Trade The Journey

Trade The Journey

My Options!

We all have options! We have options in our personal and financial lives. It took me a while to understand the power of having a choice in what you accept into your life.

I can’t say that finance ultimately helped me to understand this concept about options and choices but it definitely helped. Equally hard to understand is the option you have in your financial life as well. What are options and how do they work?

Options are a way of using leverage to minimize your financial position in the trade. The central idea of an option is that instead of buying the stock outright, you’d buy an option which is a contract to either buy or sell the stock. Notice I used the word “contract”. You can buy a contract (option) to buy or sell 100 shares depending on your outlook for the market and particular stock you are interested. In order to buy the contract, you must pay a premium made up of intrinsic value and extrinsic value.

This is where it gets confusing if it isn’t already!

Purchase a premium? Contract? Calls? Puts? These were my thoughts when learning about options.

Unfortunately, there is a steep learning curve involved when learning about options. Here are some thoughts to get you started:

Don’t be discouraged if you don’t understand options at first. It takes time to understand how options work. I still consider myself an experienced novice.

You can either buy or sell options regardless if their “calls” or “puts”. I like to think of buying calls and selling calls as two different concepts, the same with puts.

Calls

When you pay a premium to purchase a call. You are paying for a contract to purchase 100 shares of a stock at a predetermined price called a “strike”. You are not obligated to close the contract and purchase the option but the contract will close at a predetermined date. You lose the premium either by exercising the option or by the option closing at the predermined date.

Why Buy a call?: You think the stock will rise and you’d like to purchase the stock at a cheaper price to sell for a profit later.

When you sell a call, you receive the premium. Somewhat has brought the contract you have written to sell 100 shares at a predetermined date and price. You as the seller are obligated to sell the 100 shares if the buyer decides to exercise the option. If they choose not to exercise the option, you keep the premium. You can also buy back the option and close it yourself.

Why write a call?: You think the stock will fall or rise a little but not enough for the buyer to exercise and you would like an income in the form of a premium.

PUTS

Puts have the same type of concept in regards to leverage, strikes, premiums and so forth. However, they are different in that the buyer of a put contract offers to sale 100 shares and the seller of a put contract will buy the 100 shares.

The buyer of the put option hopes that stock falls so that they will be able to sell the 100 shares of the option. The buyer of the put option still pays the premium and the seller of the put still receives the premium. The seller of the put option is obligated to buy the option which is still 100 shares.

Why buy a put?: You are hoping to profit from the option by the underlying stock falling below the strike. You think the market and the stock, in particular, will fall. Think to short a stock (Selling stocks you don’t own at a higher price and then hoping to make money by selling the stocks back to the owner at a cheaper price).

Why sell a put?: You believe that the stock will rise above the strike price and you will get to keep the premium. If you would like to purchase the stock, you can now buy the stock for a lower price by closing the option (Contract). You can use the premium received in the purchase of the stock.

Options are derivatives used for different reasons and for different assets, I used stocks for the example. Some use options to hedge their long-term bets, profit from short-term fluctuations, protect themselves, and to speculate. The interesting part about understanding options is that understanding what a “call” and a “put” is just the beginning but an important beginning.

There are also complex strategies that involve selling and buying puts at the same. You are able to do the same with calls. There are also greek values available to help you better understand the options price and potential price movement.

It took me half of last year and the beginning of this year to grasp exactly what an option is. Tastytrade is a great website to assist you in further understanding options. Mike and his whiteboard helped me to see in a visual way how options work. Although the show no longer runs, you can learn quite a bit from the archive.

Thoughts?

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