When most people think about stock options they immediately think one word: Complicated ...Then the next word they tend to think is “risky.” In this blog I'll show you four option trades you can master.
There is truth to the idea that stock options can be complicated and when things get more complicated they tend to become a bit "more risky". However, there is also value in learning to understand options.
When someone truly understands stock options they will discover that options, when used properly, actually:
In addition to these benefits, options can be used to:
In reality, the playbook for using options is thick. There are many books written on the subject that use 700 pages or more to explain all of the various ways a trader can use options.
… it does 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:
The call option tends to be the option more people understand because it is a little more similar to trading stock directly.
“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.”
In a later article, we will look at the details of the strike prices, expiration dates etc. For now, you simply need to understand that a call option is the right to buy a specific stock.
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.
Put options tend to be a little bit more confusing because most people have a hard time thinking of the trade in reverse. However, that is essentially what happens with the put option.
“The buyer of a put option buyer 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 home owners understand the idea of a home owners insurance policy. You pay a premium every year (or every 6 months or every month) and 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 home owners 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 essentially 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 at its core, 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)
There are two possible positions - the buyer and the seller.
That means there are four possible option trades:
That’s it. Every option play comes down to these four basic option trades.
It doesn’t matter how complicated your strategy is; Iron condor, Butterfly, Credit Spread, Debit Spread, Calendar spread, Ratio Back spread, straddle, strangle…
You can come up with any strategic name you want and I promise at the core it will break down to the four plays listed above: Buy a call, sell a call, buy a put, sell a put.
If you can understand these four basic plays, you will be well on your way to understanding stock options.
So how do we understand the four plays?
Go back to the definitions:
Call = The right to buy a stock
Put = 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 lay out.
This little graphic is like your “rosetta stone” of options! All you have to do when deciphering a strategy is ask yourself:
“did I buy or sell, and was it a call or put?”
Armed with this basic information you can piece together every option strategy in the book!
Now you have a pretty good idea of how simple options can be. I do want to be clear, it gets more complicated from here as there are quite a few moving parts. But I 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.
Expand your flexibility and create additional opportunities.