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?
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.
Should
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. In summary 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 Or if you wish to fast-track
your
learning See our
popular Options
Trading Course
online. |