In this second option trading tutorial, we will explain Options Trading.
An Option is a financial instrument derived from a given stock that trades on the Stock Exchange.
Options Trading Explained: What Is a Stock Option ?
The origin of Options Trading can be explained by the need for investors to minimize risk or hedge.
Throughout the years, options have become fully pledged financial instruments.
A stock Option gives its buyer the right (but not the Obligation) to buy or sell a stock at an agreed price and date.
Call options is a bet that a stock will increase in price.
Put Options is a bet that a stock will fall.
Let’s suppose Trader Jack thinks that stock XYZ will rise from its current value of $50 to $60 within the next month.
Then Joe can purchase the following month calls on the XYZ company. Jack will need to determine 2 things before buying XYZ calls.
- The date of the Calls : the date of Expiration of Jack’s right to purchase XYZ stock
- The Strike Price : the price at which Jack will be purchasing XYZ stock
These two factors (we will introduce other technical factors later on) will mostly influence the cost of the Calls Jack is willing to purchase.
The more time left on an Option relative to its Expiration date, the more value is has.
Options have weekly expiration and monthly expiration.
Some ETFs (Exchange Trade Funds) have daily Expiration now.
Once in possession of the Option, the trader can sell is at any time before the Expiration date (at least in the US, as it is a bit different in Europe).
Two popular type of trades to consider:
- Scalping which consists of holding the Options only for a very brief period of time (a few minutes, a few hours) depending on market conditions and
- swing trading which consists of holding the position for a few days or even weeks depending on the time left before its expiration
Options Trading Explained: Stocks vs Options ?
Stock Options (there is also Binary Options we will not be addressing here today) are attractive because they are cheaper than the stock they are derived from also known as the Underlying.
One option gives its holder the right to 100 shares of the Underlying stock.
Stocks like Apple (AAPL) or Netflix (NFLX) are currently trading above $200 ( we are in October 2019, NFLX may not be there given its recent plunge).
So, in order to acquire 100 shares of such stock, one must come up with over $20000.
Whereas if a trader purchases let say AAPL Calls last June 1, 2019, when it was below $200 with an expiration date that is still in the future, that trader could exercise (exercise their right to buy it at the strike price) their AAPL calls Options today and thus saving a great deal of money.
This method is really more like an investment.
For reference, here is the daily chart for Apple stock over the last 12 months plotted using TradingView charting tool.
Our goal in trading Options vs Stocks as outlined in Trade Stock Options discussion is to make money from the price movement of the underlying security and typically over a short period of time.
Hence, typical expiration will be weekly (dangerous to trade) or monthly even though intent is to be in the trade for a much shorter period of time.
Price moves from one thing and one thing only : Supply and Demand.
We do not care about the fundamental of the company we trade.
This will be explained later as we continue to unveil the tutorials on How to Learn to Trade Options.
Type of Stock Options
Stock Options strategies can be as complex as needed.
For the Purpose of this discussion, we shall simplify it to Calls, Puts, and the combination of these two that can be called Strangles and Straddles.
Also, we will position ourselves as the Buyer of the securities meaning we will purchase them from Market Makers.
Note that it is quite possible for someone to become a Market maker (writing Calls or Puts) but that requires certain requirements not addressed in here.
A Call option is considered when one expects the stock to go up
A put Option is considered when one expects the stock to go down
A (Long) strangle is a Call and a Put with different strike prices
A (Long) straddle is a Call and a Put with the same strike Price
Are All Stock Options Equal ?
We already know that Stock Options have different Expiration times.
Some Stock expiration are only monthly while most have weekly expiration dates.
Traders like to stick with certain set of stocks sometimes known as Watchlist.
This helps them become very familiar with the way a specific stock behave thus providing an edge in knowing when to enter and when to exit a particular position.
An example of stock that can absolutely derail the best plan for the novice has been ROKU.
It recently jumped from 70;s to 170’s in less than 6 months.
Such a run is unusual even for the better performing growth stocks.
The price of the Stock also influences the cost of its Option outside of movement.
Amazon (AMZN) is a $1600-$1700 stock today (It dropped a bit yesterday after hours after its Earnings).
That price of the Options are way more expensive that Apple or NFLX.
means there is a barrier to entry for trading certain Options.
This can lead one to wonder: How much capital one needs to start trading options ?
Well, the short answer is as little as $5.
There is $0 commissions on trade since early October 2019 across all major brokers.
Therefore, the cost of buying an option becomes the cost of the contract plus the cost of the option itself.
Options can be bought for as little as 1 cent per contract.
Since that is for the control of 100 shares, the actual price for that option is $1.
One can take calculated risk with a relatively low budget.
Especially close to the expiration date of the options.
Because by their nature, Options will lose value as the expiration is nearer.
We just completed the definition of a stock Option.
We introduced the basic set of Options one can trade without restriction (Call, Puts, straddle and strangles) .
Next, we will explore some technical aspects of stock Options.
What makes one attractive over another one.
In the meantime, let me know on the comments section below how in depth you think I should go in the exploration of the technical aspects of Trading Stocks Options.
TBP | Becoming A Successful Stocks and Options Trader