Q: What is an option
A: Before you read any further, make a cup of coffee. For the uninitiated, options can get complicated.
An option is a contract that gives its owner the right (but not the obligation) to purchase or sell an underlying asset at a specific price, on or before a certain date.
Here's a trick to understanding an option: It's just another security, just like a stock or bond. An option has a price and trades on an exchange, just like a stock or bond.
That said, an option is a contract tied to an underlying asset (like a stock or stock market index). Hence, they're categorized as derivatives, because options derive their value from something else.
Puts and Calls
Options come in two flavors: puts and calls. A put gives the owner the right to sell the underlying asset, and a call gives the owner the right to buy the underlying asset.
If you think the price of a certain asset will increase substantially before the option expires, you'd purchase a call option. If you think a stock will dramatically drop in value, you'd purchase a put. You can also sell, or write, puts and calls. Accordingly, there are four types of players in options markets: buyers of calls; seller of calls; buyers of puts; sellers of puts.
The strike price (sometimes called the "exercise price") is specified as part of the option contract. The strike price is the price at which an underlying asset can be purchased or sold. For calls, this is the price an asset must rise above to make money; for puts, it's the price it must fall below. These events must occur prior to the expiration date.
Options take advantage of leverage because they allow you to control a large number of shares with relatively little money—a great example of Archimedes’ lever.
Stock Options Example
Assume you buy one call option. Each option controls 100 shares of a stock. The option has a strike price of $9 per share. If the current market price of the stock is $10, the total market value of 100 shares of the stock is $1,000 ($10 x 100 = $1,000). But with your option, you have the right to buy the stock for $900 ($9 x 100 = $900). The value of your option is $100.
If the market price of the stock rises to $11 per share, the market value of 100 shares the stock rises to $1,100. Because your exercise price remains the same ($900), the value of your option is now $200, a 100% jump produced by only a 10% increase in the price of the underlying stock.
The overriding point is this: There's significant leverage in owning options. A small or modest bet can pay off with a huge win—if you're right. If you're not right, your option can lose as much as 100% of your investment.
Aside from their complexity, there's another caveat about options: time is not your friend. If your option expires in three months, you not only need to be right about your hunch, but you need to be right very soon. Within such a short window, conditions can change considerably, putting you at the mercy of the market's vicissitudes.
Q: How do I get started? I don’t know anything about options trading.
A: Start by reading about calls, then move on to puts. Once you understand the fundamentals, you'll find that options are not that complicated. When you’re ready to start, trade one contract and track how the option moves. When you’re more comfortable, execute two contracts.
Q: Can you recommend options brokers?
A: For a broker, you should look around for the best commissions. There are many online brokers, so competition has forced commissions down significantly in the last few years. Analyst Jacob Mintz uses Interactive Brokers. He finds that its commission structure is extremely competitive, and the system is relatively easy to use. As a reference point, he pays around $1 a contract. That said, we have no additional relationship with them, nor is this an endorsement. Whatever broker you choose, make sure you are paying a competitive rate on commissions!
Q: How much capital should I start with?
A: The beautiful thing about options is it doesn't take much capital to gain large market leverage. You certainly don't need more than $1,000 to put on many suggested trades, though many readers trade much higher amounts.
Q: Should we add to our positions when the trade is going against us?
A: No, we don't recommend adding to trades when they're going against you. We've learned not to double down when a trade is going against me. Sometimes it works, and you can get to break even when the double down works; but when it doesn't work, you’re stuck with twice the loser. It’s perhaps the toughest lesson for traders/investors: letting winners run and cutting losers off.
Q: What is the transaction process for executing an option?
A: When we issue a recommendation to buy an option, we are "buying to open" and because we are the one initiating the transaction, we work with the ask price. When we close a recommendation we are "selling to close" and as the initiator of the transaction we are working with the bid price. If you choose, you can try and buy in between the bid and ask. But when the ask price is quoted at 1.84 like on the ArcelorMittal July 33 strike put recommendation we issued the other day, that ask price means there is at least one option for sale at that price.
The same principles apply when we close a recommendation. Take for instance when we closed the July 109 call recommendation on the Spyders the other day. Because we were selling and we were initiating the transaction, we know that at least one option was guaranteed to be sold at the bid price of 2.65 at that time.
One thing to always keep in mind is that when you see an ask price of 1.84, it is actually $184 because the option represents 100 shares.