used by professional traders around the world, on how to trade options successfully.
Our goal is simple – we want aspiring investors who have never traded before or who have been given bad advice actually understand their investment options — to enable them to take control of their financial future instead of leaving it up in the air hoping for something better later down the road.
It is like having your own personal mentor guiding you to financial success every step of the way!