Stock market introduction to options trading

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I’m actually in the process of starting my first options trade and I wanted to give you guys a little tutorial about options trading that I learned over the last few weeks. The stock market has been doing terribly lately and people including myself have made a few mistakes that cost hundreds of dollars. However, there are still many opportunities that exist in the market today. One of the ways that people trade in the stock market is options trading. Its a little more complicated that buying company shares but it is another way to get into the market in a new level.

An option is basically what it says, it is the ability to buy or sell the option to buy or sell a stock or security. This option itself is a security. So its pretty confusing. However the best way to explain it is that you buy what is known as a contract. A contract is equal to 100 shares. A contract can sell for a fraction of what a company share goes for. For example if the stock price is 100 dollars, the contract price can be, for example, 5 dollars. So you buy the contract instead of the actual company stock. The option has what is called a “strike price.” This is the price at which the option can be exercised. What does it mean to have “exercised”? It basically means that if the stock price reaches the strike price, you can sell your contract for a profit.

An example would be if you bought an option for IBM. The current IBM share price that you see in yahoo finance is 109.04. The contract cost for IBM is 1 dollar if you decide you want to buy the contract. The strike price at 1 dollar a contract is 115 dollars. The expiration for that contract is the third friday of september. This means that you can buy a contract of 100 shares for 1 dollar x 100 = 100 dollars. For 100 dollars you buy the right to buy 100 shares if the price of the stock reaches 115 dollars before the end of that contract (the third friday of september). However, remember that you already paid 1 dollar per share by buying the option. In order to break even, you have to exercise the option when the price of the stock reaches 116 dollars. Assume that the stock price next month becomes 120 dollars. You have reached the strike price because you are above 115 dollars. You decide to exercise the option and convert your 100 share contract and buy your 100 shares at 115 dollars which is your strike price so 115 x 100 = 11,500 dollars. However the new current stock price is 120 dollars. So you spend 11,500 dollars on a stock that has a value of 12,000 dollars. You have made 12,000 minus 11,500 minus 100 (sale of the option) = 400 dollars. You have profited 400 percent on your investment.

What happens if the price of the stock at the end of the contract date is only 110 dollars? You will have lost 100 dollars because it did not reach the strike price and you don’t want to buy a 110 dollar stock for 115 dollars right?

If you had bought shares of the company and not options at 109.04 x 100 = 10,904 dollars and the price went up to 120 dollars. you would have made 12,000- 10,904 = 1,096 dollars. 1096+10,904/10,904 = 10% gain in your holdings vs. 400% gain in your holdings. If the stock price was 110 dollars instead of 120 dollars, you would have made 96 dollars in profit instead of losing 100 dollars by buying the contract.

Thus, options can increase the amount of leverage you have with your money. The percentage profit you can make is much greater as is the percentage amount of loss of money too. Usually the strike price is higher than the actual stock price and if the strike price is lower than the stock price then the cost of the contract is higher.

Where do you find the strike price and the contract price? Go to yahoo finance and on the left hand column of the stock information sheet just under summary is options. There is a bid price and an ask price. When you buy an option you pay the ask price, when you sell the option, you pay the bid price. The ask price is usually higher than the bid price.

What was explained above is applicable to what is called “options calls” This means that you are hoping that prices will be higher than the strike price. You can also buy options puts which means that you are hoping that prices will be below the strike price. This is basically shorting the stock on a leverage. You can also sell options calls and sell options puts where basically you are the other party that is selling to the person that bought shares explained above.

all in all, options can be a very confusing process but once you understand the complexities of options, it can accelerate your investment returns as well as accelerate your investment losses.

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