Stock Options Trading

So what is the value in stock options trading?

First lets define what a Stock Option is:

A Stock Option is the right to purchase stock in the future at a price set at the time the option is granted (by sale or as compensation by the corporation).

To actually obtain the shares of stock, the owner of the option must ‘exercise’ the option by paying the agreed upon price and requesting issuance of the shares.”

Or another way of stating this is:

"An Option is a contract for the right to buy or sell a specified quantity (in stock options per 100 share lots, of the underlying security (the stock), at a fixed predetermined price called the Strike Price, at any time up to the expiration of the contract, called its Expiration Date."

The simplest way to explain options trading is that investing in a stock option is basically buying the right to “buy or sell” a stock at a certain price if and when you want to.

And there is no obligation to exercise the stock option at all.

Got that?...what do you mean no?

Ok, trading options can be confusing. So lets look at this from another way.

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There are three things that can happen with options trading:

1. Exercise The Option

2. Trade the Option Contract

3. Let the Option Contract Expire Worthless

1. Exercise the option: which means simply paying the strike price times the number of options and receiving the specified quantity of the underlying stock.

What is the strike price?

The Strike Price is the fixed price at which the owner of an option can purchase (in the case of a Call), or sell (in the case of a Put) the underlying security when the option is exercised. Strike price is often called the Exercise price.

Example

Lets say, on March 1, Microsoft (MSFT) is trading for $70/share.

Buying 100 shares will cost you $7,000 (100 shares * $70).

Based upon your stock analysis, you believe the share price will rise to $90.00 or higher in 3 months time of June 1. You want to see if your analysis is right.

In order to do this you buy an options contract that gives you the right to buy 100 shares of MSFT stock at the Strike Price of $70, within the Expiration Date of June 1.

Now this particular $70 option contract is selling on the open market for $5.00 a contract and expires in 3 months time of June 1 (you have different time frames in which to pick). And remember, each contract is equivalent to 100 shares. So $5.00 * 100 = $500.

Compared to $7,000, $500 isn't a lot of money to risk. So you paid $500 on one Call contract for the right to buy MSFT at $70.

Two months later, MSFT is indeed trading at $90 dollars and the price of the option contract in the open market also increases from $5 to $23.

You could exercise your contract, buy MSFT for the original Strike Price of $70 * 100 shares = $7000 and then immediately sell it for the actual current price of $90 * 100 shares = $9000, which is a profit of $2000 or a 28.5% return.

Or you can Trade the Option Contract.

2. Trade the Option Contract

Your other choice with options trading is that you could sell or trade your option contract to someone else for the new existing option asking price of $23 *100 = $2,300. In doing so, you would make a profit of $1800 which is a 360% return on your money!

So the actual dollar profit is slightly less, but the percentage profit is substationally higher, and you are only risking $500 instead of $7000. And if you would have bought two contracts instead of one, your profit would be $3600.

Can you see the leverage you achieve when Trading options contracts?

This is where the big value is when options trading in the stock market!

3. Let the Option Contract Expire Worthless

The third scenario that could happen is you don’t exercise your contract nor do you trade your contract, and let it expire worthless once June 1'st comes, which means you will lose your original $500.

Or if the price MSFT actually falls back to say $65/share, the corresponding Call contract will also fall to say $2/share, you trade that contract back on the open market for $2 and take a loss of $3 * 100 = $300.

Now the above scenario is options trading in its simplest form.

And the option traded above is known as being At The Money, which means the current price of the underlying stock and the Strike Price are the same.

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There are many options trading strategies some of which are complex in nature.

At the end of the day, your success as an options trader hinges on your ability to select the right underlying stock. This website provides all the information and tools to help you to do just that.

So learn and become proficient at stock trading first, before you jump into the world of trading options.

I recommend you read “McMillan on Options” written by professional expert Options Trader Larry McMillan.

Not only will you learn all the basics of trading options, you will also gain a unique insight into Larry McMillan's personal philosophy on options, and discover the innovative new tactics and strategies he applies to his own trading and analysis.

Next:

• Types of Options and Trading System

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