A Basic Introduction to Options Trading By Chuck Clark The Clark Financial Group, LLC ClarkFinancial.com
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Legal Disclaimers The Clark Financial Group, LLC and Chuck Clark are neither Registered Investment Advisers, nor a Registered Broker/Dealer. This guide is intended for informational and educational purposes only. It is not intended to solicit any trading in stocks, or other securities. This guide was written in reliance upon the "publisher's exclusion" from the definition of "investment adviser", as provided under Section 202(a)(11) of the Investment Advisers Act of 1940, and is designed solely to provide readers with a trading methodology and other related information. Your use of this educational material indicates your acceptance of these disclaimers. In addition, you agree to hold harmless the publisher, promoter, and author personally and collectively for any losses of capital, that may result from the use of this material. We strongly recommend that you consult with a licensed financial professional before using any information provided in this material. Any market data or commentary used is for illustrative, educational, and creative expression purposes only. Although it may provide information relating to investment ideas and the buying or selling of securities, options or futures, you should not construe anything in this guide as legal, tax, investment, financial or any other type of advice.
Options Trading Tutorial
The following is a basic tutorial about options trading. If you’re considering trading options, you need to understand the basics before you delve further into trading strategies. We hope to give you some of the basics you need to move on to more learning. Consider this “Options 101”, if you will. We’ve added a glossary of terms to the back to help you grasp some of the terminology.
The Basics What is an option? In simplest terms, an option is the right, but not an obligation, to buy or sell an underlying asset at a stated price, by a stated date. The underlying security is most often a stock, but can be a bond, an index, an ETF, a futures contract, etc. There are two basic typed of options, calls and puts.
Call Options When you purchase a call option contract you have the right to buy the asset at the strike price (a predetermined price) before or at the expiration date. You are not obligated to buy the asset. You can sell the option for a profit or a loss before expiration, or you can let the option contract expire. You want to buy a call option if you think the underlying security is going to rise in value between the time you buy the option, and the expiration date.
Options Trading Tutorial
Put Options When you buy a put option contract you have right to sell the asset at a predetermined price by the expiration date. This is similar to 'shorting' a stock in that you are expecting the price of a share of stock to go down in the value in the near term.
The Mechanics Contracts and Strike Prices Each options contract gives you the right, but not the obligation, to buy (call) or sell (put) 100 shares of the underlying stock at a certain price. That certain price is called the “strike price”. The strike price is sometimes referred to as the exercise price.
In, Out, and At the Money If you own a call option and the current price of the underlying stock is above the strike price, this is known as being “in-the-money”. If it is trading exactly at the strike price, this is known as being “at-themoney”. If it is trading below the strike price, this is known as being “out-of-the-money”. For example, if you own 1 call contract of xyz with a strike price of $100 and the stock is currently trading in the market at $102.25, your contract is in the money by $2.25. This works the opposite way for puts. To be in the money with a put, you need the stock to be trading below the strike price. Again, when you buy puts, you want the stock to drop in value. Options Trading Tutorial
The amount of money that a contract is in the money is called its “intrinsic value”. In other words in the example above, your option contract would have an intrinsic value of $2.25. Once you get into options trading strategies, you’ll see that options prices behave very differently depending upon whether they are out of, at, or in the money.
Expiration In addition to a strike price, each option contract will also have an expiration date. Most stock options expire on the 3rd Friday of each month, and will be quoted by their month of expiration. So, a June call contract will expire on the 3rd Friday of June. The expiration date is very important because option contracts suffer from time decay. The number of days left until expiration is a big part of an option contract’s extrinsic value. Each day that goes by, if all else stays the same, the contract will lose value. (See chart below.)
For a more detailed explanation of how time decay affects options, click on this link: Options Time Decay Options Trading Tutorial
How Options are Quoted Options are quoted using the symbol of the underlying security, the expiration month, the strike price, and the type of contract. So, in our example above, you would be buying an XYZ June 100 Call.
Options Pricing Using our on-going example, if you bought this call contract you would pay the intrinsic value of $2.25 plus some extrinsic value, which would include days left until expiration, implied volatility, dividends, and current interest rates. Let’s say the option contract is priced at $5.00 per contract. Since each contract represents 100 shares, the cost of buying 1 call contract would be $500 plus commission. If you wanted to buy 10 contracts, it would cost $5,000, etc.
Implied Volatility Implied volatility is a critical aspect to options pricing. Understanding how implied volatility affects options prices, and knowing whether the implied volatility is currently low or high will be critical to your success as an options trader. Implied volatility represents the expected volatility of a security over the life of an option. As expectations change, option prices will also change accordingly. Implied volatility is affected by the supply and demand of the particular contracts, and by the market's expectation of potential price movement. As expectations rise, or as the demand for an option rises, implied volatility will also rise.
Options Trading Tutorial
Knowing the current implied volatility of an option, and its likelihood to either rise or fall, will greatly increase your odds of successful options trading. Much like stocks, the idea for implied volatility is to buy low and sell high. If you are going to take a net long position in an option, such as buying puts or call, you want to buy when implied volatility is likely to increase. If the implied volatility is unusually high, and likely to decline, you'll want to be a net seller of the contracts. It's also important to note that implied volatility isn't the same for all contracts on a given security. Each strike price and expiration will have its own implied volatility.
Making Money The way most individual traders profit with options is to buy a call or a put in anticipation of the stock moving the correct direction in the near term. Rarely do individual traders exercise their contracts. While we’re not going to cover trading strategies in this basic introduction, you can find a much more extensive tutorial here that will cover this. The biggest point we want to make today is that you do not have to exercise your contracts.
Risks With the most basic strategy of buying puts or calls, your risk exposure is the dollar amount, or premium, that you paid for your contracts. Your worse case scenario is that you have an option be out of the money at expiration, and therefore, expire worthless.
Options Trading Tutorial
Because of this risk, position sizing is very important. Never risk money that you can afford to lose, and never put to large of a percentage of your options trading account into any one trade… regardless of how confident you are it will be profitable. Another important tip is do not hold on to long. Take profits before they evaporate, and if you’re on the losing side of a trade, don’t continue to hang on in hopes of a turn-around. With options trading, you don’t have time. Take your loss and move on. If you close out a trade and leave money on the table, don’t worry about it. Staying too long can burn you.
The Next Step We’ve found an options trading tutorial that will take you from a complete novice to an expert options trader in a very short period of time. The tutorial includes hands-on help from an experienced options trading professional, and it’s available at a very reasonable price. To learn more about this tutorial, click the following link: Options Trading Tutorial
Options Trading Tutorial
Glossary of Terms At the money (ATM) - An option whose strike price is identical (or very close) to the current underlying stock (or futures) price. Call option - An option that gives the owner the right, but not the obligation, to buy a stock (or futures contract) at a fixed price. Exercise - To exchange an option for the underlying instrument. Expiration - The last day on which an option can be exercised and exchanged for the underlying instrument (usually the last trading day or one day after). Extrinsic value - The difference between an option's intrinsic value and it's current price (premium). For example, with the underlying instrument trading at 50, a 45- strike call option with a premium of 8.50 has 3.50 of extrinsic value. Implied Volatility - Implied volatility represents the expected volatility of a security over the life of an option. In the money (ITM) - A call option with a strike price below the price of the underlying instrument, or a put option with a strike price above the underlying instrument’s price. Intrinsic value - The difference between the strike price of an in-the money option and the underlying asset price. A call option with a strike price of 22 has 2 points of intrinsic value if the underlying market is trading at 24. Options Trading Tutorial
Out of the money (OTM) - A call option with a strike price above the price of the underlying instrument, or a put option with a strike price below the underlying instrument’s price. Premium - The price of an option. Put option: An option that gives the owner the right, but not the obligation, to sell a stock (or futures contract) at a fixed price. Put option - An option that gives the owner the right, but not the obligation, to sell a stock (or futures contract) at a fixed price. Strike (“exercise”) price - The price at which an underlying instrument is exchanged upon exercise of an option. Time decay - The tendency of time value to decrease at an accelerated rate as an option approaches expiration.
To learn more trading strategies, visit: Online Trading
Options Trading Tutorial