When I hear those words, I feel like I’m looking into a vast, scary empty black hole of darkness. Stock options seem so untouchable, so foreign. I get frustrated hearing “Call option this” or “Put option that.” I know that options are a great way to make money and I want to be part of it all, but every time I click on the options tab in my trading platform, I see numbers, symbols, unknown terms, and things that make me click the Escape button.
What am I so afraid of?
I am afraid of not knowing what I need to know before I push the BUY button for an option, just like I used to be afraid before I learned to buy and sell stocks, which I now fearlessly do almost daily.
Q: Why am I inspired to trade options?
A: Because I have learned that options are a nifty way of trading that allows for just as much earning potential as with a direct stock buy, but you can minimize your risk, for a fee, and back out if you make the wrong choice.
Q: Why doesn’t everybody trade options?
A: Because options are extremely complicated. You can lose a lot of money if you don’t understand the complexities.
In today’s blog, I’ll go over the basics of options and explain what they are and how they work. In future blogs, we’ll explore more in-depth topics that relate to options like Delta, Theta, and more.
Let’s get started.
An option is a contract that gives the Buyer the right, but not the obligation to buy or sell stock at a specific price at a future date. The buyer has the OPTION to buy or sell (exercise the option) or to let it expire and not buy or sell. So very cool…. Option means option. You pay a premium to have the option to do something or not do it. Love it!
For example, a person may have paid a $1,500 premium to buy an OPTION contract that gives them the right to buy 100 shares at their predetermined price of $100 per share. If they don’t want to exercise the OPTION because the stock price has gone down to $75, the only money they loose is the $1,500 premium they had paid for the contract. They don’t loose the $25 per share ($2,500) they would have lost if they bought the stock regularly on the market for the price 0f $100.
If they want to exercise the OPTION because their predetermined price is $100 and the stock is now trading for $125, then they just made $25 per share, minus the $1,500 premium.
One tricky catch is the time limit on their contract. Some contracts only last for a month and others last for 2 years or even longer.
If the stock doesn’t do what you want it to do in the option contract’s allotted time period, you let the contract expire and lose the premium money.
In every Options transaction, there are two people involved:
- The buyer of the Options contract – the person who pays the premium for the contract.
- The writer of the Options contract – the person who writes the contract and gets paid the premium.
The cool part is, an option is very true to it’s title. It gives the buy the option to do what they want.
So that’s the basics of options. Soon I’ll be giving myself the gift of choosing — Option A or Option B?
Before I started trading stocks, I felt the same way – fear of the unknown. Now that I understand stocks, I trade almost daily, without fear.
Now, it’s time to overcome my fear of options, and so should you!
Here are some more resources for you to delve a bit deeper into stock options:
How Stuff Works
CNN: Employee Stock Options
IRS: Stock Option Tax Topics
Stock Options for Dummies Book