The following is an excerpt from the eBook, Options Trading 101, authored by MarketClub Options lead trainer, Trader Travis. Learn more about MarketClub Options and how to obtain this entire eBook. You can also see Trader Travis' 10 Minute Options Trading Strategy where he shows you how to find, execute and manage profitable options trades within minutes.
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I'm not sure what your particular financial situation is, but maybe you're one of the millions of people out there who are afraid you won't be financially independent at some point in your life. Or, maybe you're afraid of losing money in the stock market and would like to know how to guarantee you won't lose money.
If so, would you like to learn how to create true financial freedom and an income source you control?
I hope so, because trading options empowers investors who are tired of losing money in the stock market to earn 2 - 5% each month (without being glued to the computer all day).
And right about now you may be saying, "Yeah right…" And I have to admit, it does sound too good to be true. But, 1) It is true, and 2) I completely understand how you feel.
I'm skeptical by nature so even I thought it sounded farfetched, but my mentor showed me how little I knew about investing.
Essentially, trading options is just another way to invest in the stock market.
You can invest in bonds. You can invest in stocks or commodities. Options trading is just another component of stock market investing.
The great thing about trading options is a 1% gain in the stock market can often produce a 10% gain on your option contract. You get to benefit from a rise or fall in the stock price without actually owning the stock (more on this later).
Also, stock options allow you to make money when the stock market is going up, down, or sideways. Said another way, stock options are how investors make money when stock prices are going down or just remaining the same.
Now let me take a moment to teach you a little bit about stock options…
WARNING: I'm about to hit you with some technical jargon, but then I'll simplify it a little later on.
The primary vehicle behind options trading is something called a stock option contract.
For the sake of simplicity, I'm going to refer to options on stocks only, even though options can be traded on commodities and other securities as well.
What is a stock option?
There are four components that make up a stock option contract:
• An underlying security or stock
• The right, not an obligation, to buy or sell a stock
• A specified price for the stock
• And a fixed time period for which the option is valid
Stock Option: If you buy or own a stock option contract it gives you the "right, but not the obligation", to buy or sell shares of a stock at a "set price" on or before a "given date" (time period).
Strike Price: The fixed price at which the owner of an option can buy or sell the stock when the option is exercised.
Example: An IBM May 50 call option has an exercise price of $50 a share. When the option is exercised the owner of the option will "buy" 100 shares of IBM stock for $50 a share.
Options trading is very involved and can be quite complex, but I will try to make things as simple as possible.
For now, don't stress about getting a full understanding; that will come with time. Just read for comprehension, not a full understanding.
Expiration Date
A stock option contract grants you the right to buy or sell a specific stock, but you can only do so within a certain time period as option contracts eventually expire.
Unlike stocks, option contracts have an expiration date and after this date your contract expires and your option ceases to exist. Translation: it goes bye bye and disappears from the inventory of contracts available to trade.
This is why stock options are often called wasting assets. They are called this because they have expiration dates.
Stock option contracts are like most contracts, they are only valid for a set period of time.
Technically speaking, option contracts expire the 3rd Saturday of the month of expiration.
However, stock option contracts cannot be traded on Saturday so for trading and practical purpose we say that stock option contracts expire on the 3rd Friday of the month of expiration.
Example: If I bought a June option, it will cease to exist (expire worthless) after the 3rd Saturday in June. So if it's February and you buy a June option, that option is only good for four more months. The contract will expire or cease to exist in June, and when it expires so do all the rights the contract granted you.
Analogy: I have a contract with a local gym here. It gives me the right, but not the obligation, to go to the gym whenever I want. They don't make me go, but if I don't exercise my right to go to the gym then I lose the money I paid for this right. After a year my gym contract ends and I no longer have the right to work out at that gym. Unfortunately, this seems to be the case. It's quite silly how my wife and I keep a gym membership even though we don't go (haha anyway, back to the lesson).
Right vs Obligation
If you buy or own a stock option contract, it gives you the "right, but not the obligation", to buy or sell shares of a stock at a "set price" on or before a "given date" (time period).
You don't have to buy or sell the stock if you don't want to. If you don't exercise the rights of your contract then you simply lose the money paid for the contracts. Also, when you are looking to buy an option contract you might see a small price quoted such as $1.50.
This price has to be multiplied by 100 because 1 stock option contract represents 100 shares of a company's stock.
So when you buy 1 contract you are buying the right, but not the obligation to buy or sell 100 shares of that stock.
Option Valuation / Pricing
Buying an option contract and selling it later down the road seems pretty simple in theory. However, what makes this task hard is that there are several factors that influence the option’s price.
To the dismay of new traders, the option’s price does not always move in conjunction with the price of the underlying stock; there are six other factors involved.
The following are the six factors that determine what the price/cost of the option will be:
• The current market price of the stock
• The strike price of the option (particularly in relation to the current market price of the stock)
• The remaining life of the option (time left until expiration)
• Volatility
• Interest Rates
• Stock Dividends
Keep an eye out for my next post.
Best,
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MarketClub has been helping thousands of traders successfully navigate the markets for the last decade. But now, with MarketClub Options, members can learn how to accelerate their profits with the power of leverage and a strategy built for long-term success. Trader Travis will show you step-by-step how to find, execute and manage winning options trades. Watch his 10 Minute MarketClub Options Strategy.
I joined the Options group this week. Looking forward to the strategy and discipline I hope to get out of this. I traded options years ago, and even took a 1 day Marketclub course on them in Salt Lake City. But I was new to marketclub and everything looked like a good trade to me then.
Is there a place where other members of this forum can chat with eachother?
Hi Stuart,
Below each one of the lessons is an area where members can ask questions and also talk to each other. We also debuted a new feature this week called the Weekly Members Huddle, where member will answer a question, shares trades, and/or give each other ideas for new opportunities each week.
We hope this helps answer your question.
Best,
The MarketClub Options Team
As soon as you read this, "Or, maybe you're afraid of losing money in the stock market and would like to know how to guarantee you won't lose money."
Don't walk, RUN
I really enjoyed reading the little introduction to trading options. I know a little, but realise a little knowledge can be dangerous! I'd like to learn more and eventually trade options. I'm actually scared of the actual mechanics. Is there a demo platform you'd recommend me using?
Robert, the best way to trade options is to not trade them at all. Instead, spend $20 and buy The Intelligent Investor by Ben Graham. Then spend $25 and buy Warren Buffett's Colleted Letters to Shareholders. The total cost of both books, $45 on amazon (maybe cheaper). Then read both banks cover to cover. Then, read them again. Then come back after reading these books and observe Trader Travis mentoring about options.
Robert -
Dan's correct that there are no guarantees in trading options - it's a matter of probabilities and designing strategies to take advantage of the market that you're seeing - both in terms of the technical indicators (including the TT) and in terms of implied and historical volatility (more on that later).
Correctly structured, options positions give you the opportunity to control your risk much better than just selecting stocks to purchase. If you buy a stock - any stock - you are making a bet that the stock will go up in price. If you are correct, you make money. Otherwise you lose money ... and the amount of money you lose on a losing trade is dollar for dollar the amount that the stock goes down - and is limited by the amount of money you have in the trade. That's not the way it works with options.
To take an overly simplified example, say you think Twitter (TWTR) is going to go up in price over the next month. If you buy 100 shares of TWTR, your cost is currently about $3,542.00 (TWTR is currently selling at 35.42 a share). That means that if TWTR goes up to $36.42, you have just made $100.00 (less commissions, of course). And your risk (the maximum amount you could lose) on the trade would be $3,542.00.
Now, instead of buying TWTR outright, assume that you purchase 1 call option (controls 100 shares) of TWTR stock with an expiration date of July 31st and a strike price (meaning the price you can buy the 100 shares of TWTR for) of 35. The current cost of that option is $270.00. The delta of that option (meaning the change that will happen if TWTR's price changes by $1) is 56.59. So, the price of the option will change by $.5659 - or 56.59 per contract - the contract in my example would be $270.00 + 56.59 after the $1 change in TWTR's price - or 326.59. The maximum amount you can lose (which is the risk that you have in the trade) is the $270.00 you paid for the option.
There are a couple of things you can do to learn about options: First, you can read Sheldon Natenberg's book on Volatility and Dan Passarelli's books - one is called Market Taker's Edge and the other is Options Greeks. Or, if you prefer to watch videos, I would suggest the tastytrade.com network that's available for free. Tastytrade will give you a basic understanding of how options work and a feel for the risk/reward involved in trading - both options and stocks.
I hope this helps.