are many forms of options, but this book spends most of its time on listed stock options and listed index options, both of which trade on exchanges. These two distinct types of options function in two ways. First, they can be used to manage your risk by limiting your losses. And they offer you the opportunity for profits when used with the right strategy.
As silly as it may sound, to make the most out of options trading, it’s imperative that you really understand what options are and know the risks and potential rewards associated with them. That’s why this chapter details the information on the individual components of an option and how to recognize them in the market.
By learning the basics of options contracts and then being able to compare them to other derivatives, you will be able to get a good working understanding of these securities and how to best use them both for risk reduction and for speculative gains. The next few sections are all about the basic concepts that will get you to a comfortable point in trading options and then lead to a good understanding of the risks and rewards associated with options trading.
Grasping option basics
A financial option is a contractual agreement between two parties. Although some option contracts are over the counter, meaning they are between two parties without going through an exchange, this book is about standardized contracts known as listed options that trade on exchanges. Option contracts give the owner rights and the seller obligations. Here are the key definitions and details:
✔ Call option: A call option gives the owner (seller) the right (obligation) to buy (sell) a specific number of shares of the underlying stock at a specific price by a predetermined date. A call option gives you the opportunity to profit from price gains in the underlying stock at a fraction of the cost of owning the stock.
✔ Put option: Put options give the owner (seller) the right (obligation) to sell (buy) a specific number of shares of the underlying stock at a specific price by a specific date. If you own put options on a stock that you own, and the price of the stock is falling, the put option is gaining in value, thus offsetting the losses on the stock and giving you an opportunity to make decisions about your stock ownership without panicking.
✔ Rights of the owner of an options contract: A call option gives the owner the right to buy a specific number of shares of stock at a predetermined price. A put option gives its owner the right to sell a specific number of shares of stock at a predetermined price.
✔ Obligations of an options seller: Sellers of call options have the obligation to sell a specific number of shares of the underlying stock at a predetermined price. Sellers of put options have the obligation to buy a specific amount of stock at a predetermined price.
Use stock options for the following objectives:
✔ To benefit from upside moves for less money
✔ To profit from downside moves in stocks without the risk of short selling
✔ To protect an individual stock position or an entire portfolio during periods of falling prices and market downturns
Always be aware of the risks of trading options. Here are two key concepts:
✔ Option contracts have a limited life. Each contract has an expiration date. That means if the move you anticipate is close to the expiration date, you will lose our entire initial investment. You can figure out how these things happen by paper trading before you do it in real time. You can read more about paper trading in Chapter 7. Paper trading lets you try different options for the underlying stock, accomplishing two things. One is that you can see what happens in real time. Seeing what happens, in turn, lets you figure out how to pick the best option and how to manage the position.
✔ The wrong strategy can lead to disastrous results. If you take more risk than necessary, you will limit your rewards and expose yourself to unlimited losses. This is the same thing that would happen if you sold stocks short, which would defeat the purpose of trading options. Options and specific option strategies let you accomplish the same thing as selling stocks short (profiting from a decrease in prices of the underlying asset) at a fraction of the cost. Chapters 9–11 give you details on how you can profit from falling markets through options.
Comparing options to other securities
Options are a form of derivative, a type of security that derives its value from an underlying security. Stock options derive their value from the underlying stock. In order to better understand option valuations, it makes sense to know more about other derivatives and exchange traded mutual funds (ETFs), which are quasi-derivatives:
✔ Commodities and futures contracts: Like options, commodity and futures contracts are agreements between two parties. The major difference between a commodity or futures contract and an options contract is that the former obligates you, whereas an options contract gives you rights as an owner. This is because commodities and futures contacts set the price for a predetermined quantity of a physical item to be delivered to a particular location on a predetermined date. Options have no delivery date. On the other hand, commodities and futures contracts are similar to options in that they lock in the price and quantity of an asset. However, in both cases, you can trade away your rights and obligations if you exit the contract before expiration.
✔ Indexes: Think of indexes as collections of assets whose value is pooled together to measure the price of the group. Stocks, commodities, and futures are all index components. Chapter 9 covers index options in detail. Here is the important difference: Indexes are not securities. That means you can’t buy an index directly. Instead, you buy securities that track the value of the index, such as mutual funds that own the stocks in a particular index – for example, Standard & Poor’s 500 Index.
✔ Exchange traded funds (ETFs): ETFs are mutual funds that trade like stocks on an exchange. Most ETFs are designed to track an index or an underlying sector of a particular market. ETFs can be considered quasi-derivatives because they don’t always hold the exact same securities of the index that they track. For example, some leveraged ETFs use more exotic securities known as swaps to mimic the action of the underlying index while adding leverage. Two of the most popular ETFs are the S & P 500 SPDR (SPY) and the Powershares QQQ Trust (QQQ), which tracks the Nasdaq 100 index. These two popular ETFs let you trade their underlying indexes, directly or through options.
✔ Stocks and bonds: Stock ownership gives you part of a company, whereas bond ownership makes you a debt holder. Each dynamic has its own set of risks and rewards. Comparison of the three assets, stocks, bonds, and options, yields a fairly straightforward picture. All three asset classes can lead investors to total loss of their investment. And though stocks give you a piece of the company, and bonds offer you income, options offer you no ownership of any tangible assets. Stocks offer indefinite holding periods, and bonds have a maturity date and options have a limited life.
