There are many aspects to trading options and it can be extremely confusing for someone starting out. Just understanding the option terminology is difficult. Remember, a put option is the right to sell the stock at the strike price, and a call option is the right to buy the stock at the strike price!
Before someone starts trading options they should really know how to trade stocks. They need to be familiar with both buying and shorting stocks. If your friend told you that he turned $1000 into $10,000 and that is the reason you want to trade options, then you are better off in Las Vegas.
Options prices are displayed as the price for one share, even though the contract is for 100 shares. The means, that even though the price says $1.50, if you were to purchase one options contract then you will be paying $150.00. When it comes to selling options, like a covered call, each option that is sold is connected to 100 shares. If you would like to buy $1500 of options, do not place an order for 1000 contracts, you should place an order for 10 contracts.
The various whole dollar prices that are listed are called strike prices. A $30 stock will show prices at $1 – $5 increments from $10 till $50. Depending on the stock depends on how many strike prices will be listed. See picture below.
Some brokers unintentionally make purchasing options a little more confusing. Although they trade like a stock, to actually buy an option, a trader to needs to specify more information. Like “buy to open” versus “buy to close”. Buy to open means you want to buy the option contract. Buy to close, is the order that is placed when the option was sold short and now the trader wants to buy it back.
Call Options
The owner of a call has the right (not the obligation) to buy 100 shares of the underlying stock at the strike price.
For example: Today is January 2nd. XYZ stock is trading at $30 a share. The $30 January call option shows a price of $1.50. If I were to purchase the January $30 call for $1.50, then on the third Friday of January, I have the right to “exercise my option” and buy the stock for $30 a share, even if the stock is at $50 a share!
(If the stock is at $50 a share, then the option will be trading at $20 per contract and you don’t have to wait until expiration day to buy the stock for $30 and then sell it for $50, you can just sell the option and pat yourself on the back for making 13 times your money!)
During the month the price of the option will fluctuate based on the price of the stock. If the price of the stock goes up, the price of the call option will go up too. If the price of the stock goes down, the price of the call option will go down too.
The reason a person buys a call is because they believe that the price of the stock will go higher.
Put Options
The owner of a put has the right (not the obligation) to sell 100 shares of the underlying stock at the strike price.
For example: Today is January 2nd. XYZ stock is trading at $30 a share. The $30 January put option shows a price of $1.50. If I were to purchase the January $30 put for $1.50, then on the third Friday of January, I have the right to “exercise my option” and sell the stock for $30 a share, even if the stock is at $15 a share!
During the month the price of the option will flucuate based on the price of the stock. If the price of the stock goes down, the price of the put option will go up too. If the price of the stock goes up, the price of the put option will go down.
One reason a person buys a put options is because either they think the price of the stock will go down and they would like to profit from the fall in the stock prices.
The other reason people buy put options is to protect their stock investment. A put option is an insurance policy for your stock. How many times have we bought a stock and over night it drops 20%. If we had owned a put option then we could have limited our loses by having the right to sell the stock at the strike price, even though it is much lower.
This is just the beginning of trading options. Many more articles will follow.
If you have questions please post them to the comments section.
Dear Option weekly
what is not clear to me is what happens if, for example, I’ve sold a naked call option and the strike price is reached (than the call will be excercised). How does the Broker settle the trade, since I do not have the stock on my portfolio?
thanks in advance for your answer
regards
Francesco
Great Question Francesco!
Assuming you sell the $40 call on BP naked, and on option expiration the stock is at $41 a share, your broker will sell the shares for $40 a share and your account will show you being short 100 shares at $40 a piece.
You will need to have proper option trading permissions & margin requirements on your account in the first place for them to let you sell naked calls.
Good Luck
How many times have we bought a stock and over night it drops 20%.”
I think this happens to you because you use an outdated strategy of buying a stocks that have big gap ups on high volume, like PWER. It is all to commone today to have those “big drops” right after a major gap up. Well in short that is not a great predictor anymore, and also in the case of PWER the last two “big gaps” were earnings announcements, so you might as well just go to Vegas yourself. ALSO PLEASE CORRECT: you state that “If the price of the stock goes up, the price of the call option will go up too”. This MAY happen to be true but does NOT HAVE TO be true. Someone could buy an option and have a stock slowly climb higher and have the option gain no value or lose value and if not above the strike price + premium expire worthless causing loss of premium! This is critical for people new to options because not understand theta (time decay) or the other greeks is not good!
Something else I would like to add after looking over your site is to not be “too conservative” if you are young. I strongly disagree that to turn 1000 into 10K you would be better off in vegas. I would MUCH rather have options. If you don’t take some risks you will be “preaching” about being super conservative all the time and end up taking your whole life to turn 1000 into 10K. I started in this business with very little capital years ago, and shortly after very, very little capital. My mistake when I started was honestly being “too convervative”. I didn’t risk much, and thus, I didn’t make much, at least not enough to live off of. What I did back then and suggest to anyone starting out is to learn everything you can about options and option strategies. Back then I had about 35K to invest. I decided that I was going to use half as a long term fund and half as a option strategy fund. I figured that unless I was to take some type of risk, the “reward” would come when I had grey hair and couldn’t hear. Not fun. I used many strategies and also made big speculative bets. Take some firm bets when you can take a loss, and tighten your risk profile if if your capital gets low. Two big ones launced me off the ground. I had a huge (for me at the time) single 3 mo call way OTM on a company that ended up being bought, and another otm call on a company that doubled in several weeks. 5 figures became 7 figures. From there on I still made speculative plays but really focused on toning down risk and looking at long term growth. 10 years later and the 7 figures is now 8 figures. Best advice is master options, then use them regularly for “base hits”, and also employ speculative plays here and there but not too many that it starts to drawdown your account too much.