Options 101: The Bare Bones Basics

Options trading has become incredibly popular.

In fact, according to FIA.org:

The total volume of trading reached 62.58 billion contracts in 2021, up 33.7% from the previous year. Futures trading rose 14.6% to 29.28 billion contracts. Options trading jumped 56.6% to 33.31 billion contracts. This is the fourth year in a row that global exchange-traded derivatives markets set a record above the prior year in terms of total trading activity.”

2022 could set even bigger records.

All as traders wake up to the massive opportunity that options offer.

Still, some people are scared off by them, believing they’re far too complicated.

But as we’ll prove there’s nothing complicated about options.

Options 101: What is an Option?

Options are one of the greatest investment instruments ever created.

It’s a contract – a call and a put – that gives you the right– but never the obligation – to buy [calls] or sell [puts] a stock at a set price over a set time frame. A call option gives us the right to buy an asset. A put option gives us the right to sell an asset.

The beauty of an option is that they cost much less than a stock. They also provide a highly leveraged approach to trading that can reduce not only the amount of money you have to pay out, but your overall risk per trade.

Here’s an example.

Let’s say you want to buy 100 shares of Apple (AAPL) as we head into back to school season.

Right now, Apple trades at $165 a share. To pick up 100 shares, I need to invest $16,500. However, I can pick up the same 100 shares for far less using an option.

In fact, I can pick up an Apple September 16, 2022 165 call option for just $620.

Big difference, right?

Now, if the stock moves to $170, I make a whopping $500 profit on the stock on a $16,500 investment. But if I buy that call option, and the stock runs up $5, my call option could potentially double in size. I could make a 100% gain from the option, as compared to a tiny fractional return from the stock.

That’s all referred to as leverage.

While it may sound confusing, it’s not. With patience, and practice, it’s easy to understand.

Options 101: Types of Options Contracts

As noted, there are two types of contracts – a put and a call.

Call options are also known as derivatives that give a buyer the right – but never the obligation – to buy a stock at a set price over a set period of time. You would buy a call if you are bullish.

Put options give you the right – but never the obligation – to sell a stock at a set price over a set period of time. You would buy a put if you are bearish. It’s similar to shorting a stock because we are betting on a fall in stock value.

It’s actually safer to buy a put than it is to short a stock because max potential loss is what you paid for the put.

Each of these contracts controls 100 shares of stock.

So, if you hear someone mention one contract, they are talking about 100 shares.

Every option has an expiration date, too. This is the third Friday of the month. The option will expire that Friday. So, if you bought a September 2022 call option, it would expire the third Friday of September 2022. With options, the goal is to get out way before expiration.

Also, when we refer to options, you’ll hear us mention strike prices.

The strike price is your target price or the price at which you believe the underlying stock will trade above or to over time. With ABC, let’s assume we bought a $50 call option. The $50 is referred to as a strike price.

For example, if we examine this options chain, we can see a list of strike prices that run down the center from 80.50 to 83.50.

Options 101: What’s an options chain?

This is an example of an options chain.

It lets you know the type of option, expiration dates, strike prices, and the stock.

It also lets you know the bid and the ask prices.

This is an options chain for AAPL with seven strike prices that expire the third Friday of September 2022. After this week in September, these will expire with no value.

They would be worthless.

Options 101: What costs are associated with these options?

When it comes to options, the price quoted is per share in the contract, not per contract.

Since each contract carries 100 shares, you must multiply the ask price by 100. So, if a contract has an ask price of $5.00, you would pay $500 for one contract.

What you pay for an option contract is known as a premium. It is the total cost of the option.

What makes up an options premium?

An options premium includes intrinsic value, or the difference between stock price and strike price. For example, if Apple was trading at $100 and you bought a 95-strike price, intrinsic value is $5. If you bought a $110 strike price, there is zero intrinsic value.

Once you find intrinsic value, subtract it from the ask price. The remainder of value is what you pay for time value, determined by length of time you choose (one day to three years), and volatility. The longer the time frame, the more time value you pay.

When you open a trade, we use a buy to open. When you close a position, we use a sell to close, or we can let it expire worthless. We can exercise it, too… and take ownership of 100 shares per contract bought.

You must also understand in the money (ITM) and out of the money (OTM).

  • In the money calls (blue shaded) tell us the strike price is below the stock price.
  • In the money puts (blue shaded) tell us the strike price is above the stock price.
  • Out of the money calls tell us the strike price is above the stock price.
  • Out of the money puts tell us the strike price is below the stock price.

Options 101: Other Key Terms to Understand

That’s the beauty of options. They cost a fraction of what you would pay for a stock.

Each contract price is primarily based on the price of the stock, the time left on the contract [referred to as time value premium] and volatility of the stock.

Time is another factor of price.

Options are decaying assets. They eventually expire. Time erodes the value of all options. The closer we get to an expiration date, the higher the rate of time decay. If we buy a September 2022 option in August 2022, the rate of decay is bigger, than if we bought an option six months from expiration.

Stock volatility is also important to understand.

Historical and implied volatility are examples. Stable stocks over time are likely to have less volatile nature and will oftentimes be priced lower than a stock where value is all over the map. Implied volatility is based on the amount of volatility the market implies a stock may experience going forward. It can be reflected in higher premiums.

How to Find a Broker

We’ve all been there.

Unsure, confused, and lost when it comes to choosing the right broker, many folks simply choose the broker with the hottest offer at the time. But that’s the wrong way to think.

Unless you have a good friend or trusted broker, a lot of us just want to do it on our own.

When it comes to choosing the right broker for your needs, there are quite a few things you must identify, including:

  • Commissions and fee schedules
  • Speed of order executions
  • Ease of use
  • Site security
  • Reputation
  • Customer support issues

When it comes to commissions and fees, you are charged something on each and every transaction. Sometimes there are other fees for deposits and withdrawals, or extra fees for special orders. Be aware of all commission structures and applicable fees so you’re not being taken to the bank.

Speed of order execution is important, as well.

If your transaction isn’t placed quickly enough, it can negatively impact your trade. If not placed fast enough, it could very well impact if your trade is placed at all. The best brokers out there will place your trade as quickly as possible, ensuring best trade possible.

Always make sure your broker’s site is fast and responsive. If it has a historical tendency to move slowly, you may want to move on. The last thing you want to experience is a slow site that can lead to missing profit opportunities, or misplaced orders.

Make sure there’s ease of use.

Trading and investing are hard enough for some people. The last thing they need to see is an unorganized mess that’s hard to navigate or understand.

Are security measures up to par?

Ask around, do your due diligence… Does your preferred online broker have a trustworthy site that can’t be hacked? Identify and ask questions to see what security measures are in place.

The last thing any of us need to do is lose money, especially to a hacked site.
Make sure the site has a good reputation.

Some of the best online brokers – as mentioned above – have great track records for high quality servicing to customers. Stick to what’s well known and used often, and you can sleep better at night. We mentioned those sites above to help make your decision-making process a bit easier, too. They have some of the highest qualities.

Consider the knowledge and level of customer support.

We’ve all been through poor customer support issues before. And – as always – it’s inexcusable. If you get a guy on the line that has no idea what a limit order is for example, move on. If you get a guy on the line that’s rude or places you on hold without a care in the world, move on. It’s your money at stake.

If you have a technical issue on your end, you want to make sure it can be fixed with someone knowledgeable, as well.

We must also be aware of market orders, too.

With a market order, a trader will have a buy or sell order filled at best available current prices. These types of trades fill rather quickly and immediately. The price at which a market order is executed is not guaranteed.

The limit order tells your broker to buy or sell at a set price. The sell or buy will not occur unless that price is hit. These orders allow you to fix your price. These orders can carry higher costs and commissions.

Other things you may commonly see, include:

  • A stop loss order is a price trigger that protects you in case of falling stock value. It’s an insurance policy that’ll protect you if the stock falls. Some traders use a -25% stop loss for example. If the stock falls 25% from your buy-in price, the stop is triggered and the trade is over.
  • A Good ‘til Canceled (GTC) order – or in this case a Good for 60 Days order — is an order to buy or sell that lasts until the order is completed or canceled, according to the U.S. Securities and Exchange Commission (SEC). Typically, firms cancel these orders after a specified time of 30 to 90 days, for example.
  • A Good for the Day order will expire if it is not executed on the day the order was placed. It is only good for the day. If it does not fill, the order is canceled.
  • A Fill or Kill is an Order that must be immediately filled at limit order or better, otherwise the order is canceled. Day traders looking to scalp a trade, for example within a short time frame, use these…
  • Immediate or cancel orders must be filled immediately at limit price or better. If it can’t be, it’s canceled.

If you’re capitalizing on stocks in the market already, that’s fine.

By adding an option, you can actually maximize your profit potential 5-10x over. You don’t even need to spend as much money on an option that you would on a stock.

And you never have to take ownership of stock to realize gains.

Unfortunately, a lot of traders and investors believe options are too risky, too hard to learn, are too complex, too expensive, and that options are only for the ultra-wealthy with money to throw around.

It’s an old excuse because none of that is true.

Adding options is what gives you the leg up, the leverage you need to make even more money. You can increase your income levels. You can buy stocks at discounted prices. You can even profit from changes in stock without ever having to take ownership of a stock.

Skepticism exists, sure, but it makes no sense.

Options are not just for professionals with years of experience, and gobs of money. Any one can trade options with less than $1,000 if they wanted to…

Traders believe 80% to 90% of all options expire worthless. But it’s not true. Only 30% of them do. That 85% is from a famously flawed study, which never accounted for exiting options prior to actual expiration.

You can trade security upside, even downside without having to leap through hurdles shorting a stock outright. While options do carry considerable risk, there is substantial upside potential. And a trader is well aware of how much is at stake for loss.

Options do carry risk, as does any trading vehicle. But that’s why education is imperative. But with the right skill set you can reduce that risk… and do incredibly well.

It gets easier with practice.