Foundations of Trading: Options [Part 1]

The Foundations of Trading program has provided an excellent starting point for your journey into the world of stocks. If you wish to revisit any part of that journey, please click on the Foundations of Trading blog category on the right-hand side of the page, and that will instantly bring up all the blogs from that program for you. However, now is the time to expand your trading horizons even further by introducing you to the world of options. Welcome to the Foundations of Trading Options class 1 overview which will highlight my main takeaways from Chris’ first class teaching.

​What is an Option?

When it comes to stock trading, there are two main approaches; you can either buy a stock and sell it when it increases in value, or you can short a stock and take your profits as the price of the stock drops. In both cases, you are dealing with transactions of actual shares of a company’s stock. Stock options, which are a slightly different type of security asset, are more concerned with the control of a company’s shares instead of actual ownership. Basically, what an option gives you, the buyer, is the right but not the obligation to buy or sell an original asset for an agreed-upon price at a later date. Now, there are two main 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 specific price. The monetary value of a call option increases as the value of the underlying 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, and the limited risk.

On the flip side, a put option gives you the right to sell a stock at a specific 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 higher previous price point. 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, and limited risk.

​An Example of an Option

Let’s use a real estate analogy to explain how options work. Anna is looking to purchase a house. After much searching, she finds a great deal for $400,000. However, Anna is unable to put money down on the house close the deal, but she really wants to lock-in that particular house at that specific price. So, Anna strikes a deal with the owner of the house. She will give him $2,000 today, and in exchange, the owner of the house will exclusively hold the property for the next three months just for Anna. This means at any time in the next three months, Anna can purchase the house for $400,000. However, this brings up two related questions: what if Anna ultimately does not want to buy the house, and what if the price of the house goes up over the course of her ninety days?

Anna has an appraiser look at the house, and he reports back to her what the house is currently worth. The appraiser reports back the house is worth $375,000 or $25,000 less than what the homeowner wants. So Anna decides it is not a wise investment to purchase the house at her locked-in price, so she lets her deal with the homeowner expire after ninety days. Her loss on the deal is $2,000, but it could have been much more. If she had purchased the house at $400,000, she would have immediately lost $25,000 due to the reduced price of the appraiser’s report.

The reverse of the above paragraph plays out this way. The appraiser reports back the house is worth $425,000 or $25,000 more than what the homeowner wants. Anna decides this is a wise investment because as soon as she purchases the house for $400,000, she will gain $23,000 in instant profit. Minus the $2,000 which it took to secure the deal initially.

​In Closing

This is a basic example of the flexibility which trading options can provide. You can lock in a price point on a stock for a fee. If the stock goes up, you can purchase the stock and then sell it for a profit. If the stock goes down, you avoid trading the stock, and even though you have lost the money you have put down to secure your option, there is a fair chance you have lost less than you would have if you had purchased the stock. Needless to say, if you are like me and find the concept of what options can provide interesting, then join me next week for part 2 of Foundations of Trading: Options.