Option Trading Basics
Trading options is a simple concept to learn but a very difficult one to master. However, in order to become proficient at trading options, you first must completely understand the basics. So what exactly is an option? An option is the right to buy or sell (it depends on the type of option) an asset (like a stock) at an agreed upon price for a fixed amount of time. The two basic types of options are a call and a put. A call is an option that gives you the right to buy a stock at an agreed upon price for a specified amount of time while a put gives you the right to sell a stock at an agreed upon price for a specified amount of time.
Let me give you an example: In your opinion, you think that Microsoft is undervalued at $30 per share. In this case you would want to buy a call on Microsoft at a strike price (the agreed upon price) of 30. The longer an option is good for the more the option will cost. Let's say you decide to buy a 3 month call option on Microsoft with a strike price of 30. This option is likely to cost around $150 for every 100 shares. One option gives you the right to buy 100 shares of stock. To summarize, it has cost you $150 for the right to buy 100 shares of Microsoft at $30 per share anytime in the next 3 months.
Now that you own a call option you want the stock to go up. If Microsoft were to go up to $35 in the next 3 months you could still buy it for $30 per share with your option. This would give you a $500 gain [($35-$30) x 100 shares] from the purchase of 100 shares of Microsoft. If you subtract your option cost of $150, your profit would be $350. You may be able to earn a higher profit by closing your position through selling your option, but to fully explain why would require me to go into much more detail that is not suited for a beginning article on option investing. Of course, if Microsoft were to go below $30 for the next 3 months, you would lose the $150 you spent on the option. When you buy an option, you can never lose more than the cost of the option.
On the contrary, if you think Microsoft is overvalued at $30 per share, you would want to purchase a put option. After you purchase a put option you would like the stock to decrease in value. For example, if Microsoft were to decrease to $25 per share you would still be able to sell the stock for $30 if you have a put option with a strike price of 30. If Microsoft were to go up, you would lose whatever you spent to buy the option. Once again, you can never lose more than the cost of your option when buying an option, regardless of whether it is a call option or a put option.
A few things to keep in mind when buying options as an investment. Basic options require something to happen to become profitable. This simply means that if the stock price doesn't change much, the option will erode in value until the option expires and becomes worthless. Also, an option's value will erode more quickly the closer it is to expiring. Finally, options offer the opportunity for a greater investment return, but with this opportunity comes greater risk.