The Basics of Option Trading

Many investors remain fixated on the vehicles they know the best. For this very reason their portfolio growth can stagnate after a particular amount of time. As you probably already know, the market tends to ebb and flow which can result in violent swings in either direction. It is important to learn how this market volatility can actually benefit you. Knowing the basics of options trading is imperative if you are ever going to be a well-rounded investor.

First, what is option trading? It is a derivative investment, and can be used in futures trading, commodities, and stocks. Think of options as vehicles which allow investors a great deal of flexibility. In fact, the field is so broad that many traders focus solely on options.

Options can be categorized into two main categories. The first is the Call option. A call option contract can be bought, or it can be sold (written). The buyer of the option has the right, but not the obligation, to buy shares of an underlying security at a given price (also known as the “strike price”). The seller of the option has the obligation to sell the shares to the buyer at the strike price, if the buyer chooses to exercise the contract.

The second is the Put option. Put options work in the opposite manner. The buyer of a put option pays for the right, but not the obligation, to resell the shares to the writer of the contract if a strike price is reached. The seller assumes the obligation to buy the shares of the put contract.

It is important to keep in mind several key facts about options contracts.  Each contract represents 100 shares. Also, the buyer of the contract has to pay a small amount of money called a premium. These premiums are quoted per share. So, they must be multiplied by 100 to determine the total premium price of the contract. The writer (seller) of the contract receives this premium because he or she is taking on the obligation to sell the 100 shares.

The main things to remember when you purchase or sell options are merely time and target. Options are time sensitive mechanisms. Options expire on a certain date. If it is a European style option, you may not exercise your contract until the date of expiry. However, if your contract is American style, you have the ability to exercise your option any time before the contract expires, which gives you much more leverage.

You may not see how this can produce yield, but there are a variety of strategies you can implement to create enormous gains in a relatively short amount of time. If you were bullish on General Electric (NYSE: GE), for example, you could buy a call option. It is currently trading at roughly $23.60. The August 17th call option, with a strike price of $24 has a premium of .35. The total price of the contract would be $35 plus any brokerage commissions associated with facilitating the contract. If the price rose to $25 per share before August 17th, you could exercise your contract for a gain of $100. After subtracting the premium and brokerage fees, you would net approximately $55-$60 in profit. Though this may not seem like much, considering the initial investment of about $40, it is an incredible gain.

If you are already an owner in at least a hundred shares of an underlying security, you can employ the “covered call”. If you do not believe the stock will exhibit much upwards movement, you can collect premiums for writing a contract at a higher strike price. This can recur monthly, which can create consistent positive cash flow, as well as great downside protection.

There are a variety of free resources you should find and use to educate yourself on the various options strategies that exist today. In the end, you will become a better, more well-informed investor.

Do you have anything to add? You can leave a comment below. 

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4 Responses to The Basics of Option Trading

  1. I have used options a lot to help protect from downside risk. They were a big part of my portfolio when the market was dropping in 2008.
    Sean @ One Smart Dollar recently posted..How to Travel The World for FreeMy Profile

  2. I’m thinking about getting into covered calls as a way to generate additional income on the stocks I already own.

    Good article!
    Derek | MoneyAhoy.com recently posted..Does High Deductible Car or Home Insurance Actually Save Money?My Profile

  3. Sean,
    Kudos to you! I’m glad you had the foresight to do so. Many people thought that their only choice was to cut their losses and hold onto their cash for dear life. Using put options afforded a few savvy investors, like yourself, some great downside cushion.

  4. Derek,
    Thanks for reading. Covered calls are an underrated options technique. Past experience has shown me selling covered calls works best when you: a.) write multiple contracts to decrease blanket commission costs, b.) have already accrued a nice unrealized gain in the stock, and c.) Select the next possible expiry date. This lets you essentially on average 12 premiums annually (unless of course the contracts get exercised — Which isn’t necessarily a bad thing). Good luck!
    Prateek Maitra recently posted..Bull Markets Continue to Sprint, but For How Long?My Profile

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