Perhaps you own mutual funds in your 401k account, or you have bought and sold stocks in the past. This is how most investors begin their trading. Then you hear of a mysterious term, “options”, that requires little cash outlay and has large profit potential. Here is a little primer about the basics of option buying (calls & puts), to demystify for you some of the complex nature of this financial trading instrument that offers great leverage and protection for your portfolio.

For the purposes of this discussion, know that options can be used in somewhat the same way as stocks are in terms of betting on the direction of the stock price, just like buying a stock. But options have very different characteristics of a stock and there is a lot of information you’ll need before you jump into live option trading.

Just like stocks, option trading involves a buyer and a seller making bids and giving offers. In the options market the trading unit is a contract that gives the owner the right to buy or sell 100 shares of the stock per 1 option contract. Options provide traders with more versatility than owning the actual stock. Understanding the process of trading options does take some time, but in the long run the flexibility of option trading makes the learning process worth the effort.

Real-life Options Example

Most importantly let’s first talk about how options work, and help you get a deeper understanding of what you would be trading.

I’ll use a simple example that you can relate to in everyday life. Let’s say you find the car of your dreams, but the only problem is that you don’t have the $30,000 that the seller is asking for. So you cut the seller a deal that gives you the option to buy the car in three months when you have the money. But for the option of buying at the later date you give the seller $3,000 so he will hold it for you.

Then let’s say that during those three months you find out that the car is the descendant of Herbie the Love Bug, you can only imagine the power this car has now, and the value of the car jumps to $70,000. Since the seller sold you the option he is now obligated to sell the car to you for the lower price of $30,000, and you just made $37,000 profit!

To contrast the example, within the three months you find out that the car has been in several wrecks, and the transmission needs to be replaced not to mention the car needs new tires, A/C and a radio. The car is no longer worth $30,000. You decide to keep looking for that “dream car” but you are out the $3,000 premium you paid to the seller for the option to buy.

Does owning an option make sense now? Options can be confusing but once you know the basics they are quite easy to understand. What you need to know now is the Options Trader vocabulary.

Options Trading Vocabulary

There are a lot of different terms that are unique to trading options. We’ll first begin with the two types of options, Calls and Puts. When you buy a call option you have the right but not the obligation to purchase a stock at the strike price before the option expires. When you buy a put option you have the right to sell a stock at the strike price before the option expires.

The price of an option is called a premium. When buying an option you cannot lose more than the initial premium paid for the option contract, no matter what happens to the stock. Options are normally priced in dollar ($) increments, but this represents $100 x the option price (due to the option representing 100 shares of stock) – so an option that is $3.00 actually costs $300 cash outlay to buy.

If you bought $3,000 worth of an option, just like our example of the car, you couldn’t lose more than the $3,000 even when the car lost value. But the profit potential is unlimited, which is one reason option trading is attracting more and more traders

Have you heard of out of the money or in the money options? Out of the money is when the strike price of a call option is above the current price of the stock and when the strike price is below the stock price it is in the money. And put options are the exact opposite.



Dates to Watch

Now that you have a glimpse into the vocabulary of an options trader, we’ll move onto the dates to watch. You not only have to expand your vocabulary when trading options but you also have to make sure to keep your eyes on your calendar.

Because Options expire on a certain date called the “expiration date” you have to keep your eyes open for when your option expires. Normal listed options can last up to 9 months from the date the option is first listed. LEAPS, which are longer-term options, are also available on many stocks and these can have an expiration date of up to three years later. Unlike shares of stock, which have a 3-day settlement period, Options actually settle the next day.

Options will officially expire on the Saturday that follows the third Friday of the expiration month. That’s why if you ever see our options analysts here at BigTrends during the third week each month we’ll be running around frantically making sure we get the biggest bang for our buck before the options expire.

Since options take a day to settle you must exercise or trade the option by the end of day on expiration Friday in order for the option to settle on the expiration Saturday.

Bringing It All Together

Options are often used to diversify a trader’s portfolio and are part of a larger trading strategy. But trading options is very different from trading stocks. And like I mentioned earlier it takes some time to learn how. Because they are so different you should not take on the risk until you are fully versed in option trading.

Price Headley is the founder and chief analyst of BigTrends.com.