| Owning stock has only two, maybe three, | | | | Buying an option cannot cost you more than |
| possibilities. The stock goes up. Or the | | | | what you pay for the option. Selling an |
| stock goes down. Or, as a third possibility, | | | | option can cost you far more than what you |
| it does a little of both. If you buy a stock, | | | | receive for selling the option. |
| all you want it to do is go up. | | | | |
| | | | Let's examine the terminology of calls and |
| If you sell a stock short or close a position | | | | puts. The underlying is the actual instrument |
| (or consider buying it and then decide not to | | | | such as a stock or commodity that is being |
| ;), all you want it to do is go down. I call | | | | represented by the options contract. In the |
| this one-dimensional trading. You're long, | | | | real estate example, the house would be the |
| you're short, or you're flat. Your gains and | | | | underlying. Options are said to be |
| losses travel up and down the number line you | | | | derivatives because their value is directly |
| may remember from elementary school in lock | | | | tied to or derived from that of the |
| step with the movement of the stock. Not only | | | | underlying. An option has no meaning without |
| that, but it takes a big move to make a big | | | | an actual asset underlying it. It is the |
| profit. And a big move against you can mean a | | | | right to buy or sell that underlying asset |
| big loss. Potentially all the way down to | | | | that gives the option a reason for being and |
| zero. | | | | some value. |
| | | | |
| You need to add a second dimension to your | | | | The strike price is the agreed upon price for |
| trading. You need more choices than picking a | | | | which the underlying can be bought or sold |
| direction and hoping you are right. You need | | | | under the terms of the option contract. In |
| to limit your losses, improve your returns, | | | | the real estate example, the strike price was |
| and increase your flexibility. You need | | | | $100,000. The expiration date, obviously, is |
| options. | | | | the date when the option expires. The day |
| | | | after expiration, an option is worthless. |
| For many people, options are something to | | | | This is the single most important fact about |
| avoid, being dangerous, complex, and scary. I | | | | options that you must remember. This is why |
| would like to introduce you to the joy of | | | | your friends think you are crazy for your |
| options. Any time you think you want to buy a | | | | interest in options. Unlike a stock, which |
| stock, I'd like to get you in the habit of | | | | you can hold forever, an option has a clearly |
| first looking at how you could do more with | | | | defined shelf life. |
| less using options. | | | | |
| | | | One term remains, and that is the premium. |
| In the stock and commodities markets, the | | | | The premium is what you pay for the option, |
| type of option we just described would be | | | | when you are the buyer. Or what you receive |
| known as a call. A call typically represents | | | | for an option, when you are the seller. In |
| 100 shares of a stock. In the commodities | | | | our real estate example, the premium was |
| markets, a single option contract represents | | | | $500. That's what it cost you to hold the |
| a single futures contract. (For simplicity, | | | | right to buy the house any time in that |
| from this point forward, I will talk about | | | | thirty-day period. The last day of the |
| options on stock. Just remember that the same | | | | thirty-day period would, again, be the |
| discussion applies to options on futures.) | | | | expiration date. |
| | | | |
| Owning a call gives the owner the right to | | | | We have barely scratched the surface. I say |
| buy 100 shares (usually) of the underlying | | | | that not to intimidate you, but to make you |
| stock at the agreed upon strike price at or | | | | realize that you only have enough knowledge |
| before the expiration date. (I say "usually" | | | | to be dangerous to yourself. Please do not |
| 100 shares because, due to splits or | | | | think that you are ready to go out and buy |
| acquisitions, there are times when an options | | | | calls or place spread trades. You are not. |
| contract may represent something other than | | | | You don't know how an option moves relative |
| 100 shares.) Selling a call gives the seller | | | | to moves in the price of the underlying. You |
| the obligation to sell, if asked, 100 shares | | | | don't know what time does to the value of an |
| of the underlying stock at the agreed upon | | | | option. You don't know what volatility is or |
| strike price any time up until the expiration | | | | how it plays into option prices. You don't |
| date. | | | | know the types of spreads or what they are |
| | | | used for. |
| The other kind of option is called a put, and | | | | |
| it is exactly the same as a call with one | | | | Please, please get yourself better educated |
| simple difference. A put gives the owner the | | | | before you start putting money into option |
| right to sell 100 shares (again, usually) of | | | | trades. Resist the temptation to buy some |
| the underlying stock at the agreed upon | | | | cheap options, just to try it out. This is |
| strike price at or before the expiration | | | | expensive education. There are plenty of |
| date. You can think of a put as insurance. No | | | | advantages to trading options, but it's still |
| matter how badly the stock price crashes, | | | | a ruthless market, happy to take your money, |
| having a put means that you can sell your | | | | your wallet, and your hand if you give it an |
| stock for the strike price. On the flip side, | | | | opportunity. Learn the rules of the game |
| selling that put means you may be obliged to | | | | before you put money on the line. |
| buy stock at far more than its current market | | | | |
| price. | | | | Trading options can be satisfying, rewarding, |
| | | | stimulating, and fun. I invite you to add |
| An important distinction to always keep in | | | | another dimension to your trading by |
| mind: Buying an option gives you rights. | | | | including options to your repertoire. |
| Selling an option gives you obligations. | | | | |