Congratulations and welcome to the final blog post for our class series, the Foundations of Trading. Over the last few months, we have opened the door to the world of trading stocks. Now, you may think we have reached the end of our journey; however, as we close out one chapter, we are opening the next chapter: options.
The definition of an option in its truest form is as follows: a buyer of an option buys the right but not the obligation to buy or sell a specific stock at a specific price, on or before a specific date. That, of course, is a very textbook definition that can be unpacked as follows. When you are normally trading, you are buying and selling actual shares of a company's stock; however, when you trade options, you are buying and selling the right to purchase those same shares. If you own an option that grants you the right to purchase a company's shares, you can purchase the shares in question as long as your option contract is still active. However, you do not have to purchase the stock as you can let your option or your right to purchase them expire as option contracts are only good for a limited amount of time.
Now one of the best reasons for learning to trade options is their capability to limit the risk of your capital. They accomplish this by allowing you to control a hundred shares of a company's stock with only one option contract. This means you could have control over more shares of a company with less capital investment, which in turn keeps the possible risk of financial loss to a minimum. Plus, anytime you can reduce your risk in the market, that is a good thing.
There are two types of options you can trade: a call option and a put option.
A call option gives you the right to buy a stock at a certain price. The monetary value of a call option increases as the value of the stock increases, which means call options are bullish in nature. These options are valuable to short-sellers as they function as a type of price insurance. For example, if the price of a stock goes up on a short trade and you have a call option in place, you can exercise that option to purchase the stock in question for a previous price point, which is lower, and cover your short sale. The benefit of trading call options is the lower cost of entry, the ability to leverage more shares, limited risk, and unlimited reward.
On the flip side, a put option gives you the right to sell a stock at a certain price. The monetary value of a put option increases as the value of the stock decreases, which means put options are bearish in nature. These options are valuable to long buyers as they function as a type of price insurance. For example, if the price of a stock goes down on a long trade, and you have a put option in place, you can exercise that option to sell the stock in question for a previous price point, which is higher. The benefit of trading put options is the lower cost of entry; they do not have any margin requirements, the ability to leverage more shares, limited risk, and unlimited reward.
To sum up, 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 types 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, that both are worth something and that something can be traded and sold.
One of the most familiar features of 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 is 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 review our previous blogs covering the Foundations of Trading classes, please click on the Foundations of Trading blog category on the right-hand side of the page. That will instantly bring up all the blogs from this series for you. Thank you for reading!