So, you are here perhaps because you have heard stories about people making lots of money through this thing called options and you are wondering what exactly options trading is.
Perhaps you have heard horror stories about how people lose all their money in options trading and wish to find out what exactly this scary thing called options is.
It is recommended that all options trading dummies read this tutorial from the top as I attempt to simplify the concept of options trading using a continuous story. However, for those of you who is re-reading this, feel free to skip to the relevant chapters below:
If its not 2017, I won't need to start this tutorial by making a very important distinction about what options trading isn't. Options trading isn't BINARY OPTIONS TRADING.
This is an extremely important distinction to understand right off the bat due to how widely marketed this thing called "Binary Options Trading" is in 2017. In fact, Binary options trading has gained such popularity online that I am not even surprised that most options trading dummies might be here only because they have heard about "Binary Options Trading" rather than options trading per se. In fact, in 2017, if you searched for options trading online, you are most likely going to get search results related to "Binary Options Trading" on the first page of your search results rather than real options trading. This alone has confused most options trading dummies about what options is and many of them actually end up getting involved in the wrong "option".
So, it is important right off the bat for options trading dummies to understand in 2017 that real Options Trading isn't Binary Options Trading.
Options trading is the trading of a real financial contract which gives you actual rights to buy or sell a real equity asset (stock or currency etc) within a real government regulated public market where real people buy and sell to each other, while having real protection of one's wealth in case the broker they are trading through closes down.
The so-called "Binary Options" that they created, borrowing the name and features of real binary options (Learn about what real binary options are), are merely a way of quickly betting on one of two possible outcomes, frequently under extreme short and unrealistic time spans, sometimes as short as the time it takes to roll a dice. If you do win, you win 80% to 95% of the total amount you betted with and if you lose the bet, you lose 100% of the bet money... doesn't this sound familiar? Yes, these are nothing more than private online casinos dressed up to look like financial institutions through the use of financial terms and jargons on their website and their materials with no real protection of your wealth. If you open an account with one of them and they close down, you can never get your money back because they are not government regulated.
So, now that we are clear that Options Trading is not "Binary Options Trading" and you know the risks of "Binary Options Trading", lets now look at what exactly real options trading is from the perspective of an options trading dummy.
In a stroke of genius, you reach into your pocket to find that you actually have some money, not much, about 1% of the cost of this item. You decide to negotiate with the shop owner in order to "book" the right to buy the item at the current price next week by paying a 1% deposit now. The shop owner is concerned with whether or not you would actually buy the item next week and counter proposed that if you do not return to buy the item next week, your 1% deposit will be forfeited as the shop owner misses opportunities to sell the item before you return again.
You agreed and both you and the shop owner entered into a written contract that specifies that for a deposit of 1% of the item, you gain the right to buy the item at any time within the next 7 days. At the end of the 7 days, this contract expires and you lose both your right to buy the item as well as the deposit you paid. This contract is an "Option Contract", giving you the right (or literally the "option") to buy something at a fixed price before expiration of the option contract.
Process When You Exercise An Option in Real Options Trading
You happen to get your pay check or pocket money 3 days later and you promptly returns to the shop owner in order to exercise your right to buy the item at the price agreed last week. The contract is fulfilled, the shopowner keeps the deposit you paid for the opportunities he missed holding the watch for you for 3 days and you bought the watch for the price agreed last week. The contract ceases to exist.
In the example above, you entered into an options contract, sold to you by the shop owner, for the purchase of the watch at a fixed price by a fixed date in exchange for a deposit which reduces in value as time goes by. This is exactly the same as the stock options that are traded in the stock market. In the stock and options market, instead of a watch, the item that you are purchasing is a company stock / share, for example, shares in Apple or Google etc. So, in real options trading, the options contract allows you to purchase (known as to "exercise" in fanciful options jargon) the stock at a fixed price (known as the "strike price" in fanciful options jargon) by a fixed date (known as the "expiration date" in fanciful options jargon) in exchange for a deposit (known as "options premium" in fanciful option jargon) which reduces in value as time goes by (known as "time decay" in fanciful options jargon). This kind of options contract is called a "Call Option" and is commonly the first kind of option that options trading dummies learn about.
In the example above, the shop owner who sold you the Call Option to buy the watch is known as the "Writer" or "Seller" of the options contract. The Seller or Writer of the options contract is known as to have "Shorted" the options contract. You then is the "Buyer" or "Holder" of the options contract and is known to have "Longed" the options contract. A lot of options trading dummies get the concept of "Long" and "Short" wrong thinking that when you buy an option with a very long expiration date, you are Long the option while when buying an option with a short expiration means you are Short the option. This is not only wrong but very dangerous as you could potentially make the wrong options trade by getting this term wrong. Imagine you are being asked to "Short" an options contract and you do the exact opposite of buying the options contract only on a shorter expiration. The result could be catastrophic and how some options beginners and options trading dummies lose all their money. Learn more about Options Writing.
Sellers of call options feel that the stock will go down
while buyers of call options feel that the stock will go up
The seller or writer of a call options contract is obligated to make sure that the delivery of the underlying asset is available to be sold to the buyer as and when the buyer wishes before the expiration date. In this case, the shop owner needs to make sure the watch is available for you to buy if and when you return to buy it within the 7 days expiration period of that particular options contract. If the shop owner should somehow not have that watch when you return, be it being stolen or sold by accident, the shop owner needs to buy one from somewhere to sell to you. For the options premium that you paid, the shop owner is obliged to make sure you are able to buy when you "exercise the option" to do so.
The buyer or holder of an options contract is the side that has the "Rights" to exercise the option but not the "Obligation" to do so. Almost having no responsibility at all since you paid money to get into this options contract agreement and is more or less like the "customer". This means that as the holder of the options contract, you could even decide to do nothing with the contract and just let it expire, allowing the seller of the options contract to pocket the options premium that you paid. Yes, if you decide not to buy the watch afterall, you could simply not exercise your option to buy the watch and allow the shop owner to pocket that 1% that you paid to get into this options contract agreement. In real options trading, there are situations in which the options holder is obliged to exercise the option but that is not what you need to know as an options trading dummy. For now, it suffice to understand the concept of what options and options trading is.
You happily wear the watch back home thinking this is the latest 2017 model and is going to be valuable for quite a while until you get home, turn on the TV and the newscaster say that the watch manufacturer may be coming up with a new model soon and therefore this model you just bought may be worth very little soon! No confirmation was released for when the new model is arriving and you are afraid that the value of your watch may be affected. What can you do as an options trading dummy?
In another stroke of genius, you remember that neighbour who is also interested in buying this watch (remember the initial example?)! You approach that neighbour and ask if he or she would still like to purchase the watch. Luckily, that neighbour really liked the watch but someone else also approached him/she wanting to sell that same watch. However, you may not really want to sell the watch if the watch manufacturer eventually decides not to release that new model and you reckon that you should know within the month if the new model is really coming or not. As such, you really wanted the first right to sell your watch to this neighbour within the month (he or she obviously doesn't check the news) if the new model arrives and the price of this model starts to drop drastically. However, if the news doesn't come, you also want the right to continue to own this watch. As such, giving the neighbour the right to buy your watch would not work for you because he or she could exercise the right to buy your watch as and when he or she wants within the expiration period.
Now, you could simply wait for the news and come back to your neighbour to sell him or her the watch only when the news hit the wire but there is one problem... other people are also trying to sell your neighbour the same watch! So, by the time you come back to him or her, your neighbour may already have bought the watch from someone else. Also, if you sell the neighbour the right to buy the watch from you how you did with the shop owner earlier on, the neighbour might buy the watch from you even if you don't wish to sell the watch eventually. You came up with a new idea... instead of selling the neighbour the right to buy your watch, you decide to PAY the neighbour instead to buy the first right to sell the watch to the neighbour anytime within the month instead. So, under this new contract, you will be able to come back anytime within the month to sell the watch to this neighbour at the current agreed price if you want and just keep the watch and not sell it if you wish. However, why would the neighbour give you such a right to sell him or her something whenever you like? You decide to pay him a small fraction of the price of the watch as a contract fee which he or she could keep if you should eventually not sell him or her the watch. Seeing that there is money to get just by giving you a promise to buy something the neighbour intended to buy anyways, he or she agreed.
2 weeks later, confimation of the release of the new model arrives and the price of the watch you own currently starts to drop drastically as you have feared. You quickly exercise your rights in the options contract with the neighbour and the neighbour, disgruntledly, buys your watch at the price agreed in the options contract even though it's worth much lesser now. The neighbour comforts himself or herself on the fact that he or she would have bought the watch at that price anyways if it was initially available.
In the example above, you bought what is known as a "Put Option" contract which is sold to you by your neighbour, for the sale of the watch to your neighbour at the agreed price (strike price in fanciful options trading term) within the contract period if you choose to in return for a small fee (options premium in fanciful options trading term). This is the exact same thing in the options market as well except that you would be buying to rights to SELL your stocks at a fixed price within the contract period. While call options are easier to understand, most options trading dummies struggle with the concept of a Put Option. It takes some time for most options trading dummies to digest the concept of buying the right to sell someone something.
Sellers of put options feel that the stock will go up
while buyers of put options feel that the stock will go down
The seller or writer of a put options contract is obligated to make sure that cash is available to buy the underlying asset at the strike price from the buyer of the option as and when the buyer of the option wishes to within the contract period. In this case, the neighbour, as the writer of the put option sold to you, needs to make sure he or she has the money to buy the watch from you at the agreed price within the contract period of that particular put options contract. For the options premium that you paid, the neighbour is obliged to make sure you are able to sell when you "exercise the option" to do so. Basically the writer of a put option must stand ready to BUY at all times
within the put options contract period.
Learn More About Selling Put Options with infographic and video.
The buyer or holder of a put options contract, like in a call option, is the side that has the "Rights" to exercise the option but not the "Obligation" to do so. Almost having no responsibility at all since you paid money to get into this put options contract agreement and is more or less like the "customer". This means that as the holder of the options contract, you could even decide to do nothing with the contract and just let it expire, allowing the seller of the options contract to pocket the options premium that you paid. Yes, if you decide not to sell the watch afterall, you could simply not exercise your option to sell the watch and allow the neighbour to pocket that options premium that you paid to get into this options contract agreement. You are not obligated, meaning its not a MUST, to sell the watch but you have the rights to.
Referring to the example above, you would buy a call option when you intend to purchase an asset at a fixed price, right? How does that translate into actual options trading?
This means that you would buy a call option when you wish to purchase a stock at a fixed price some time in the future. For example, GOOG is trading at $800 now and you wish to secure the rights to buy GOOG at $800 some time in the future. However, why would you want to do that? Why would you buy the right to buy the stock at today's price in the future?
Of course when you expect the price of the stock to go UP, right?
If you expect the price of the stock to go up in the future, you would secure the rights to buy at today's price so that when the stock rises to the higher price, you could exercise your right to buy at the lower price and then immediately sell at the higher price for a profit.
However, if the stock price is expected to rise, why don't you simply buy the stock and wait? Well, there are 2 good reasons why some people buy call options instead of the stock in this case:
1. The stock price is way too expensive to buy. For example, the stock price of GOOG is $800 while its 1 month call option at the $800 strike price costs only $18. As an options trading dummy, you don't have $80,000 to buy 100 shares of GOOG but you have $1800 to buy its call options which covers 100 shares of GOOG.
2. You are not extremely confident that the price of the stock is definitely going to rise so would not like to risk so much money at once into buying the stock but instead buy the call options for cheap as a form of "lottery ticket".
Options Trading For Dummies
Lets go back to when you first went to the watch shop! Now, after getting into a call options contract with the shop owner, 3 days an unexpected news hit the wire; the manufacturer closes down and the watch that you have the right to buy at the old price through the call option that you own, suddenly becomes limited edition and prices lept 3 folds overnight! (Of course the shop owner must be feeling pretty down now that he has committed himself to selling you the watch at that fixed old price) At this time, you could quickly exercise the rights to buy the watch at the old price and then quickly resell it to your neighbour (remember the neighbour?) who wish to buy the watch at the new inflated price, turning around an instant profit. However, your pocket money / salary isn't coming in for another 4 days (remember why you got into the call options contract in the first place?) and you wish to profit from this scenario now, how could you do that?
In a stroke of options trading dummy genius (yet again), you reckoned that since the watch is now worth 3 times the price, let's say $1500, your option to buy it for the old price, lets say $500, should be worth at least $1000, right? If you have a contract to buy something at $500 when that something is worth $1500 now, naturally that contract is worth $1000 due to its ability to buy something for $1000 cheaper, see? Now, your neighbour who wishes to buy the watch will have to buy it from someone at the new price of $1500 anyways so, you approach the neighbour and sold him this call options contract for $1000. Paying you $1000 for this contract, he can go to the shop and buy the watch for $500, which works out to the same total cost of $1500 as if he bought it elsewhere anyways, see? In this way, you took profit on your call options contract without ever owning the underlying asset.
This is exactly the same as in the stock and options market!
When you hold a call options contract and the price of the underlying stock rallies, you could take profit on that move in 2 ways; 1, Exercising, buying the underlying stock and then selling it at the new higher price for a profit. Or 2, simply selling the call options contract at a profit just like in the illustration above.
Options Trading For Dummies
As you can see from the above example, taking profit either way gives you the same profit. Such an option is referred to as an "In The Money" or ITM Option (Read more about what In The Money means). In practise, real options traders usually choose to just sell the option rather than exercising because exercising inevitably costs more in commission as you need to buy and sell the stock. I have lost count of the number of options trading dummies that I have met in my professional options trading career so far who thinks that the only way to take profit on a profitable options position is by exercising the option. I sincerely hope that through my "Options Trading for Dummies 2017" tutorial, you are not one of them.
Going back to the watch shop! Now, after getting the call options contract with the shop owner, lets say announcement of that new model hit the wire immediately the next day without warning and the watch is now worth only half of what you contracted to buying it for. This is where the beauty of options come in... remember, you have the RIGHT to buy the underlying asset IF you choose to... you are not OBLIGATED to do so! So, in this case, it makes no sense to exercise the contract to buy the watch at a higher price right? You simply allow the options contract to expire, allowing the shop owner to pocket the small deposit rather than waste more money buying the watch at twice the price.
This is exactly the same in the stock and options market. If the price of the underlying stock goes down, it makes no sense for you to exercise the option anymore, right? So all that remains of the value of that option is the length of time remaining that the contract remains valid. Remember, in the watch shop example, the deposit you paid for the 7 days contract depreciates as the remaining days reduces, right? This is the same as in real options trading. Such an option is referred to as an "Out of The Money" or OTM Option (Read more about what Out of The Money means). For such as option, all that remains is the value of the time left to the contract, which reduces as time goes by (known as Time Decay in fanciful options trading terms). When your option land in this predicament, you could continue to hold the option until it expires hoping that prices somehow turned around again or you could simply sell the option to salvage its remaining value.
Options Trading For Dummies
At this time, you may be wondering, who would buy from you an options contract that is "Out of The Money" when you want to sell it? Well, the good news is this, there are plenty of people who are willing to buy out of the money options as a form of cheap lottery ticket, risking only very little money to make a huge profit if the price of the underlying stock should suddenly move strongly in the expected direction! (Learn more about Out of the Money Options)
Options Trading For Dummies
Going back to the story of you trying to sell the watch to your neighbour. You entered into a contract to sell the watch to your neighbour because you were afraid that the price of the watch would suddenly drop and you wish to book the right to sell the watch at the original price to your neighbour, remember?
Translating into real options trading terms, you would buy a put option when you want to have the right to SELL a stock at a fixed price. Now, why would you want to do that? You would do that when you expect the price of the stock to drop just like in the watch example above. When the price of the stock drops, you still have the right to sell the stock at a higher price, thus benefiting from it, see? Exactly like how you protected the value of the watch from dropping by buying a put options contract from your neighbour, securing the rights to sell your neighbour the watch at the old price, just like an "insurance", you could also buy put options to protect the value of your stock from dropping! This options strategy is known as a "Protective Put" and is the reason why its commonly referred to as "Buying Insurance for your Stocks".
Options Trading For Dummies
However, you could also buy put options without owning any shares in the underlying stock! Its like buying the right to sell the watch to your neighbour at a fixed price without even owning the watch in the first place! Your neighbour don't care if you have the watch at that time or not because all he or she does is get the deposit money from you and wait to see if you come around to sell him or her the watch at all. Now, why would you go get the rights to sell the watch to your neighbour if you don't even have the watch? Well, that's because you are expecting the price of the watch to go downwards on the probable announcement of the new model (please read the story above if you don't know what this is all about). If it does, all you have to do to profit from this is to buy the watch at the cheaper price and then exercising the put option and sell the watch to your neighbour at the higher price just like how you would if you had owned the watch in the first place. So, in this case, you are more of a speculator than buying the put options to protect the value of the watch.
Similarly, in real options trading, you could buy put options without owning the underlying stock if you expect the price of the stock to go downwards in order to profit from the put options if the price of the stock really does go downwards.
At this point, I need to mention one common mistake that most options beginners and options trading dummies make, especially on their first put options trade and that is, they think they "Buy" call options but "Sell" put options since put options gives them the right to "Sell" when they intend to be "long" the put options rather than "short" it. This is a terrible options trading mistake as it will give you the exact opposite effect. You buy a put option using a "Buy To Open" order exactly the same way that you would buy to open a call option. That's why it's called "Buying a put option" rather than "selling a put option".
Going back to you trying to sell the watch to your neighbour. Now, just as you feared, the watch manufacturer announces the new model and instantly, the price of the current model you are having is only worth half the price you bought it for in the open market. You exercise the rights of the put option and successfully sold the watch to your neighbour at the old price, incurring no losses beyond what you paid your neighbour as deposit to enter into this contract in the first place.
In real options trading, If you own the underlying stock and you bought put options in order to protect the value of your stocks, you now have 2 choices:
1. Do as you did in the watch example, exercise the rights to sell the stock at the strike price of the put options, pocket the money and you are done.
2. Even though the price of your stocks dropped, the value of your put options also rose in the same amount below the strike price as it allows the holder to sell the stock at the strike price. You can now simply sell the put options for profit through its now inflated value and then continue to hold your stocks hoping for a rebound.
Options Trading For Dummies
What if you did not own the underlying stock and merely bought the put options as a form of speculation that the price of the stock would go downwards?
Options Trading For Dummies
As you can see, you buy and sell put options pretty much the same way you buy and sell stocks and call options.
Going back to you trying to sell the watch to your neighbour! Now, after buying the right to sell the watch at the current market price to your neighbour in anticipation that the watch manufacturer would release a new model, the exact opposite happened; the manufacturer went bankrupt and suddenly, the watch becomes limited edition and its price skyrocketed 3 times what you bought it for. What do you do with the put options contract you entered into with your neighbour? Remember the beauty of being the holder of a put option? Yes, you can decide if you wish to sell the underlying or not! You are not 100% obliged to do so! As such, since the watch is worth alot more than the price you entered into with your neighbour, you simply allow that put option to expire, allowing your neighbour to pocket the whole deposit you paid to go into the contract and then sell the watch at the market price to someone else.
This is exactly the same in the stock and options market. If the price of the underlying stock goes up, it makes no sense for you to exercise the option to sell the stock at a lower price anymore, right? So all that remains of the value of that option is the length of time remaining that the contract remains valid, just like in the call options example above. When your option land in this predicament, you could continue to hold the option until it expires hoping that prices somehow turned around again or you could simply sell the option to salvage its remaining value.
Options Trading For Dummies
At this time, you may be wondering, who would buy from you an options contract that is "Out of The Money" when you want to sell it? Well, the good news is this, there are plenty of people who are willing to buy out of the money options as a form of cheap lottery ticket, risking only very little money to make a huge profit if the price of the underlying stock should suddenly drop in the expected direction!
Options Trading For Dummies
Going back to our watch story. We rewind back to you staring at the watch in the shop, your money to buy the watch only comes in a week and you know this neighbour is also looking to buy this watch. You also happen to know that the watch manufacturer is in trouble so it could probably do one of two things in the new future; either close down, making the current model a limited editions, causing its price to surge. Or two, it could release a new model in order to quickly garner more sales, thereby depressing the price of the current model. As an options trading dummy, you wonder if there is a way to profit no matter which scenario turns out...
Then, a stroke of evil genius strikes you! Why don't you buy the right to buy the watch from the shop owner for a month in case the watch becomes a limited edition, paying the shop owner only 1% of the price of the watch as deposit at the SAME TIME go to the neighbour promising to sell him or her the watch within one month even though you don't yet have the watch just in case the new watch is released and this watch becomes only half its price. You also pay the neighbour 1% of the price of the watch as deposit for that contract. Yes, you bought BOTH options at the same time in order to profit from both of those situations you expect to happen within the month!
If the manufacturer really closes down, the price of the current 2017 model watch triples and you go to the shop owner, exercising your right to buy the watch at the old price and then selling the watch in the open market at the new price while allowing the contract with the neighbour to just expire without action. In this case, you only lose the 1% deposit with the neighbour and 1% with the shopowner while making 3 times the money back on the price of the watch.
If the manufacturer instead announces a new model and the price of the current 2017 model watch becomes half, you simply buy the watch at the new half price from another shop, allowing the contract with the original shop owner to expire without news. After that exercising the rights of the options contract with the neighbour, selling him or her the watch at the old price, thereby making a 100% profit on the watch while losing only the 1% deposit with the neighbour and 1% with the shopowner.
Nice work, Options Trading Dummy! You are so ready to make some money in 2017!
This is the exact same thing you can do in real options trading and don't worries, its perfectly legal! Combining different options together in a single trade is known as an "Options Strategy" and the smart use of options strategies is the true magic of options trading. In fact, there are hundreds of possible combinations or Options Strategies (Get a list of options strategies or read about my recommended Options Strategies for 2017).
In real options trading, when you expect the price of the underlying stock to make a big upwards or downwards move in the near future, you could do like what you did in the example above by buying BOTH call option and put option so that in the same way, you will profit no matter which direction the stock breaks out! This is known as a "Straddle" in options strategies terms.
Options Trading For Dummies
See how through combining options together into options strategies even an options trading dummy could profit no matter which way the stock goes like a financial wizard? Read more about the creative use of Put and Call Options.
Now that you understand what options is and isn't, know what call options and put options are, how they work and how to combine them, you can now move on to our Options Trading Basics Guide and also try putting on some virtual trades for practise through online options brokers such as Optionsxpress.com.
These are the key points you need to remember from studying this tutorial:
1. Binary Options Trading is NOT real options trading
2. You BUY (not SELL!) put option when you want to be long a put options contract.
3. Call UP, Put DOWN. That's an easy way to remember when to buy a call or put.
4. As a holder of the options contract, you can choose whether you want to exercise the option or not.
5. You can take profit on your profitable options contracts just by selling them, there is no need to exercise them to take profit.
6. Options can be combined creatively into options strategies capable of profiting from a multitude of different scenarios.
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