Introduction to Options Trading

  What is an Option?

An option is a derivative of a stock.  This means it gets its value from the stock it represents.  You can buy weekly mini options which represent 10 shares of a stock. Weekly options are options that represent 100 shares of a stock.  Both the weekly mini and the weekly options come on the market Friday and can be traded until the next Friday before the market closes.  So these options have 7 days until expiration.  

The monthly options come on the market the 3^rd Friday of the month and expire on the 3^rd Saturday of the month.  (But remember the stock market is not open on Saturdays, so you have to sell them on the 3^rd Friday of the month if you are not going to exercise the option).  Exercising the option is when you have the right but not the obligation to buy or sell 100 shares of stock, so if you do not buy the 100 shares, you are not exercising the option, if you do buy the 100 shares you are exercising the option.    

There are two types of options contracts that a person can buy.  The contracts are called CALLS and PUTS.  A Call option is purchased by a person who is bullish on a stock.  A Put option is purchased by a person who is bearish on a stock.  Buying a Call Option gives the owner the right but not the obligation to buy 100 shares of the stock at a certain Strike Price.  The same is true about the Put Option; it gives the owner the right but not the obligation to sell 100 shares of the stock at a certain Strike Price.

The Strike Prices are set by the market.  For stocks that are lower than $25, they have a strike price every .50 Cents.  For stocks with a value greater than $25 and lower than $200, they have a strike price every $2.50  For a stock that has a value greater than $200, it has a strike price every $5.  These are the strike prices that each contract is set at for, both calls and puts.  This is how an options chart would look.  Let’s assume that Apples current price is $400 a share, and there are weekly options, that expire at close of market on Friday.

                        CALLS                             STRIKE PRICE                            PUTS

      Bid                              Ask                                                       Bid                         Ask

$4.00	$4.10	$395	$3.80	$3.90
$3.90	$4.00	$400	$3.90	$4.00
$3.80	$3.90	$405	$4.00	$4.10

  

The Story

Let’s say that I won Publishers Clearing House and I have check coming to me for $300,000, but I have to wait up to 30 days to get it.  I decide that day I want to invest this money on a house.  So the same day, I do some serious research and I find a house that I want to buy.  I visit with the seller and she tells me that the house is worth $250,000 today, but the housing market is still weak, so we are anticipating that the value of this is house could go down.  I want this house because I am aware of some information that she is not informed on.   I believe that the house this land sets on has oil on it and if that is the case, I can make more money than I spent on the property which is buying the house for a discount.   I let her know that I am getting some money and I would like to come back in 30 days the buy the house and I asks if she can hold the house for me.  She declines the offer and says she just can’t take the house off the market to wait on me.  

I then ask, if I pay her a premium of 1% of the value of the house ($2,500) would she hold the house for me, and she says yes, but the $2,500 is only to hold the house, I will still have to pay the $250,000 for the house if I want it , no later than 30 days from today.   So she writes the contract, (because she thinks the value of the house is going down and I will not return and she will get the keep the $2.500) I buy the contract because I think the value of the house if going up.  So she gets $2,500 to put the house on hold. 

The contract states that I have the right, but not the obligation to buy this house at $250,000…    It also states that whatever the value of the house is everyday my premium will be adjusted to reflect 1% of that value. (So if the housing market finds out it could be oil on this land, it will adjust my premium to reflect 1% of the value of the house)  It also states, that every day I will lose some premium to time decay.  Which is $2,500 divided by 30 days which equals $833 a day.  I will lose $83.33 a day until I buy the house.  So If I come back tomorrow and the house is worth the same value it was when I bought the contract, I will tell her I do not want the house and she will give me back all my money except for the $83.33 I lost to time decay. 

The next day, word has leaked on the housing market that this land could possibly be rich in oil.  Everyone wants this house now, but the seller cannot sell to anyone else because we have a contract.  The value of the house is now worth $750,000.  This means my contract premium that I paid the seller is now worth $7,500 already making me a profit of $5,000.  Now, I have a choice to either cash in my option and tell the seller I do not want it, this would be not exercising the option and I make $5,000 profit. Or I can keep the contract active to make more money.  Even though the house is worth $750,000 now, I will only have to pay $250,000 for it.  So if  publishers clearing house calls me and says sir, we have your winnings ready early, I could just get the check and give the seller her $250,000 and now put the house back up for sale and sell it for $750,000 making a profit of $500,000.  This would be known as exercising the option. 

So you can see in this example we made the most money by exercising the option, but a lot of the times in real life, you make more money on the premium, this would be buying calls and puts which is what I do. 

But, that’s not the whole story.  I left something out on purpose so it would not confuse you.  Remember the next day when we came back and the house was worth $750,000?  The market has 5 sisters working for it.  Their names are Delta, Gamma, Theta, Vega and Rho.  These sisters are very important because they decided how much money we made when the value goes  up or down on our contract.

 

            Gamma gave money to Delta, every time the value of the house went up $1.00. 

Delta gave me the money she got from Gamma and her money every time the house went up $1.00.

Theta took money from me every day; this was the $83.33 we lost on the premium.

Vega, she controls the demand of the contract. The more risk involved in the contract the more    premium is added to the price. 

All of this is under the assumption I wanted the value of the house to go up.  It is the total opposite for the seller of the house who thought the value of going down. 

This is a very basic look at options, it may sound more complicated than it really is so do not let that scare you from learning more about options.  If I can do , anybody can.  Please leave feedback.