So if you've read this far you're probably interested in trading options and making good money doing it. Just like anything else, you need to be well informed about what you're doing if you want to succeed. The concept of options has already been explained. Now it's time to learn how to actually trade them.

 

As previously mentioned, we will concentrate on only the long call and the long put, avoiding all the unnecessary calculus along the way.

 

Trading stocks is rather simple. You simply buy in at whatever they're currently valued, decide how many shares you want, and your return depends on how much the stock gains or loses. If it gains 5%, then you gain 5%. If it loses 5%, then you lose 5%. Simple as that.

 

With options, it's a little bit different. In order to trade options, you first need to select options associated with an underlying stock. As previously mentioned, an option gives the buyer the choice, but not the obligation, to buy or sell a stock at a given price within a set period of time. Since the investor is not obliged to execute whatever action is in the terms of the contract, you can simply sell that option for whatever it may be worth when you want to sell it. For many options, this return can be worth far more than if you invested in the underlying stock. In some cases this may be as high as 100% or 200% within just a matter of days, sometimes even higher.

 

When selecting options, you should keep in mind that there are 3,000 to 4,000 stocks with associated options. There are about 40,000 publicly traded stocks in the United States. So by doing the math, only about 10 percent of stocks have options. This may not sound like much initially, but rest assured that being able to pick between 4,000 or so choices is plenty enough. In the end it's all about returns, not necessarily the number of choices available to you.

 

An important point should be made here. Many options traders choose to concentrate on only a handful of associated options with underlying stocks when executing their trading, sometimes as low as 4 or 5 companies. They believe that they can make solid and consistent returns by simply concentrating on the oscillations of only a few stocks and tracing their movement patterns. And many of them actually do. You can make money on any stock and their underlying options whether they are going up or down, so long as your investment is targeted in the right direction. So by focusing attention on only a select group, many investors can make more informed decisions. Again, it's about the quality of your analysis and information available that's more important. Too many choices can sometimes be a diversion from making the best decisions and investing in the options that can make you good returns. Try not to focus too much on "playing new games." It's important to find out where your "bread and butter" is and to turn to it consistently if it's making you money.

 

 

The long call is the simplest type of option there is. If you learn how to execute it, however, you are probably better educated than most investors out there who only trade stocks. You should read other sections of this site to better understand some of the terminology explained.

 

If you take a "long" call position on a particular stock, it means that you are invested in an option that will increase in value if the underlying stock increases in value as well. It gives you the right, but not the obligation, to buy a stock at a particular strike price (which is discussed below). For our purposes, we are not focused on following through with such rights. We are only concerned with trading the options themselves.

 

If you buy option .XYZKL for $4.00 and the underlying stock XYZ is valued at $50.00, the value of the option will increase so long as stock XYZ is bullish. As discussed on this site, a delta is associated with every option. The option will increase by delta for every dollar that XYZ goes up. Deltas for long calls max out at .99. If the delta for option .XYZKL is .99, then option .XYZKL will go from $4.00 to $4.99 if XYZ goes from $50.00 to $51.00. The option has increased by about 25% in value, whereas the stock increased by only 2%. Time value will devalue the option as it approaches its expiration date, so it's important to consider all factors that affect what an option is worth.

 

 

The long put is the opposite of a long call, giving the holder of the option to sell a particular stock at a given strike price. In this case, the option will increase in value if the value of the underlying stock decreases. Let's say a put option has a strike price of $80 and the value of the underlying stock is $85. Now, let's say the value of the stock hits $65 two weeks from now. Since the option gives its holder the right to sell at the strike price (in this case, $80), this particular option looks pretty attractive to anybody who holds the stock. Think about it... Would they rather sell at market value, which is $65? Or would they rather sell at $80? $80, of course. To be able to do this, though, they need to be holding the option. As such, if this scenario were to occur, the value of the option will increase because it holds the power to help "increase" the value of the stock beyond its current market value. This is why a long put option increases in value when the value of the underlying stock decreases.

 

A couple of important points should be made here. First, do you need to be holding shares of the stock in order to have the right to sell them? That is, can you be invested in a put option if you don't hold the stock? The answer is yes. This is because you are only buying and selling the right to sell the underlying stock at a particular price. What you won't be able to do is exercise your right to sell it. After all, how can you sell something that you don't even own? But again, we're concentrating on trading the options themselves, not executing them.

 

Second, the put option is not the same as taking a short position in a stock. When you short a stock, you are borrowing shares, selling them to the market at the current value, and agreeing to "repay" the stock at hopefully a smaller price if it decreases in value. With a put option, you are not borrowing any shares or contracts and do not "owe" anybody anything. With stock shorting, most brokerages require you to have a margin account, which means you are borrowing money from them, usually with interest. This is because your liability becomes theoretically unlimited when you short a stock. For example, if you short a stock at $50 and all of a sudden it hits $400, you will have to buy it back at some point no matter how much it costs. In such a case, you could easily lose more than you put in. Sometimes this becomes exponentially more. With put options, you are only at risk with what you put in. If you invest $600 in a put option, the most that you can lose is $600. So obviously, shorting a stock and investing in a long put option are not the same thing. The similarity is that in both cases you are hoping that the value of the stock will decrease in value.

 

There are such things as short calls and short puts, but we will not discuss those here.

 

 

The strike price is the price in the option contract for which the holder is allowed to buy or sell (depending on whether it's a call or a put) the underlying stock. If the strike price of the option is equal to the current value of the stock, it is said to be "at the money." That is, the holder can buy the stock at a price that is equal to market value (or sell, if it's a put).

 

Call options are "in the money" if their strike price is below the current market value of the stock. This is because the holder of the options can buy the stock at a value that is below what it is currently worth. In such a case, the option becomes more attractive and therefore has an appreciated value. The option is "out of the money" if the strike price is above the current market value of the stock. There would be no reason for the holder to buy the stock at a price that is greater than what anybody could get it for in the open market. Therefore, the option becomes less attractive and its value is less than if it was "in the money."

 

It is just the opposite for puts. A put option is "in the money" if the strike price is greater than the current market value of the stock because the holder can sell the stock for more than what the market will accept for it. It is "out of the money" if the strike price is below the market value of the stock because the holder can receive more for the stock in the open market than the strike price.

 

The strike price is only really important to consider when executing options. Again, we're not concerned with that. We are concentrating on the trading. And when trading, the strike price isn't all that important to consider. What's important to take into account is whether to take the call or put position and track which way the underlying stock moves. So long as you invest in the right direction, everything will take care of itself, regardless of what the strike price may be. If you trade options as oppose to execute them, the strike price becomes an extraneous piece of data.