Options trading can be attractive to investors because it offers flexibility based on ever-changing market conditions.
Up, down or sideways markets become irrelevant because there will always be a strategy.
Savvy option traders know that can use strategies to suit their goal of generating income, hedging other investments or simple speculation.
Speaking from experience, I am more comfortable using options for generating income, but I only learned this will hedging a specific trade. I will expand on that later, but for now, I wanted to go back to the basics of trading options and take a look at the two main contract types.
Most people reading my Option Specialist are probably more advanced in their experience, but it can be a helpful refresher for some and a primer for others.
Let’s go take a look at Calls and Puts.
Option contracts give the owner either the right to buy a set number of shares or the right to sell those same number of shares of stock.
Each option contract controls 100 shares of stock. Never more, and never less. It always controls 100 shares of stock.
The two types of options are calls and puts.
The buyer of a call or a call option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price).
The owner of a put contract has the right, but not the obligation, to sell an asset (the underlying), at a specified price (the strike), by a predetermined date (the expiry or maturity) to a given party (the seller of the put).
Calls and puts are just the beginning of options trading. They form the basis of many more complicated trading strategies you can use in different market environments.
Here is a neat little chart that you can refer to if you ever get confused.
Why The Multiplier Is Important
This is a huge one, and it will become second nature but it can be very confusing.
The multiplier is for an option contract is 100.
This is confusing because it is counter-intuitive.
When traders look at a option chain for the first time, or early in their trading life, they see this.
Look at the bid/ask for the 25.00 line.
It looks like it would be 14.00, but in fact it is 14 xs 100.
So 14, it 1,400.
If you are buying the call, at $14.00, you are actually paying $1,400.
It is helpful to wrap your head around this early and make sure you keep track of the multiplier (100) when you are entering, exiting or adjusting your trade.
How Puts and Calls Can Be Used
Options are attractive because they can be used many different ways depending on your financial objectives. Here are a couple of common examples of how you can use puts and calls.
Long calls are the most basic option strategy when you expect a stock to rise. It is very similar to a buy and hold strategy.
When you are going to buy (or go long) a call, you need to decide on two things: the strike price and the expiration.
Let’s say you are very bullish on a stock currently trading at $20.
You could choose to buy the 1 call contract of the stock with a strike price of $25 set to expire in March 2018. The option premium on that could be $6.
Your maximum loss on that stock would be the premium of $6 or $600 ($6 premium x the multiplier of 100 = $600). Your maximum gain is, however, unlimited.
If that stock went from $20 today to $40 by the time you option expired here is what would happen.
You paid $600.
The stock would be trading at $40.
Your $6 in premium would now be worth, at least $15.
($40 in share price – $25 strike price = at least $15 in premium)
So your $600 investment would be worth at least $1,500.
Not bad from a simple call contract.
Of course you could also take ownership of the stock which is your right and from there you could sell some covered calls for income, but that’s a story for another day.
Now let’s say the stock went from $20 to $15.
Well you lost the $600.
You will never lose more than that $600.
It is, and will always be your maximum loss.
Now the inverse of this would a simple long put.
You would purchase a long put if you thought the stock was going to go down.
It’s a bearish play.
So using the exact same $20 stock you loved, imagine you now hate it.
You would buy the March 2018 put for $2 at the $20 strike.
The stock goes from $20 to $10.
You invested just $200 in that one trade.
If the trade worked out like this, your put contract would go from $2 all the way to $10 (at least), making you a 500% gain on your investment.
And in the event the stock rallied, all you would have lost was that initial $200. Never more!
There are so many different strategies you can choose from out there.
— The Option Specialist