Introduction to Options
In this introduction to options, I will firstly explain how options work. Although the information that follows may seem like an extremely powerful and fast way to make money - and it is certainly much more profitable than trading stocks by themselves, because it gives you the opportunity to enter the market risking a lot less money upfront, but with the potential to make a lot more money in the shortest timeframe.
While all this may seem very attractive, we also need to consider the risks and reward potentials, as well as other factors which govern options trading.
But for now, let's take a look at a few basics about options trading that you need to know first.
What Are Options?
Many private traders believe that options are a risky investment. Others say they are too hard to understand and best left to the experts. However, if you want to make a lot of money trading the markets, you can't afford to be lazy and must be hungry to learn. The quickest and simplest method requiring the least amount of work is not always the most effective.
When it comes to trading, most people like to stay within their "comfort zone" so they stick with stocks. While it's true that options trading does take more skill, dedication and understanding, the rewards can be far greater. So the required effort to get started with options is well worth it.
The Basics of Stock Options
There are essentially two different kinds of options: call options and put options.
Purchasing a call option gives you the !jgjt, but not the obligation to purchase X amount of shares for a certain fixed price, on or before a certain fixed date.
Purchasing a put option gives you the !i, but not the obligation to sell X amount of shares for a certain fixed price, on or before a certain fixed date.
The price you pay for these options is called the premium.
The “certain fixed price” that you are able to buy or sell the shares for is called the "exercise price” - or “strike price".
Options have an expiration date: The expiration date is the day that the option contract expires, and can no longer be used.
Let’s have a look at an example:
Suppose you are out driving around and you see a beautiful house; it’s the kind of house that you have always dreamed of, and just as luck would have it, it’s for sale!
The guy is only asking $250,000 for it, it’s a real bargain!
You really want to buy it, but just don’t have the money right now. You know you should be able to get the money without any problems, but you need to sell your house first and also talk to your bank manager about borrowing the rest of the money.
So after a little while negotiating, the guy agrees that if you pay him $2,000 now, he will hold onto the house for you for up to three months, and will not sell it to anybody else.
This is not a deposit, and will not be deducted from the price of the house, this is a fee you have negotiated with the man for the privilege of having him hold the house for you for three months and not sell it to anybody else. You are not obligated to purchase the house, but he is obligated to sell it you. Regardless of whether you buy the house or not, you will not ever see that $2,000 again, as that was the "premium" you paid for the right to have that privilege.
Therefore, should you wish to buy the house, you will still need to pay the full $250,000. This means your total cost to buy the house is $250,000 + $2000 (already paid) = $252,000. You have up to three months in which to come up with the money to purchase the house.
You have just bought yourself a call option!
What are your choices?
Well, within three months you raise the $250,000 and buy the house, you don’t buy the house and just let the whole deal fall through, or you could sell this right to buy the house to somebody else.
Let’s say that in two months time you sell your own house, and the bank manager gives you the money so you now have the required funds to purchase your dream house. However, housing prices in the area have dropped dramatically and your dream house is now only worth $230,000! - Would you still pay $250,000 for it? Absolutely not! Remember; you have the right to buy the house for $250,000 but not the obligation. If you still wanted to buy the house, you would only need to pay the current market value of just $230,000.
You are $18,000 better off. $250,000 minus $230,000 = $20,000 - $2000 premium paid = $18,000.
Let’s look at another example:
Let’s say that in two months time you have the required funds to purchase the house, however, houses in the area have skyrocketed in value, and the house is now worth $270,000! What should you do? Obviously, you would exercise your right to buy the house for just $250,000. Remember this is what you paid the initial $2000 premium for. The person selling the house is obligated to sell it to you for just $250,000, even though it is now worth $270,000.
So essentially, you have just made $20,000! You could buy this house today for $250,000, and sell it tomorrow for $270,000.
This is what a "call" option is all about.
Here’s another thing you could do;
You could simply sell the option.
Let’s just say that you couldn’t get the money to buy the house, or changed your mind altogether and no longer wanted to buy this house. You could simply sell the option to somebody who did.
Supposing that the house is now worth $270,000, yet you have the right to buy it for $250,000, what is that option worth? Essentially, it is worth at least the $20,000, plus maybe a little bit more, depending on how much time you have left in which to buy the house; (the expiration date).
So, what is a put option?
Let’s just say you owned 1000 XYZ shares that were currently trading at $10 each. They have reached an all-time high as they usually trade somewhere between $7.00 - $8.00 ea.
you sell now? - What
if they go higher still? Then again, they have reached a
What should you do?
This is where a put option comes into action.
You call your broker, and he tells you that for just 20 cents per share, he will give you the right to sell those shares for $10 each, so long as you sell them within three months. Again, you have the right, but not the obligation to sell your shares.
You have essentially just bought yourself an insurance policy. Basically what has happened is that you have just bought yourself some time. You have locked in a selling price of $10.00 for anytime between now and 3-months time.
For just 20 cents per share x 1000 shares = $200. Again, this $200 is the premium that you have paid, and will never see this money again, regardless of what happens.
For the sake of just $200, you can now continue holding your shares, knowing that if the worst happens, you can in fact still get $10 per share for each of your shares.
Let’s have a look at an example:
Let’s just say a couple of months go by and the shares now are worth $14 each! What would you do? Would you sell your shares for $10 each? Absolutely not! - Why would you? - They are now worth $14 each. What you could do in this case is sell them for $14 each, and be miles in front.
However, supposing that in two months time the shares did actually fall and were now worth just $8 each. What would you do? Obviously, you have the right to sell them for $10 each, so you would exercise this option. You would therefore collect $10 per share instead of $8 per share that you would get if you sell them right now on the market.
A Call option gives the option owner the right - but not the obligation - to buy.
A Put option gives the option owner the right - but not the obligation - to sell.
Components of an option
The first thing you need to consider is that there are two parties involved in options contracts.
The buyer (the option taker), and the seller (the option writer).
For the purpose of this training module, we are going to mainly just look at option buyers. We will cover option selling in the next modules; these are some more advanced strategies that have the potential to make some very large amounts of money.
Think of it as a retail / wholesale situation.
As an option buyer you are buying at the retail level, and are spending money to purchase products; in this case, options. As an option writer, you are operating from the wholesale level, and are creating products to sell to the market. Therefore you are not spending money, but rather having people pay you money.
This is very exciting! Once you know these advanced techniques, you too will be able to create products that will generate you wealth fairly rapidly.
The thing you need to know about options, is that they ALL have an expiry date, and more often than not, expire worthless.
This means that very few options actually get exercised.
While there is plenty of money to be made trading options, (buying and selling options) you generally do not want to be holding the option right through until expiration date.
Trading options (from a retail point of view) is like playing muscal chairs. You want to make as much money as you possibly can, until the music stops. When the music stops, you don’t want to be left holding the expired option.
It is said that about 9 out of every 10 options expire totally worthless!
Let me ask you this ...
If 9 out of every 10 options expire worthless, then would it be fair to say that the people buying the options are not the ones making the money, but rather those who are writing them, or creating them?
If you could create a product to sell on the stock market that already had these kinds of odds (90% probability) already working in your favour would you be interested?
Absolutely! - This is what I have developed this training course for. However, before you can start writing options, you need to understand the very basics of how they work.
Hence, this introduction manual.
Look at it for a moment from the eyes of the option writer.
Does he want to be exercised? IF, if I was the one selling you the right to sell me your stocks for $10 each knowing full well that the only reason you would take me up on that offer is because your shares were suddenly selling for a lot less than $10 each on the market, Do I really want to buy stocks from you for $10 each when I can buy straight from the market for just $8 each?
In case you wondering - the answer is no!
So, why then, would anyone even make this offer to you?
Simple. Because I am not expecting to be exercised. I am not expecting you to take me up on the offer, and sell your shares to me. Therefore, I am more than happy to take your $200 premium from you.
However, I would only make these types of offers if I had a high certainty of not having to fulfil my obligation. In the case of the stocks in the above example, if I was 100% sure that the stocks were going to continue to rise past $10, I would be more than happy to collect $200 from you knowing that I would not need to purchase the stocks from you. Or if I did, that they would turn around and go back up in value again.
What about our first example? What about the guy selling his house for $250,000? What was his motive? Well it was obvious; his house was currently worth around $250,000, and he was looking for a buyer. You came along and offered him $250,000, and even paid him $2000 for the privilege. Does he want to sell the house to you for $250,000 if all of a sudden the market value is $270,000? Absolutely not! But he is obligated to. Would he expect you to buy the house from him for $250,000, if the current market price is $230,000? He would like you to - but knows of course that you wouldn’t, as you are not obligated to. In this case, he pockets the premium (the $2,000 paid by you) as the option expired worthless.
If he knew beforehand that the price of his house was going to fall in value over the coming months, and knew that you would not buy if from him for the full $250,000 - then getting you to pay this premium is a way of offsetting some of his future losses.
It works exactly the same way for shares.
If I gave you the option to sell some of your stocks to me for a certain fixed-price on, or before a certain fixed time, you would pay me a premium for that right. That money would be deposited into my bank account, and is mine to keep regardless of what happens. Hopefully, (from my point of view) you don’t take me up on the offer, and I have no further obligation to you, and keep your money.
This is the simplest form of writing options, and we will go into some advanced strategies and techniques in the next training modules.
But as you can start to see, writing options is simply a matter off collecting money from people for situations where the odds are stacked heavily in your favor.
The added advantage of writing options is there are several techniques we can implement to protect ourselves.
For example: we can write two or three options at the same time. We can write both call and put options, and collect money from both. Only one or the other would be exercised (or possibly neither), yet we collect money for both. On top of that, we can also write options as the insurance over the options that we have already written. (I will go into more detail in the next 2 training modules)
This may sound a little confusing at first, which is fine, as I will explain it all to you.
We will continue at ….. Introduction – Part 2
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