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INTRODUCTION

If you’ve ever been curious about the interesting world of options trading, look no further. Options are one of the fastest-growing areas of the financial markets and for good reason: They offer you the potential to make money quickly. However, options can move more quickly than other investment types and can be highly volatile, so those looking to trade need a strong foundation before they begin.

Options Trading 101 teaches how options work and how to make money trading them. This book also covers how and when to close your options position, how to manage options risks, and how to handle common setbacks eventually faced by all traders. In short, this book walks you through the basics and beyond, with topics ranging from:

The fundamentals of options, including how options are structured and their key risks and rewards

The four core options strategies, including examples and how to fine-tune your risk and return

Advanced options strategies that you can use to generate profits with reduced risk

How options are priced, what drives their price, and how to anticipate their price changes

Common pitfalls of options trading and how to avoid them

The important options trading vocabulary, so that you can speak confidently and knowledgeably

And more!

Whether you’re a novice options trader looking to learn the ropes, or a more experienced trader looking to review the basics, this book has something for you. Of course, if you do happen to be a novice trader, you should have a solid background in investing and understand how stocks and securities work. That said, whatever your experience with options trading is, this book approaches options using an easy-to-understand style that explains the core concepts in detail. It then uses examples to show you how fascinating options are, how they work in practice, and how you can calibrate your options trading to your desired risk level. You’ll walk away from this book with a variety of strategies that you can use to make money in any market—and you’ll know their potential rewards and risks.

Whichever options you focus on, you’ll soon understand why this form of trading is so fascinating and use Options Trading 101 to help guide you along your trading journey. So, turn the page and begin.

Chapter 1

Options Overview

Options open a whole new world for people like you who are looking to juice their profits from the financial markets. While options may be based on assets that you’re already familiar with—stocks, exchange-traded funds (ETFs), and stock indexes—options present an entirely new set of securities and strategies, an entirely new set of risks and rewards, and an entirely new vocabulary to master. But for those who master options, the upside can be immense; as a knowledgeable trader, you can multiply your money quickly—at the risk of losing it all if you’re wrong.

To capture the potential profit, you need to understand how options work, the advantages and disadvantages of options, and what you’ll need to begin trading. Of course, you need to understand the many risks of options, but you’ll also need to know how options can reduce your risk—an often-overlooked benefit. Ultimately, you’ll need to understand all these features before deciding whether options are right for you.

WHAT IS OPTIONS TRADING?

Understanding the Principles

Options are one of the most exciting areas of the financial markets but paradoxically also one of the least understood. Options have the potential to deliver serious wealth to people who can master them, and that’s why options trading is so popular among sophisticated investors. As an options trader, you can make—and lose—a fortune in just weeks or months due to the highly volatile nature of options. Plus, there are a variety of strategies to thrive in the options market while minimizing your risk, and as a savvy operator, you can learn how to navigate the options markets to take advantage of this.

OPTIONS ARE DERIVATIVES

Options are one kind of financial derivative, which is a way of saying that their price derives from or is based on the price of another asset. Options are often based on stocks, exchange-traded funds, and indexes, and when the prices of those underlying assets change, so do the prices of the options on them. When trading, you’ll try to anticipate these moves in the market so that you’re buying options that are poised to rise or selling the ones that are ready to fall in value. To do so, you’ll trade options based on your expectations of how the underlying assets will perform. If you’re right, the option may increase in value much faster than the stock or fund it’s based on, and the speed of earning a profit is part of the huge appeal of options trading.

OPTIONS REQUIRE CONTRACTS

Options are structured as a standardized contract, with contractual terms that are similar from option to option. Each contract represents 100 shares of the stock or fund it’s based on. Options exist for a finite period, which is specified in the contract when you trade it. Then when an option reaches its expiration, it ceases to exist, and the terms of the contract are settled between the option’s buyer and seller. So, when you purchase or sell an option, you know exactly what you’re getting. Standardized options trades are conducted on public exchanges, helping to offer transparent pricing for traders.

OPTIONS HAVE TIME LIMITS

With options trading, you’re buying and selling risk over a predetermined period that you and another trader both agree on. In a real sense, you’re simply buying and selling parts of an asset’s returns above or below a certain stock price over a limited period. One trader might want a certain type of risk—say, a stock’s returns above $40 per share for the next six months—and another is willing to sell that risk for a price.

OPTIONS ARE RISKY

You might hear the word risk and think of only negative things, but with options and other financial securities you should think about risk as both a positive and a negative. Sure, there are risks with negative consequences. However, without risk you have no potential for return either. The financial markets constantly price risk and return, with traders generally offering low returns for low risks and higher returns for higher risks. It follows that you must take some risk to make a return. So, you’ll ultimately want to take good risks that can deliver attractive returns and be on the hunt for mispriced risk. Because of the limited duration of options contracts, you own that risk only for the length of the contract and then must repurchase the risk if you want that exposure again.

OPTIONS PROVIDE MULTIPLE PATHS TO PROFITS

Options trading can allow you to make money in virtually any kind of environment, whether the stock is moving up, down, or even sideways. The beauty of options is that they allow you to buy and sell various parts of a stock’s return profile, at least over a period. Different types of options can be stacked together to get exactly the kind of risk profile that you want. If you expect a certain risk is unlikely to come to pass you can simply sell that risk to another trader who thinks it could happen. This quality makes options so wonderfully flexible and so potentially lucrative but also often misunderstood.

OPTIONS TRADES ALWAYS HAVE A WINNER AND LOSER

While options may be based on stocks, the two types of financial securities differ in fundamental ways. A stock is an ownership stake in a company, which is issued by the company to fund its operations. A stock can exist indefinitely, if the company remains financially viable. But when an option contract expires, the bet is settled, and only one side can come out a winner, making options trading a zero-sum game. Either an option’s buyer or seller comes out the winner on every transaction. Of course, brokerages that charge a commission for options trading do profit on every trade.

Lucrative Side Bets

Investing in stocks need not be a zero-sum game as the company grows and increases profits for all its shareholders. In contrast, an option is effectively a side bet between traders on how a stock or fund will perform over the duration of the option contract.

OPTIONS REQUIRE ACTIVE MANAGEMENT

Stocks and options differ in how you manage them. Because stocks can exist indefinitely, as an investor, you can purchase a stock and hold it for literally decades as long as it continues to exist. You can take a buy-and-hold approach to this potentially long-lived asset and may look at its performance only once or twice a year, though stocks are frequently traded with a much shorter holding period, of course. In contrast, options positions must be actively managed, with you evaluating a contract’s risk and return, determining when to sell at an optimum time, and generally keeping a close eye on what’s moving the positions. While you can be successful with stocks by taking a passive approach, options trading needs active management, requiring more time and attention to be successful.

HOW OPTIONS WORK

Understanding the Operation of Options

Options allow you to buy or sell an asset at a predetermined price for a period. One type of option, a call option, governs the buying—and one option, a put option, governs the selling. While these types of options contracts entitle their owners to do different things, in other fundamental respects they operate similarly.

CALL OPTIONS AND PUT OPTIONS

The buyer of a call option is entitled to purchase the underlying asset, often a stock, at a preset price for the duration of the contract. The seller of a call option is obligated to sell that asset at the agreed-upon price, regardless of how unfavorable the price is, if the buyer exercises the option. For this advantage, the call buyer pays a fee to the seller.

The buyer of a put option is entitled to sell the underlying asset, often a stock, at a preset price for the length of the contract. The seller of a put option is obligated to buy that asset at the agreed-upon price, regardless of how unfavorable the price is, if the put buyer exercises the option. For this advantage, the put buyer pays a fee to the seller.

Each contract allows an option owner to transact 100 shares of the underlying stock up until the time the option expires. If you purchase one call, you’re entitled to buy 100 shares of the stock at the preset price, while six options get you exposure to 600 shares and so on. Options prices are always quoted in per-share amounts ($1.50, $2.25, $3.00, and so on) rather than the total cost of the contract, which is the per-share value times 100 shares (or $150, $225, $300, and so on).

Expectations of Buying and Selling Options

If you own an unexpired option, you have the right, but not the obligation, to exercise it and derive any advantages from it. However, if you sold the option to open a position, you’re obligated to perform the actions specified in the contract, namely to buy or sell an asset at the preset price.

Options are known as wasting assets, a term that means their value tends to decline over time. A contract with more time until expiration has more value than the same contract with less time to expiration, reflecting the former’s potential to move more. A portion of the value of every option reflects how much time is left on the contract, up until the option expires. Of course, a rise in the underlying stock or a change in other variables can make the option price move up at any time, but the option’s total potential is waning day by day.

HOW OPTIONS ARE SETTLED

After an options position is started, how is it finally settled? A trade is concluded in one of three ways:

A trader closes the position. As long as the option has not expired, the buyer or seller of the option can close the position at any time and remove all contractual rights and obligations. For example, if you bought an option to start a position, you would simply sell the option for the going market value, closing the position and ending any rights conferred by the option. Similarly, if you sold an option to start a position, you would repurchase the option from any willing trader, closing the position and ending any obligations. A buyer and seller need not close the position with the person they originally opened the position with, and they can purchase or sell the same option from any trader willing to make a deal. But they’ll have to pay whatever the fair market value is at the time, which may be more or less than they originally transacted at.

The option is exercised. An option’s owner can exercise that option at any point if the option has not expired. If a call option is exercised, the call’s owner purchases the stock from the seller at the contractual price. If the seller does not own the stock, the brokerage will purchase the stock at the market rate and deliver it to the option buyer. If a put option is exercised, the put’s owner sells the stock at the preset price to the put’s seller. Traders are not likely to exercise an option unless it’s worth some money and less than a week or two remain until the option expires, at which point it has little potential or time value left. If the option expires and is worth more than $0.05, the brokerage usually automatically exercises it.

The option expires worthless. If the option expires worthless, the option seller keeps the whole fee for selling the option, and the buyer ends up with nothing. The brokerage removes the worthless security from the traders’ accounts by the next trading day.

OPTIONS AND LEVERAGE

Options are appealing to traders because they offer what is known as leverage. This term means that an option’s price can move a lot in response to a stock’s price movement. Because of leverage, you can put up a little bit of money in an option and have a large gain, even if the stock moves only a few percent. Here’s an example to see how it works.

Imagine a stock trading for $60. A call option is available enabling the purchase of the stock for $62.50, and the option costs $1.50. So, for a cost of $1.50, the option buyer has the right to purchase the stock for $62.50. If the stock rises to $65.50 at the option’s expiration, the option would be worth $3. The option’s owner can purchase the stock for $62.50 from the option’s seller and sell it for $65.50, for a $3 gain per share. In effect, the buyer purchases the option for $150 ($1.50 × 100) and its value doubles to $300, though the stock itself increased only about 9%, from $60 to $65.50.

OPTION SELLER RESULTS

The option seller must deliver the stock to the buyer, and the brokerage makes the delivery automatically. If the seller does not own the stock, the brokerage purchases it on the seller’s behalf, charges the seller the market value of $65.50, and settles the option. In effect, the option seller buys the stock for $65.50, then sells it to the option buyer for $62.50, taking a loss of $3 on this part of the transaction. The seller initially received $1.50 for selling the option, so the seller lost $1.50 per share (or $150 overall) on this trade, the $3 loss offset by the $1.50 received from the option buyer.

ADVANTAGES AND DISADVANTAGES OF OPTIONS

The Good and Bad of Trading

Options provide a lot of, well… options for investors, making this trading especially attractive for intermediate and advanced investors who know their way around the market. Their flexibility means that options provide various ways to make money, generating capital gains or regular income. Options also allow you to limit risk and hedge a portfolio, and they let you make money in any market—up, down, or sideways. These advantages, of course, are balanced against some important disadvantages, in particular the potential for significant and even catastrophic loss if you don’t know what you’re doing.

ADVANTAGES OF OPTIONS

The following are seven major benefits of options trading, as this form of trading offers many ways to make money.

Ability to Multiply Your Money

The most attractive feature of options is the ability to rapidly multiply your money. Yes, with the right options strategy you can double or triple your money and more, sometimes in months and on rare occasions even weeks or days. Though it’s not easy and you run the risk of total loss, it can be done with some knowledge and a little luck.

Ability to Trade Risk

Options allow you to buy and sell the risk of stock price movement for certain periods of time. You can carve off just the piece of risk that they’re willing to buy or sell, and you decide the period you’re willing to own it. You can choose to purchase the riskiest parts of a stock’s potential return profile and perhaps generate significant gains, or you can stick to relatively safe areas and generate more likely but lower profits.

Tremendous Flexibility

Options can provide tremendous flexibility. Because they mimic the moves of stock positions, these financial derivatives can be sliced and diced to create the risk exposure (and payoff) that you want. You can set up any number of options strategies that can be overlaid on how you expect the stock to perform. You can use options to generate income or capital gains and limit risks while this trading achieves stock-like returns or better.

Generate Incremental Income from Your Stock Positions

Options can also be useful to generate income in other ways. For example, you can sell options on stocks you already own to create income. With the option, you promise to sell the stock at a specific price by a specific time. If the stock does not reach that price in the time, you keep the stock and can repeat the trade again and again.

Hedge Risks in Your Portfolio

Not only do options help you shoot for the moon, but they can also be used to hedge risks in your portfolio, reducing the impact of individual stocks. You can purchase options that completely offset the bad performance of a given stock, at least for some time.

Set Up Regular Income by Acting As an Insurer

Options can also be used to act like insurance. By selling certain types of options, you promise to purchase stock at a specific price for a specific period. By acting as insurance for stock prices, these options trades can generate regular income. Keep