Basic Stock Options Trading Explained

What is Option ?

An option is a contract giving you the buyer/holder the right,not the obligation ,to buy or sell stocks or indexes , commodities or any optionable financial instruments at a fixed price , known as Strike price before a predetermined date , known as expiration date, which expires normally after the 3rd Friday of the month and becomes exercised on Saturday.

As a buyer of options contract, you pay a small option premium for the right to purchase the underlying instruments, whether or not you wish to exercise the right at the end of of contract expiration date. This premium along with strike price, is called Options Chain and can be found on most options trading websites such as www.bigcharts.com

When trading in the US, this is equivalent to buying/ selling 100 shares of the underlying equity. In Europe, like trading on Euronet, 1 Option contract consist of 1000 share.

Options are derivatives of the underlying equity or indexes or any optionable financial instruments. Stock Options trading are short term trading strategies as the Time decay factor affect the price as it approaches expirations. Options can be traded electronically by any private investors like you and me.

Options Exchanges

There are some options exchanges in Europe,but they are not that popular and have less companies listed to choose from, so most people prefer stock options trading in the US. There are more than 6 exchanges- Chicago Board Of Options Exchange being the main one. Due to time zone difference, most people can trade the US market from Europe after they return home from their day job. So all stock options trading examples and explanations on this website are related to US options.

Types Of Options

There are only two types of Options: Puts and Calls.

You buy a CALL Options, if you think the stock /index price is going to rise and Buy a Put Options if you think the stock/index price will drop.

Stock Options Leverage

Using US listed Options, say you are buying 100 shares of Microsoft, currently trading @ $ 26 and you buy 100 shares, believing that it will at least go up to $30 soon. Excluding commission, this would cost you $ 2600 with potential profit of $ 400, which is 15% profit.

However, if you buy 1 x Microsoft 27.5 Call Options @ Call Premium of $0.9 , this will cost you excluding commission 100 x0.9=$90 and when stock price moves up to $ 30 , the new options value becomes say $ 5. Your profit would be $ 410 or (5-0.9)/0.9 x100=455 % . Wow! A lot of difference.

Hedging

If you own shares and do not want to sell them while the stock is doing it's normal correction/ retracement, you can use a PUT option to profit from the decreasing value of the stock.

Options Seller Obligations

If you sell ( also known as Write) a CALL , the buyer of the CALL can exercise it anytime if he or she chooses to once the options have 75 cent or more intrinsic value . You are obliged to deliver the stocks .

As an example to the above Microsoft Call OPTIONS, say HARRY bought the $ 27.5 Call Option and paid the right to do so for $ 90 excluding commissions.

The price has gone up to $30 now. Harry wants to exercise it thinking Microsoft price will go up even further. Now he has the right to buy from say Sally @ $27.5.

Although they have not met, Sally has the obligation to deliver the 100 Microsoft shares to Harry via her stock broker through option clearing house. Harry's stock broker will somehow purchase these shares via the option clearing house at the agreed price for Harry.

Likewise, if you sell a PUT ( selling someone the right to sell to you )and the Put option has 75 cent or more intrinsic value , you are obliged to buy the shares from the the Option clearing house via your broker at the original agreed price.

As a seller or writer of an option contract, you will receive a premium for the right to buy or sell the underlying instruments and is your to keep regardless whether the option is exercised.

Ready To Trade Options?

Now that you know the basic, let's see how we can use simple stock option trading strategy for our Stock Options Trading to make money when the market or you think the stock market is

• going down, like this credit crunch,
• going up
• going sideway
• not sure which way it's going

Options can also be combined to form option spreads which can give you higher probability trades.


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