Beginner’s Guide to Options Trading

Options trading is one of the most difficult yet intriguing of advanced trading techniques and can be very confusing at first. Many professional stockbrokers do not even understand it and thus do not deal in options. However, with research and study, options trading can be quite rewarding. When done poorly, it can turn bad quickly and become an expensive education. However, when done correctly, options trading can be profitable and actually reduce the risk in your portfolio, becoming a very viable hedging strategy.

Before even starting to explain options trading, let me state: options trading is not for everyone. It should not be attempted by someone without a lot of experience and study on the practice. In fact, most people should not attempt options trading on their own. Brokers generally advise their clients to never have more than 15 to 20% of their portfolio value in options and there are several different rules limiting the number of options contracts you can carry at one time.

If you have gotten past the proverbial “Enter at Your Own Risk” warning, then you are now ready to engage the educational portion of the article.

Options Trading Explained

An options contract is basically a contract that gives whoever owns it the right to buy or sell a specific stock at a time yet to come. Each contract involves a buyer and a seller. The buyer, who is also called the holder or owner, pays a premium for the right to buy a stock from or sell a stock to the seller of the contract at a future time. The buyer is always called long, while the seller, who is also called the writer, is always short. The owner does not always execute the contract by buying or selling the stock before the expiration date, but the writer will keep the premium whether or not the option is exercised. The premium is basically just the sales price that the buyer pays for this right.

Call and Puts

There are two types of options contracts, calls and puts. The standard contract is for 100 shares of stock and contracts usually last for a nine month period. When a buyer purchases a call option, he is purchasing the right to buy a stock at any point within the contract timeframe at a set price. If your position is a long call (you are buying calls), then you are bullish on a particular stock and believe the stock’s price will rise. Likewise, if you are selling puts, you think the price of the stock will increase as well. On the other side, long puts and short calls are bearish on a stock and think the stock may decrease in value. Most investors who sell options do not believe the option will ever execute. They are selling options simply for the premium. Buyers expect to execute the option in order to profit on the contract.

Examples of Option Trades

Example One: If the owner buys 1 call option on XYZ Stock that expires in July and is good at $100 per share for a premium of $4 per share, then the owner would have the choice to buy XYZ stock at $100 per share any time between the purchase date and the expiration date, no matter what the current price is. In return, the writer (the seller) would receive $400 (100 shares x $4 premium per share). The $400 is the seller’s, even if the contract expires without execution. The standardized order for this transaction would look like this: 1 XYZ July 100 call at 4.

Example Two: A put order would look similar. If you saw a standard order that said 1 ABC Aug 50 put at 3, this would be an options contract where they buyer has the option to sell 100 shares of ABC at $50 per share any time before the August expiration date. He paid $300 for this option.

Calculating Profitability

In order to figure out the profitability of the options contract, we need to first find the breakeven point. Let’s use the previous examples to figure this out. In the first example, we paid $400 for the option to buy 100 shares of XYZ at $100 per share. In order to break even, we need to make $400, so we need the stock price to rise to $104. The math for this is 100 sh. at (times) $100 = $10,000 + $400 (premium) = $10,400 ÷ 100 sh. = $104 per share. At this point, if we wanted to break even, we would execute the call option, buy the shares for $100 per share and sell them for $104 per share on the open market. We would be left with $400, which we originally paid for the option, thus breaking even. Our potential profit when we are long a call is technically unlimited, since there is no ceiling on how high the price of the stock may rise. Our maximum loss is the premium paid. On the flip side, if we are short calls (selling calls), our maximum profit is the premium and our loss is potentially unlimited.

In the second example (1 ABC Aug 50 put at 3), we use the strike price minus the premium to figure out the breakeven point. So the breakeven point for this contract is $50 x 100 (the number of shares) = $5000 – $300 (the premium) = $4700 or $47 per share. To break even, the contract is executed at $47. We could buy the stock on the open market for $47 per share and sell it to the writer for $50 per share, earning us $300, which was the premium we paid. The maximum profit is calculated by subtracting the premium from the strike price. So $5000 – $300 = $4700 max profit. This is because even if the price of this stock went to zero, we could sell it for $5000 ($50 per share) for a net profit of $4700. Conversely, the maximum loss the short side could lose is also $4700, since they would be on the other side of this transaction.

Expired Contracts

As mentioned previously, options sellers expect that the contracts will expire without being executed. However, this is not always the case. When a buyer executes an options contract, the contract is assigned to a writer randomly, meaning that even if some contracts are executed, you may not be assigned a contract. Your other alternative as a writer, rather than waiting to see if a contract executes, is to close the position by purchasing an identical option. You then have two options contract that cancel each other out and you are no longer responsible for the contract. Some writers will still profit when purchasing the same option back. For instance, if you write a contract with a $5 premium and are later able to purchase the same contract back for $3, then you have still made a profit of $200 on that contract, even while closing the position. Options writers do not expect the contract to execute and they profit when the contract expires or they close the position for less of a premium than they received when opening the position.

On the other hand, options buyers expect to be able to execute their contract. They profit when they can execute the contract at a price better than the break-even price, or they too may close the position by selling the same options contract. If they can sell the contract for a more of a premium than they paid, they profit on the sale without even having to execute the contract.

Conclusion

As you can see, options trading can be very involved. It is not as simple as buying shares of stock and waiting for the price to rise. There are a lot of options available, whether you are buying or selling options contracts. In a future article, we will discuss more in-depth why people trade options as well as some of the more advanced options contracts and strategies. A great way to get into options trading is with a virtual trading account. This can be used for practice without any fear of loss. Many online brokerages will offer free virtual accounts with no obligation and many will offer training, articles and seminars on options trading.