Before getting into the specific trade setups, it is important to understand a few basics. In this post I am going to give an overview of Contracts, Puts and Calls, Why we use options, and a brief discussion of Options pricing
An Options contract
is an agreement between two parties to facilitate a potential transaction involving an asset at at a specific price and date.
Call options can be purchased as a leveraged bet on the appreciation of an asset, while put options are purchased to profit from price declines.
- Buying an option offers the right, but not the obligation to purchase or sell the underlying asset.
- For stock options, a single contract covers 100 shares of the underlying stock.
Puts and Calls
Are the two most important building blocks for all options strategies.
Simply stated, a “call” gives the buyer (owner) of the option contract the right to BUY the underlying security at the strike price on or before the expiration date of the contract. A “put” on the other hand gives the buyer of the contract the right to SELL the underlying at the strike price on or before the expiration. In both of these situations the buyer would pay a premium for this right. Another point to remember is that the buyer has the right, but not the obligation to buy or sell the underlying.This is an important point to remember and we will discuss it later, when we look at an example.
Both puts and calls can be bought as individual positions and/or combined with other calls and put to design strategies to take advantage of developing market conditions
The underlying could be a stock you believe is undervalued and is due for a rise in price. You could also buy or sell options on ETF’s (Exchange traded fund). In addition, many traders have position in a market INDEX’s such as the S&P 500 (SPY), the Dow Jones industrial Average (DIA), and the very popular index the QQQ. QQQ is a marketable security that trades on an exchange, offering traders a way to invest in the largest 100 non-financial companies listed on the Nasdaq. The benefits of trading options will be made clear as we progress.
Why do we use Options
We understand stocks as long-term investments that can be bullish and bearish. But, where do options come into play?
Why do we trade options? We use options because they aren’t just directional like stocks. They’re more flexible and allow more advanced strategies that play on probabilities. Also, they’re cheaper than stock, so your trades can make a bigger impact for the same usage of capital.
Overall, the biggest difference is that you can set the price and the time period of your trade. Instead of just taking a 50/50 bet on a stock, Options allow you to set a price where you are willing to either buy or sell the underlying and be able to do that wih much less capital than you would need to put up to buy the stock outright. By doing this your use of capital is much more efficient.
Let’s say you are Bullish on XYZ stock, but you would like to buy the stock at a lower price.
By selling a put option at a strike price lower than the current price of XYZ stock we are still taking a bullish stance (short puts are a bullish strategy. By selling the put at a strike price below the current stck price, we are giving the buyer of the put contract the right to sell shares to us at that lower strike price, the price we wanted to buy the stock, when we put on the trade.By entering a short put trade such as this, we receive a credit for taking the risk . If we are assigned the underlying stock, the credit we received will further reduce the cost basis of the shares we will be obligated to receive.
Option Pricing
The price of an option is made up of intrinsic and extrinsic value. Intrinsic value represents the difference between the stock price and the strike price. Extrinsic value is the time premium portion of the option. We’ll delve more deeply into option pricing in a future post.
I hope this brief discussion has been of value to you and would happy to answer any questions you might have about these topics.
Your comments are welcome in the comment section, or you may send me an email at baughstenc@gmail.com.
Here is a link to one of the most comprehensive books on option trading.
