Introduction To Options

So you want to learn about options do you? Welcome to StockJock-e's Options Wiki!

Options can be your best friend, or your worst enemy. Like any leveraged instrument you can make a lot of money very quickly, or lose it just as fast.

In this wiki I will attempt to get you on the right side of option trading with the correct mind set that should help you avoid the deadly pitfalls that most new option traders fall into.

Before I explain what options are, you need to understand what leverage is.

Leverage

Leverage can most easily be explained using a mortgage on a house as the metaphor. If you want to buy a $500,000 house, but you do not have $500,000 cash to do it, what do you do? You can pay a little money (a premium) to get a lot of asset (the house). A little for a lot - that is Leverage. Just like a lever lifting a heavy object. A little force at the end of the lever is multiplied by the fulcrum pivot point and increases the force on the object, lifting it up.

So you go to the bank for a mortgage (a contract between you and the bank). The bank will ask you to put down $50,000 as the down payment, then give you the additional funds to buy the house. In simple terms you have invested $50,000 and you now hold an asset worth $500,000.

Lets say the next month an interested buyer knocks on your door and offers you $550,000 for your house. If you sold your house to him for $550,000 and pay back the bank $450,000, it leaves you $100,000 - minus your initial investment of $50,000, gives you a profit of $50,000. So you have basically doubled your initial investment of $50,000. 

This will also work the other way around, lets say the housing market takes a dive and you really want to sell, but the only interested buyer is offering $450,000. You have to give all that back to the bank, so you have nothing left over. You lost your initial investment of $50,000.

Options

Using the concept of leverage, options allow you to spend a little, to get a lot. Instead of having to pay $100 to buy a share and hoping it will go up in price so you can sell it and earn a profit, you can pay a few dollars to buy the option of buying a share at a certain price before a certain date. Then if the price of the share does go up, you can chose to exercise your option, but the share at the lower price, immediately sell it, and make a profit.

There are two kinds of options, call options and put options. Call options go up in value if the underlying stock goes up. Put options go up in value if the underlying stock goes down.

Options work much the same way, for a price calculated using the Black-Scholes model you get to control 100 shares of the underlying stock. In English that means if you own 1 call option of AAPL, it is the same as if you own control 100 shares of AAPL stock. Sounds amazing right?

Do not get too excited just yet. There are time limits on options, meaning they expire at a predetermined date. If you buy some call options on AAPL betting that it will go up by the end of the month, but AAPL goes down, your call option expires worthless, zero, zilch, nada.

If you buy options, you need to be right about the direction and the date.

There are different calendar dates at which options expire, it can be weekly, monthly (the third Friday of every month, this is an important date) and up to 1yr and even 2yrs out (these are call LEAP options).

(More to come...)