When most people think about stock options, they immediately think one word: Complicated. Then the next word they tend to think is risky. There is truth to the idea that stock options can be complicated, and when things get more complicated, they tend to become a bit risky. However, there is also value in learning to understand options because when someone truly understands stock options, they will discover that options, when used properly, lower your overall risk, lower your capital exposure, and can increase your Return on Investment or ROI.
In reality, the playbook for using options is thick as there are many lengthy, complicated books written on the subject. However, the good news is stock options do not have to be complicated. We can simplify this down to four basic option trades, and these four trades are used to make up every one of the possible trading strategies available.
If we want to break options down to their most basic elements, it can be said this way: there are only two possible options and four possible trades; that’s how simple options can be. No matter how complicated someone tries to make a strategy, everything is built from two basic options:
In its most simplistic form, a call option is the right but not the obligation to buy a specific stock. It breaks down in more detail like this: a call option is the buyer of a call option buys the right, but not the obligation, to buy a specific stock, at a specific price, on or before a specific date. Traders who have been around stock for a while tend to understand this option because it is so similar to buying stock. Instead of buying the stock, you own the right to buy the stock. If you choose to exercise that right, now you own the stock. That’s pretty straight forward. The call option tends to be the option more people understand because it is a little like trading stock directly.
Put options tend to be a little bit more confusing because most people have a hard time thinking of the trade-in reverse. Essentially, that is what happens with the put option, which can be defined as follows: the buyer of a put option buys the right, but not the obligation, to sell a specific stock, at a specific price, on or before a specific date. Since the put option is dealing with selling instead of buying the underlying stock, almost every detail of this trade is inverse to the call option.
The simplest way to explain put options is to relate it to an insurance policy.
Most homeowners understand the idea of a homeowners insurance policy. You pay an insurance premium in the event that something horrible happens to your house, the insurance policy steps up and covers the cost of the damage. When you buy a homeowners policy, you are buying the right, but not the obligation to put all damages off onto the insurance company if something tragic happens. This is what happens with a put option.
The put option gives the buyer the right to sell the stock at a certain price. If the stock goes down, that put owner can either sell at the higher price or cash out the put option the same way you would cash out an insurance premium.
These two trades are the foundation of all stock options. You will never find yourself in an option trade that does not have either a call or a put option.
Now that we understand the two types of options, let’s look at the four possible trades that can take place. Remember, there are two types of options, calls and puts, and there are two possible positions, buyer and seller.
That means there are four possible option trades:
So how do we understand the four plays? We need to go back to the definitions. A call equals the right to buy a stock while on the flip side a put equals the right to sell a stock. The buyer of the call will always buy the right to buy the stock, and the buyer of the put will always buy the right to sell the stock.
If we flip that position and recognize that the seller of the option takes the opposite position as the buyer of the option, then we can construct a four-way grid that tells us everything we need to know about how the option positions layout.
Armed with this basic information, you can break down every option strategy in the book.
However, we do need to be clear, because it does get more complicated from here as there are quite a few moving parts in the world of options, but we promise the journey to learning about stock options will be worth it. If you will take the time to learn them, stock options will provide you a lot of flexibility in your trades and possible strategies you can construct. Once you understand them, you will never be able to look at stock trading the same again.