What Are Stock Options (?) And How To Explain Stock Options!

There’s a whole batch of underlying assets one can buy options for.

You can buy options on oil, interest rates, gold, all kinds of commodities and even airplanes. The list is endless! The term “option” refers to a type of derivative in which category it falls. An option is a derivative because it derives from something namely the underlying asset. In our case it’s the stock which is why it’s called a stock option!

And because a stock option derives from a stock, it also follows its direction. So wherever the stock tends to go, either up or down, the option goes. It tags along with the stock.

To explain stock options one must first understand that a stock option is a contract that gives the owner i.e. buyer the right, but not the obligation to purchase stocks (also referred to as the underlying asset) at a specified price called the Strike Price, and to exercise this option contract on or before a future date called the Exercise or Expiration Date. The price the buyer pays for the option is called the Option Premium.

But How Do Stock Options Work Now?

A simple method to understanding stock options is by an easy to understand example and explanation of the various things revolving around an option. So let’s get started.

The benefits of stock options - at least one of many - are that they are a lot cheaper than the stock itself. My very first options contract that I bought was from Starbucks (SBUX). At the time of my options purchase, the stock price was $41,37, but the option price was only $2,15.

Now I already mentioned that an option is a contract. This means that if you buy stock options you buy them in terms of contracts. Your broker will always ask you how many contracts you want to buy. Here it is important to know that one contract represents 100 stocks.

So what did that mean in terms of my Starbucks options? As I already mentioned, stocks of Starbucks were trading at $41,37 and so I bought 7 option contracts which means that (one contract representing 100 stocks) you would have to multiply 7 by 100 (which will give you 700 of course) and then multiply 700 by the options premium which in my case was $2.15. Thus, I ended up with an amount or $1,505 for these 7 contracts not including commissions. These vary from broker to broker.

But lets continue with the math. Had I bought the stock itself for $41,37, these 700 stocks would’ve cost me $28,959. But by purchasing 7 options contracts, I controlled a batch of stocks worth $28,959 for only $1,505. And that’s another benefit stock options!

In the stock option market you often you hear the expression “leveraging the market”. Now what does that mean in options trading?

Back to Starbucks. When I sold my options position, Starbucks’ stock price was $44,60. That’s a $3,23 or 7.8% profit. But I sold my 7 contracts when the options price was up $4,30. And that’s a 100% gain. You see now what leveraging the market means? For an option to go up and make you a nice profit, the stock itself just has to move a little in comparison because options move much faster.

Ok. Now where’s the drawback you may ask.

The hazards of stock options is that if things go in the wrong direction for you (down instead of up or up instead of down) you lose just as fast as you can make a profit. Period. That’s the way it is and it can be a very painful and brutal experience. That’s why it is so extremely crucial to really know what you are doing when you want to be a stock options trader, use a trading system that is easy and not complicated and apply sound money management rules. But I’ll get to that later.

Another drawback is that options contracts have an Expiration Date which means that they are not valid forever. A stock you can buy and hold for as long as the company exists. With options you can’t. Once the option has expired it’s gone. Off the face of the earth. Even if you made a million in profits. If you forget to sell or exercise your options before the expiration day, your millions are gone. Too bad so sad, good bye! Better luck next time or rather, next time, don’t forget to sell!

But before I get into how to trade stock options, one more thing. There are two types of options. A Call option and a Put option. The buyer of a call option wants the price of the underlying asset to rise in the future, meaning that call options are most profitable for the buyer when the underlying asset, in our case the stock, is moving up.

Vice versa, the buyer of a put option wants the price of the underlying asset to drop in the future, meaning that put options are most profitable for the buyer when the underlying asset is going down.

So here’s another benefit of stock options. You can profit from both directions. When the stock goes up and when it goes down! And now that we covered some stock options basics, let’s start getting into…

…How To Trade Stock Options.

It all starts with choosing a stock that is optionable. All large corporations like General Electric, Microsoft, McDonalds, Boeing etc, are. Otherwise just look it up. How? I’m gonna tell you. Just hang on a sec.

So lets say you chose Apple (APPL) for instance and you want to buy a call. Now you want to know at what price AAPL is trading, and that price is called the Strike Price. Another term that you will hear a lot in the stock option market.

The strike price is a 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 stock.

Lets just assume that you found that APPL is trading at $160. You then go to what is called an options chain. You can find these among others on www.cboe.com which is the Chicago Board Options Exchange and which is also the largest U.S. options exchange.

In the navigation bar of this site, you go to Quotes and Delayed Quotes Classic. Now you enter your stock symbol like AAPL for Apple, click the radio button at the bottom that says “List all options, LEAPS, Credit Options & Weeklys if avail” and click “Submit”.

And here you can also find out if your stock is optionable or not. Just enter the symbol of your stock. If the programme comes up with a options chain like AAPL, then your stock is optionable.

On the left of the options chain you have your Call Options and on the right you’ll find the Put Options. So now you scroll down the options chain until you find a $160 option. This can look like this:

08 Oct 160.00 (APV JL-E) or 09 Jan 160.00 (APV AL-E) for instance. Now what do these hieroglyphics mean?

The first part, 08 Oct or 09 Jan etc. represents October 2008 or January 2009 etc. which is the year and month of expiration. And here you must know that options in the United States expire on every 3rd Friday of the expiration month. So something like 08 Oct will tell you straight away that this option will expire on the 3rd Fryday of October 2008.

160.00 is the strike price which is the price that you opted or chose to buy Apple for in the near future. The symbol like APV JL or APV AL is simply the options symbol. So if you tell your broker that you want to buy an x-amount of contracts of APV AL or simply enter the symbol into the respective space of your online trading account, then basically all is said and done.

The letter behind hyphen of the options symbol can be neglected. It just represents the exchange where the option is being traded. New York, Chicago, San Francisco etc. In this example it happens to be the letter E. Please don’t ask me what exchange E or other letters stand for, it is not important for your options trade.

Another term you will hear very often is Exercise Stock Options. This simply means that you now go ahead and purchase the stocks that you bought the options for at the fixed price - the strike price - which works like this: If you bought Apple options at a strike price of $160 and the stock of Apple has now risen to $170, you can then exercise your options and buy Apple for $160 and sell them for $170.

But nobody really buys the underlying stock or, in technical terms, exercises his options. Because of the huge leverage options offer, one simply sells the options contracts which will make you much more profits than the stock itself as I explained above.

The market for stock options is huge! There are several thousands of options you can buy in the United States alone, not to mention how many other thousands there are out there internationally.

Three other terms that come up all the time is At-The-Money, In-The-Money and Out-Of-The-Money.

An option is At-The-Money if the strike price, i.e., the price the option holder must pay to exercise the option, is the same as the current price of the underlying security on which the option is written. In out Apple example above, it would mean that the option strike price and the stock price of Apple are both $160. No movement in the stock has taken place.

A call option is In-The-Money when the strike price is below the current trading price. Still staying with our Apple example above, if Apple is now trading at $170 this would then be above the strike price of $160. Remember, with a Call option you want the underlying stock to go up.

A put option is In-The-Money when the strike price is above the current trading price. This would be the case if Apple’s current trading price is $150 and the strike price is $160. Remember, with a Put option you want the underlying stock to go down.

You can also look at In-The-Money this way: when you’re in-the-money, you’re making money!

Out-Of-The-Money is just the opposite of In-The-Money. When you’re out-of-the-money, you’re losing money because your trade is going in the opposite direction as desired. A call option is out-of-the-money when the strike price is above the current trading price of the underlying security.

A put option is Out-Of-The-Money when the strike price is below the current trading price of the underlying security.

There’s still a lot more to understanding stock options than explained in this article. But looking at it as a tutorial on stock option for the beginner, then these are the basics and very first things to know about stock options. If you want to know more about this topic and/or about the stock market, then simply sign up for my 7-Day Ecourse on “Why Most Private Investors Lose Money In The Stock Market”. It’s free of charge and you will also find a lot about the substantial importance of Money Management! Also, upon signing up, you will receive a weekly newsletter that you can unsubscribe at any time. It’s all free and no strings attached!

Yours in Successful Trading

Ricky Schmidt