Foundations: Breaking Down Options Part 2

Today we are continuing our options journey by taking a closer look at trading options. Since this is ​my first time completely through the Foundations of Stocks and Options class, options are still new territory for me. However, it is the territory which I plan to map out and learn as we progress through FOSO Level 3.

To sum up, what we have discussed in previous FOSO blogs, you purchase call options for bullish trades and purchase put options for bearish trades. If you are in a long or bullish position with your option, you want the price of the stock to go up. Conversely, if you are in a short or bearish position with your option, you want the price of the stock to go down. You can also buy and sell both calls and puts, which means there are four ways to trade an option: buy a call, sell a call, buy a put, and sell a put.

This may seem a little daunting at first but let us take a step back and look at stocks and options like this: both hold value of something. Stocks hold value because they grant you the right to company ownership. Now, options are different type of tradeable security, but they still hold value. However, the value they hold is a right instead of a tangible asset. Stocks grant you company ownership, and options grant you the right to execute ownership. The good news is, both are worth something and that something can be traded and sold.

One of the most familiar features about options is they function similarly to stocks. You can buy them, and you can sell them, and you can also set stops, set trailing stops, limit versus market orders, and you can place contingency orders. When it comes to closing your open trade, as with stocks, you merely do the opposite of what you did to open the trade. Thus, if you buy to open, then you need to sell to close. On the other hand, if you sell to open, then you need to buy to close.

The main difference when dealing with options is, unlike trading long with a stock trade, which we could leave open for years if we wanted, all option contracts would expire at some point. This was one of my main concerns when it came to working with options, the apprehension of buying something and then watching it expire worthless. After all, nobody likes getting stuck with worthless security.

In reality, the possible negative of an option worthlessly expiring serves as a positive guideline when trading options. It keeps me focused on placing trades that meet all of my criteria for a good reliable trade. If the trade fails to meet all the requirements, then I need to stay away from placing it. Plus, even if the trade turns against me and the option becomes worthless, all I am out was the original cost of the option. Yes, it is a loss, but it is a limited loss as I can only lose what I put into the option trade. Unlike shorting a stock, which has unlimited loss potential if the market goes up and even during a long trade if the market drops, the chance of loss can be dramatic due to market fluctuation.

In closing, this blog touches on one of the best reasons to explore trading options; the ability to mitigate risk. Then factor in the capability to control one hundred shares in one options contract for pennies on the dollars, and you have an excellent place to trade with smaller capital requirements and a more structured environment for risk mitigation.

As always, if you wish to learn more regarding this topic, please consider signing up for our Foundations of Stocks and Options class, which you can do here. Thank you for reading, and we look forward to seeing you in next week’s Foundations of Stocks and Options blog!