Options Education for Individual Investors

Please don't start trading options until you understand these basics

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Options. The Basic Concepts

Download our abbreviated version of this section: Introduction to Options: The Basics.

A. What is an option?

An option is a contract between two parties, the buyer and the seller.
The price the buyer pays to the seller is the premium.

There are two types of options:

A call option gives its owner the right to buy something.
A put option gives its owner the right to sell something.

Thus, the option contract gives its owner the right to buy or sell

  • a specific item: the underlying asset (usually 100 shares of stock)
  • at a specific price: the strike price
  • for a specific period of time: from the time the option is bought through its expiration date

For listed stock options, the expiration date is the third Friday of the specified month.

The format used to describe an option is:

EXAMPLE: IBM Apr 110 call

This represents an option to buy 100 shares of IBM at $110 per share, any time before the market closes on the 3rd Friday, next April.

Example: GE Jan 35 put:

An option to sell 100 shares of GE at $35 per share, any time before expiration, next January.

B. How does an option work?

An option buyer has rights.

a) The call owner has the right, but not the obligation, to exercise the option to buy 100 shares of the underlying stock at the strike price.

          Example: You exercise one IBM Apr 110 call. You pay $11,000 and receive 100 shares of IBM stock.

The price at which the stock is currently trading in irrelevant: This transaction takes place at the agreed upon price (strike price).

b) The put owner has the right, but not the obligation, to exercise the option to sell 100 shares of the underlying stock at the strike price. Upon exercise of the option, the exerciser delivers 100 shares of stock and receives the strike price per share.

          Example: You exercise one MSFT Nov 35 put, You deliver (sell) 100 shares of MSFT and receive $3,500.

An option seller has obligations. If the call buyer exercises the option, then one seller of the option is assigned an exercise notice, and is obligated to deliver 100 shares of the specified stock. For this stock, he is paid the agreed upon price (strike price) per share.

C. Why should options be part of your investment portfolio?

Stock options can be used in conservatively to

  • increase the return on your investments
  • provide protection against a decline in the price of your stock
  • allow you to buy stock below current market price
  • allow you to sell stock above current market price
  • reduce the fluctuations in the value of your portfolio
  • profit from taking a bulliish, bearish, or neutral position on the stock market, or a specific stock
  • trade without owning a single share of stock

See The Rookie's Guide to Options: The Beginner's Handbook of Trading Equity Options for details on how to accomplish these goals using six different option strategies.

D. Why don't more people use options?
There is a common misconception about options. Although the options exchanges make a valiant effort to educate individual investors, many people mistakenly believe options are risky investment tools, suitable only for speculators. The truth is that it's the investors, not options, who are 'risky,' because they adopt strategies that have little chance of success.

When used conservatively, options can provide significant risk reduction and an increase in the annual returns of your investment portfolio.

If you can make good profits by using conservative methods, why take unnecessary risk?

E. Am I now ready to trade?

No. But you are ready to open a paper trading account and practice buying and/or selling a few option contracts to see what happens. Don't use real money yet. Before trading, you want to be aware of basic strategies you can use.

Read my personal trading philosophy, which includes advice for option rookies.

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