A Primer For The Stock Market Trader Interested In Trading Options

Because of their reputation of being a high-risk speculation, trading options may not appeal to many who are new to trading in the stock market. However, the person who understands the stock market and is able to make profitable decisions in trading stocks should be a good candidate to speculate by trading options on the stocks they normally buy or sell.

By using simple call and put strategies, the aspects of risk that accompany options trading can be minimized. As one becomes more proficient in trading options only then should the trader venture into the more complex strategies commonly used by professional traders for both speculation and for hedging risk.

Stock option definition

A stock option is a derivative, meaning that it derives its existence from the stock to which it is associated. An option is a contract that gives buyer of the option the right to purchase 100 shares of a specified company’s stock at a specified price for a specified period of time.

We are not likely to encounter option styles other than those known as the “American Style” but there are several other forms of options with varying conditions attached depending on the geographic region to which they have an association, the two main forms are known as American style and European style. The American style options can be exercised at any time during the valid life of the option in contrast to the European style of option that can only be exercised on the expiry date.

Underlying stock, strike price, and expiration

The specified stock is usually referred to as the underlying stock, the specified price is referred to as the strike price, the settlement price, or the exercise price. The length of time during which the option rights can be exercise ends upon a specified expiration date, an expiry date beyond which the option ceases to exist.

Stock options are traded on options exchanges that set the calendar months in which options expire so there is a range of possible option dates for a particular stock. The effective day of expiration is always on the third Friday of the chosen expiration month.

The option does not have to be exercised but can be sold at any time during its term, which is the way that most option speculation occurs, as a vehicle for speculation, most stock options expire worthless.

Leverage, the major advantage (and disadvantage)

The major benefit to be found in trading options is the leverage they provide. Stock options cost a fraction of the underlying stock but as the stock price changes, the option moves in price to almost the same degree as the stock, whether gaining or losing in price. In a winning stock option trade the gains will be far greater in percentage terms than those of the underlying stock.

When a losing option trade occurs, the maximum amount that can be lost, in most forms of option trading, is limited to the total amount paid for the option. This enables the option trader to set the maximum loss that can be tolerated, even though the anticipation for entering the option position is based on an assumed high probability of gain.

The loss is limited, but the gain that an option trade can achieve is limited only by the amount of price change that can occur until the option is sold prior to expiration.

Calls and Puts

Options can be used to benefit from stocks that rise in price or fall in price, not unlike the way of stocks bought long or sold short. The options traded to take advantage of a rising price in the underlying stock are called Calls, those that take advantage of a falling stock price are called Puts.

Simple option trade strategy

When a stock has been identified as likely to move in price, for whatever reason, up or down, a simple way to speculate with options with lower risk is to buy only calls or puts that are in the money and with an expiration date far away.

In the money refers to the strike price being set at a lower price than the prevailing price of the underlying stock in the case of call options.

In the money in reference to put options means the strike price is higher than the prevailing market price of the underlying stock.

There is a lot more to be said and learned about trading options and the many more complex strategies used by experienced and professional traders. But in the early days of options trading it would be wise to use the simpler Call and Put strategy referred to above. For more introductory material on the subject check out these links: Four Rules for Option Trading and How to Trade Stocks.