I provided some basics on option spread trading in one of my previous articles and also in my ‘11 Things You Can Do with Option Spread Trading’ piece. Alternatively, you might already know at least something about option trading. However, even those who have traded options will benefit from reviewing some of the basics before I get into more complex option trading strategies.
One version of an old adage states that amateurs practice to make sure they never get it wrong and professionals practices to make sure they get it right every time. By reviewing some of the basics of options you will get closer to the professional level of never getting your options trades wrong from a fundamentals perspective.
No one can guarantee that every option trade will be profitable. However, proper education will dramatically increase the probability that you will have the knowledge to execute profitable option trades.
So, what is the main advantage of options over a variety of other investments — stocks, bonds, mutual funds, commodities, etc.?
The main advantage of options is that you can take a small amount of money and control a large security or contract. Consequently, you can create a huge profit off a small initial investment. In the investment world, we call this ability granting leverage.
Let’s look at the copper futures market for example. A commodity broker trading copper futures takes on significant risk for large contracts of copper deliveries. Anyone who buys or sells a futures contract for copper actually has the responsibility of either taking a delivery or providing delivery of the copper when that futures contract comes to term.
Delivering or receiving copper futures contract is the equivalent of having four or five tractor-trailer loads of materials either delivered or shipped from your warehouse. That is not something I want to be involved in and neither do most investors. For this reason, trading options on futures is a far better opportunity to get involved with the copper market, without exposure to the risks present in futures trading.
Options are defined as the right to either purchase or sell the underlying security at a future date and at a certain strike price. The most important attribute of options is that this is a right and not an obligation. This means that we do not have to buy or sell exactly what the options contract says. The same applies to dealing with copper futures or stocks or indexes for a variety of different securities when we buy them in options form.
Option contracts allow you to ride the profit or potentially the loss of the underlying security controlled by the option. However, you do not have to deal with buying or selling the underlying security if you do not want to.
Options are either calls or puts. I can sell a call or buy a call, sell a put or buy a put. Despite all the complex types of options trades, I will describe in future articles, options really all come down to these four choices. The other terms popular in regard to options and futures and the market in general are going long and going short. Going long means we are bullish on the price of a security or an option going up. Bullish means essentially that we expect the price to increase. When we go short, we are expecting the price of either the security or the options on a security to go down. This is also known as being bearish.
Options trading terminology is relatively standardized. However, there are minor variations in how people use some of the terms. Some people try to use call or put as equivalent to going long or going short. That can get very confusing sometimes. As much as possible, I will use simply call or put to describe the transactions and bullish or bearish, but not the terms long or short.
Options allow us to control the underlying security on which the option is based with less money than it would normally take to buy the security directly.
For example, the Class C share price of Alphabet, Inc. (NASDAQ: GOOGL) is trading around $800 as of October 2016. If I want to buy a hundred shares of Alphabet, Inc., I have to spend $80,000, plus commission. Generally, if I buy shares of stock, that means that I am bullish on the stock and I expect the price of the stock to increase. If I don’t have $80,000 handy to go ahead and buy a hundred shares of Alphabet, Inc., I can decide that I would like to control the same hundred shares by buying options on the price of Alphabet, Inc.
Assume that I can buy a call option for Alphabet, Inc. stock at the strike price (this term will be explained in another article) of $810 for about $125 per option. At that option contract price, I can control a hundred shares of Alphabet, Inc. for $12,500. I can benefit when the price of Alphabet, Inc. goes off, and I can still create a fairly significant profit from the price of Alphabet, Inc. rising, but I do not have to come out of pocket $80,000 to buy the shares. I only need to come up with $12,500 plus commission, unless there are any margin requirements for taking on the option, which is unlikely in this case.
In future articles, I will explain additional terms and advantages of option trading, as well as provide details on several trading strategies.
Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.