The Joy of Options

The Joy of Options
Owning stock has only two, maybe three, possibilities. The stock goes up. Or the stock goes down. Or, as a third possibility, it does a little of both. If you buy a stock, all you want it to do is go up.If you sell a stock short or close a position (or consider buying it and then decide not to ;), all you want it to do is go down. I call this one-dimensional trading. You're long, you're short, or you're flat. Your gains and losses travel up and down the number line you may remember from elementary school in lock step with the movement of the stock. Not only that, but it takes a big move to make a big profit. And a big move against you can mean a big loss. Potentially all the way down to zero.You need to add a second dimension to your trading. You need more choices than picking a direction and hoping you are right. You need to limit your losses, improve your returns, and increase your flexibility. You need options.For many people, options are something to avoid, being dangerous, complex, and scary. I would like to introduce you to the joy of options. Any time you think you want to buy a stock, I'd like to get you in the habit of first looking at how you could do more with less using options.In the stock and commodities markets, the type of option we just described would be known as a call. A call typically represents 100 shares of a stock. In the commodities markets, a single option contract represents a single futures contract. (For simplicity, from this point forward, I will talk about options on stock. Just remember that the same discussion applies to options on futures.)Owning a call gives the owner the right to buy 100 shares (usually) of the underlying stock at the agreed upon strike price at or before the expiration date. (I say "usually" 100 shares because, due to splits or acquisitions, there are times when an options contract may represent something other than 100 shares.) Selling a call gives the seller the obligation to sell, if asked, 100 shares of the underlying stock at the agreed upon strike price any time up until the expiration date.The other kind of option is called a put, and it is exactly the same as a call with one simple difference. A put gives the owner the right to sell 100 shares (again, usually) of the underlying stock at the agreed upon strike price at or before the expiration date. You can think of a put as insurance. No matter how badly the stock price crashes, having a put means that you can sell your stock for the strike price. On the flip side, selling that put means you may be obliged to buy stock at far more than its current market price.An important distinction to always keep in mind: Buying an option gives you rights. Selling an option gives you obligations. Buying an option cannot cost you more than what you pay for the option. Selling an option can cost you far more than what you receive for selling the option.Let's examine the terminology of calls and puts. The underlying is the actual instrument such as a stock or commodity that is being represented by the options contract. In the real estate example, the house would be the underlying. Options are said to be derivatives because their value is directly tied to or derived from that of the underlying. An option has no meaning without an actual asset underlying it. It is the right to buy or sell that underlying asset that gives the option a reason for being and some value.The strike price is the agreed upon price for which the underlying can be bought or sold under the terms of the option contract. In the real estate example, the strike price was $100,000. The expiration date, obviously, is the date when the option expires. The day after expiration, an option is worthless. This is the single most important fact about options that you must remember. This is why your friends think you are crazy for your interest in options. Unlike a stock, which you can hold forever, an option has a clearly defined shelf life.One term remains, and that is the premium. The premium is what you pay for the option, when you are the buyer. Or what you receive for an option, when you are the seller. In our real estate example, the premium was $500. That's what it cost you to hold the right to buy the house any time in that thirty-day period. The last day of the thirty-day period would, again, be the expiration date.We have barely scratched the surface. I say that not to intimidate you, but to make you realize that you only have enough knowledge to be dangerous to yourself. Please do not think that you are ready to go out and buy calls or place spread trades. You are not. You don't know how an option moves relative to moves in the price of the underlying. You don't know what time does to the value of an option. You don't know what volatility is or how it plays into option prices. You don't know the types of spreads or what they are used for.Please, please get yourself better educated before you start putting money into option trades. Resist the temptation to buy some cheap options, just to try it out. This is expensive education. There are plenty of advantages to trading options, but it's still a ruthless market, happy to take your money, your wallet, and your hand if you give it an opportunity. Learn the rules of the game before you put money on the line.Trading options can be satisfying, rewarding, stimulating, and fun. I invite you to add another dimension to your trading by including options to your repertoire.