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Gregory Mannarino
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I started my financial career working for the securities and trading arm of the now defunct Bear Stearns before thedot-com bubble. I am an active trader of the capital markets. I have published several books pertaining to finance, global economics, and equity trading; My most recent book is... More
My company:
TradersChoice.net
My blog:
MarketReport
My book:
Money Matters.
  • Options Trading 101. By Gregory Mannarino 3 comments
    Aug 25, 2014 6:24 PM

    Options Trading 101.
    By Gregory Mannarino

    For those of you who have asked, I have written this basic outline to help you understand what option trading is.

    What is an option?
    An option is a contract which gives the buyer the right, but not the obligation, to buy or sell a stock/equity at an agreed price within a certain period of time.
    An option is a derivative.
    What this means is the value of the option derives its value from the underlying stock.

    The reason why option trading is so lucrative is leverage. When you buy a single option contract you are actually acquiring the option to purchase, or sell, 100 shares of the underlying equity. This is also why option trading is so risky. However with regard to risk, if you are simply buying call or put options all you can lose is the price of the option, (plus any other associated fees). Unlike using a margin account to gain leverage when you can lose more than your initial investment. For the sake of simplicity I am going to leave out defining what "trading on a margin" is, but as I always urge you to do on my business day MarketReport on YouTube, do your homework!

    The very basics of trading options are calls and puts, let's define these.
    A call option gives the buyer the right, but not the obligation, to buy a security at a specified price within a specific time period.
    A put option gives the owner the right, but not the obligation, to sell a security at a specified price within a specified time.

    Below is an example what of an option chain looks like.

    11.85

    -1.60

    11.35

    11.90

    88

    493

    57.81 %

    0.9802

    320

    9.51

    -0.54

    8.85

    9.40

    43

    279

    46.88 %

    0.9762

    322.5

    6.80

    -0.85

    6.40

    6.85

    118

    519

    35.16 %

    0.9717

    325

    3.80

    -1.80

    3.85

    4.35

    697

    238

    20.31 %

    0.9791

    327.5

    1.33

    -1.82

    1.36

    1.88

    2,010

    1,204

    14.26 %

    0.8681

    330

    0.03

    -1.71

    0.02

    0.06

    5,444

    747

    7.42 %

    0.109

    332.5

    0.01

    -0.68

    0.00

    0.01

    5,473

    1,838

    15.62 %

    0.0144

    335

    0.01

    -0.24

    0.00

    0.01

    3,270

    1,363

    25.00 %

    0.0092

    337.5

    0.01

    -0.09

    0.00

    0.01

    1,241

    3,109

    31.25 %

    0.0037

    340

    0.01

    -0.07

    0.00

    0.01

    182

    1,765

    37.50 %

    0.0019

    342.5

    I want you to look at the column on the extreme right, these are the "strike price."

    The strike price is important because it determines the price of the option. For example, a call or put option that is "in the money" is more valuable than an "out of the money" option because the option is now worth more than just the value of "time."

    Options also have an expiration date, and this is the last day you can exercise your right of the option.

    If you were to buy an out of the money option, you are really just buying time, and this is why an out of the money option costs less than buying in the money. The deeper in the money your option is, the more it costs, the deeper in the money you buy, the less risk as well. However if you were to buy an out of the money option which moves into the money because the value of the underlying equity changes, then the value of the option greatly increases. The opposite is also true. If you were to buy an out of the money option and it moves further away from the strike price, the more magnified your loss will become. Choosing a strike price for your option depends on many factors, one of which is your risk tolerance. The second is where you see the price of the underlying asset going. If you believe that stock XYZ is going to explode to the upside then buying an out of the money call would be the most profitable. Now, if you are not certain as to the magnitude of the move in the underlying equity you would buy in the money or deep in the money to reduce your risk.

    You can also minimize you risk when using options by adopting specific strategies, I will outline two here.

    The first is a straddle. This strategy involves the investor holding both a call and put option with the same strike price and expiration date.
    The second is called a strangle. This strategy also involves holding both a call and put option but with different strike prices, both out of the money on either side of the trade

    You would choose either a straddle or a strangle strategy if you were unsure of the movement in the price of the underlying equity, but you expect a significant move in either direction. You can take advantage of earnings reports in this manner when the underlying stock makes a big move up or down.

    I really hope this short outline of options has been helpful to you in your quest to capitalize on the equity markets.

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Comments (3)
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  • DaiseyMay
    , contributor
    Comments (5) | Send Message
     
    Thanks Gregory!
    This makes it a lot more clear. Not as clear as win, place or show at Saratoga :) but more understandable.
    26 Aug, 05:38 AM Reply Like
  • skeptic_european
    , contributor
    Comments (7) | Send Message
     
    You should mention that writing options should be the prefered way for non speculative investors.
    26 Aug, 04:11 PM Reply Like
  • drudometkin
    , contributor
    Comments (4) | Send Message
     
    Greg, any thoughts on buying vertical debit spreads? Seems like a good alternative to simply buying a call. Especially on higher priced stocks.
    27 Aug, 12:47 AM Reply Like
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