Understanding Stock Options


Let’s just say I have $10,000 and I want you to invest in and trade stock options. Now, while you may have some experience buying and selling stocks, you don’t have much experience trading stock options or for that matter, understanding how stock options work. What chance do you think you have of investing that $10,000 and turn it into $15,000? What you would have is a gambler’s chance, essentially because you are gambling. You simply must understand how options work to give yourself a fair opportunity to make money.

It is amazing how many people are willing to commit their hard earned dollars into an investment or investment strategy without having an understanding of how that particular strategy works. Yet, unscrupulous stockbrokers and traders spend a significant portion of their day trying to entice new investors into the world of trading options. You don’t have to invest a lot of money and you can quadruple your money very quickly. That’s usually something that is used as a sales pitch to lure new investors.

The old saying goes you can and will lose money investing in stock options. This is a 100% fact. Understanding stock options and how and when to make a decision on executing a trade is of paramount importance if you hope to be profitable as an options trader. So how do you become an educated options trader?

Trading options just like anything else, begins with principles that are foundational to understanding the trading platform. Options can be defined as a right to buy or sell a stock or commodity at a given price, within a specific time frame. So let’s say you have 60 days to make a decision whether to exercise your right or to let your options expire worthless. How will you make that decision? What factors enter into your decision-making process? Will your emotions force you into making a bad decision?

I have personally never experienced any options trader or any stock investor that did not at some point make a decision based on emotion. That is not to say that is correct or the right thing to do but until you are faced with a buy or sell decision under pressure, you will not know how you will respond.

However, understanding stock options or the stock market better prepares you to make that decision. You must have a plan and then implement your plan and then work your plan.

If you do not have the time or inclination to understand how options work it would be best for you to stay away investing in mutual funds or ETF and avoid the possibility, the very real possibility of you losing large sums of money.

Anyone who is a subject matter expert or considered the best in their particular field has spent endless hours practicing and diligently learning their craft. The same is true with the most successful options traders. They are relentless in their pursuit of educating themselves to how and why the options market works the way it does. In short they practice just as much as the most successful professional athletes.

If you are intent on trading options before your time of education is through it is advised that you paper trade options to learn without the risk of losing your hard earned money. In fact after you spend some time learning how to trade options you would be wise to paper trade options and test your theories and strategies without risking capital.

Understanding options is about education and preparation. Please read through our information and resources to better prepare you to trade options and to be a successful options trader.

Trading Stock Options Explained

Before we go much further in our how to trade stock options lessons, let’s define what a stock option is. Seems rather basic doesn’t it?  It is however part of understanding options. I promise you if you asked 10 of your friends how to define a stock option the majority of them would not know the correct answer.

A stock option essentially is a contract that gives the owner or the holder of the option the right to buy or sell a particular asset, in this case the underlying stock, at a fixed price, known as the strike price, for a designated period of time, known as the expiration date. You have the right to buy the asset, but you are not obligated. If you choose, you can let the options contract expire worthless. Hopefully now, you understand what a stock option is and could repeat the definition if needed.

Now let’s see if we can put it in more practical terms. Let’s assume through your diligent research you have found a stock that you believe is poised for an increase in price. We will call this stock, XYZ. It is currently trading at $20 per share. However, your research because you know how to research tells you that it is going a lot higher within a couple of months. How much higher? That doesn’t matter at this point, you just know that according to your data the prices going higher.

You decide that you want to purchase and options contract on XYZ. According to the terms of your options contract you have a right but not an obligation to purchase 100 shares of XYZ at $20 per share, within the next three months. If your research is correct, and XYZ moves to $23 or $24 or even higher, you can still buy 100 shares at $20 each. Hopefully you can start to see the profit potential.

But, alas, your research was incorrect and over the next 2 1/2 months the stock declined to six dollars per share. Obviously, you will not want to exercise your option at $10 per share. You decide that since you have the right to buy the stock, but you do not have an obligation to buy the stock, you let the option expire. What have you lost? The seller of the option group basically held the stock for you why you decided if you wanted to buy it or not, sold you the option with a premium attached.

The seller was in a position of holding the stock and no one else according to the terms of the contract could buy the stock. So in this example, the premium attached to the contract that entitles you the right to buy the stock is $200. That is your loss on the option for XYZ that expired worthless.

Now that didn’t feel very good. Consider if you had purchase the 100 shares at $10, using the same research used to buy the options contract. Your losses sold at six dollars would be $400 plus a brokerage firms commission. Now it does not seem as bad does it?

This is a basic example of a stock option purchase and we will delve into more sophisticated strategies in our future articles. Remember for the time being the underlying stock as we will explore the secret to trading stock options successfully.

Trading Options and The Underlying Stock

There are many an options trader that claims to have a secret of trading options for profit. Perhaps it is a trading strategy or an advanced trading strategy. They really is only one real secret to trading options successfully. All stock options are attached to a stock. Many people either disregard, or underestimate the importance of the stock that the option is linked to in trading options. From here forward we will call that stock the underlying stock.
That being said, there is a fundamental principle that an options trader needs to comprehend and apply to their options trading. When the price of the underlying stock goes up, so does the option price. So as we have discussed if you have a working knowledge of what drives individual stocks up and down you are now half way to trading options successfully. It really is as easy as picking a profitable underlying stock.

It does not matter if you are a buyer or the seller of an option, the most significant factor in successful options trading is choosing the right underlying stock. Penny stocks or stocks that trade under three hours a share, are not allowed to have options. If you focus on well-known companies, you should have more than enough trading opportunities. If you ever have traded Penny stocks you know that sometimes there isn’t a lot of liquidity. It’s the same with options.

We should mention another issue or concern about the underlying stock. A mistake that many beginners make trading options is confusing contracts and shares. If you are entering the options market from a historical perspective of trading individual stocks, this could be a costly mistake. One standard options contract equals 100 shares of stock. However, if you make a mistake and enter 100 contracts you just bought the rights to buy 10,000 shares of the underlying stock. Again while this seems like a elementary lesson in trading stock options, you would not be the first person to make this mistake.

It is advised that any beginner options trader should place their trays one options contract at a time, and that would give them the right to buy 100 shares of stock. As we have discussed it is best to test your strategies and develop your style early on. How you evolve as a stock options trader is largely based on how you train and educate yourself in the beginning.

So now as you begin your research looking for opportunities to trade options, where will you begin? Will you look at options contracts, or will you look at underlying stocks?