Last updated on March 28th, 2020
When I mention to people that I trade options, the response is usually, “That sounds way too risky for me.”
That’s simply due to lack of knowledge because once they understand some option basics and how to trade them, people start to become a little less risk adverse in their thinking.
It’s clear that options are one of the most misunderstood trading instruments out there today.
Those that do understand them, they become one of their favorite approaches to the markets (even beating out futures trading) due to the outstanding returns they can bring.
In order to trade options successfully, it is important to first understand some Options basics and definitions. Let’s start by defining an option.
What is an option?
An option is a contract that gives the right to buy or sell a particular security at a given price for a predetermined amount of time. The given price is known as the strike price. The options are good until the stated expiration date.
We are going to use stock options in our examples so one option controls 100 shares of that particular stock.
If a call option is quoted for $2.50, the price of buying this single option would be $250 (plus commissions).
- A call option buyer pays a premium for the right, but not the obligation, to buy a particular stock at the strike price prior to expiration
- The option seller collects the premium and is obligated to sell the particular stock at the strike price if called upon before expiration.
For example, with Apple stock trading at $125 at the end of April, the May 120 Call gives the holder the right to buy Apple stock at $120 anytime before May expiration (which is the third Friday of the expiration month).
The seller of this option is obligated if called upon to deliver 100 shares of Apple stock for $120 per share to the holder of the 120 call.
- A put option buyer pays a premium for the right, but not obligation, to sell a particular stock at the strike price prior to expiration.
- The put option seller collects the premium and is obligated to sell the particular stock at the strike price if called upon before expiration.
Let’s take the previous Apple example and look at the trade using puts. With Apple stock at $125 at the end of April, the May 130 put gives the holder the right to sell 100 shares of Apple stock for $130/share anytime before May expiration.
The seller of this put option is obligated if called upon to buy 100 shares of Apple stock at $130 from the owner of the put option.
What is an option premium?
The option premium is made up of intrinsic value and time value (also known as extrinsic value).
- The intrinsic value is the in-the-money amount of the option.
- Time value is the portion of the premium that is over and above its intrinsic value.
The in-the-money amount is the amount that the stock exceeds the strike price of a call option and for a put the difference between the strike price and the current price of the stock.
In our Apple example from earlier, with the stock at $125 the 120 call option would be $5 in the money. An option is “in-the-money” when it has intrinsic value. An option is “out-of-the-money” when it does not have intrinsic value.
An option is “at-the-money” when the stock price is at the strike price.
Option prices are greatly affected by volatility. The more a stock moves, the more expensive the options will be.
At such times of higher volatility, option prices can be inflated.
If you buy an option at a time of high volatility and volatility drops, the price of the option will drop as well. There can be times where the stock will move in your direction and the drop in volatility will cause you to still lose money.
So it is very important to be aware of the levels of volatility of the options that you are trading.
Trading options as taught in our Fast Track program where we go much further than option basics can be very profitable but it is important to understand these basics before diving in.
Building on Option Basics Knowledge
You can build on this foundation to cover how we use these option basics by visiting our Options Trading Tutorials page and viewing articles from beginning options trading to more advanced topics.
When using options, one needs to be right on both the direction of the stock move as well as in the amount of time it takes for the stock to make this move.
Option selection is critical when using them in place of the actual stock.
Before you dive into options trading, it is important to grasp some of these basic concepts so you will be able to put the odds in your favor.
Options trading has become very popular over the last few years. Netpicks own “Options Guru” Mike has put together a hot list of some of the best names to trade in the Options market. You can click here and download your free hotlist to see what names Mike has been piling up the winners with.