An Introduction to Trading Options

If you have never traded options before, don't worry, it is easier than you might think. I have personally trained hundreds of individuals in option trading, and I can train you too.

The first thing you must understand is that a stock price can move in 3 directions:

1. it can go up,
2. it can go down,
3. and it can stay the same.

The second thing you must remember is that a "call option" gives you the right to buy a stock at a certain price by a certain date; and a "put option" gives you the right to sell a stock at a certain price by a certain date. You can remember the difference easily by thinking a "call option" allows you to call the stock away from someone, and a "put option" allows you to put the stock (sell it) to someone.

The third thing to remember is a few key terms. The "strike price" is the price at which you have the right to buy (if we are talking call options) or the right to sell (if we are talking put options). The "expiration month" is the month in which the option will expire (this is usually the 3rd Friday of each month).

The final thing you must understand is that if you think a stock is going to go up, there are 3 ways to make money:

1. you can buy the stock
2. you can buy a call option on the stock, and
3. you can sell a put (we will not cover this strategy in this article).

Likewise, if you think a stock is going to go down, there are also 3 ways to make money:

1. you can short the stock
2. you can buy a put option on the stock, and
3. you can sell a call (we will not cover this strategy in this article).

Now let's look at a specific example so this starts making sense. Let's say we have done our analysis on IBM and we think IBM will go from $84 to $87 in the next few days. Because I think IBM will go up I want to buy a call and since option strike prices are in multiples of $5, I could buy the $80 call, the $85 call, or the $90 call. Note from the Table 1 below that the IBM April 85 Call has the greatest percentage return.

Scenario 1--Buy 100 Shares of Stock and 1 Contract of Each of the $80, $85, and $90 Calls and IBM Closes at $87.

Security	Shares	Purchase Price	Cost	Selling Price	Proceeds	Profit	% Return
Stock	100	$84	$(8,400)	$87	$8,700	$300	3.57%
IBM April 80 Call	1	$4.00	$(400)	$7.00	$700	$300	75%
IBM April 85 Call	1	$0.75	$(75.00)	$2.00	$200	$125	167%
IBM April 90 Call	1	$0.25	$(25.00)	$ -	$-	$(25.00)	-100%

Now in the Table 2 below, we go ahead and invest the same initial amount in options as in the stock so we spend $8,400 on 100 shares, and on each of the calls. Naturally, the percentage return is the same as in Table 1 above but since now look at the $14,000 profit on the April $85 Call! Even the profit on the April $80 call is nice at $6,300.

Scenario 2--Invest Equal Amounts of Money in Each Stock and Option and IBM Closes at $87

Security	Shares	Purchase Price	Cost	Selling Price	Proceeds	Profit	% Return
Stock	100	$84.00	(8,400.00)	$87.00	$8,700.00	$300.00	3.57%
IBM April 80 Call	21	$4.00	(8,400.00)	$7.00	$14,700.00	$ 6,300.00	75.00%
IBM April 85 Call	112	$0.75	(8,400.00)	$2.00	$22,400.00	$14,000.00	166.67%
IBM April 90 Call	336	$0.25	$(8,400.00)	$-	$     -	$8,400.00)	-100.00%

Now, here's the risky part of trading options. In Table 1 and Table 2 we showed the results assuming IBM climbed from $84 to $87 a share by the expiration date. Of course, stocks don't always move the way we think, so Table 3 shows what happens if the stock price just declines a bit to $83 a share. Note that for the $85 Call we lost all of our money, but for the $80 Call we only lost $2,100 and, of course, for the stock we only lost the $100.

Scenario 3--IBM Closes at $83.00

Security	Shares	Purchase Price	Cost	Selling Price	Proceeds	Profit	% Return
Stock	100	$84.00	(8,400)	$83.00	$8,300	$(100)	-1.19%
IBM April 80 Call	21	$4.00	(8,400)	$3.00	$6,300	$(2,100)	-25.00%
IBM April 85 Call	112	$0.75	(8,400)	$-	$     -	8,400)	-100%
IBM April 90 Call	336	$0.25	(8,400)	$    -	$    -	8,400)	-100%

Conclusion

If you are sure that a stock is going to pop up a few points before the next option expiration date, it is the most profitable (and the most risky) to buy a call option with a strike price slightly higher than the current stock price. If you want to be a little more conservative, you can also buy the call option with a strike price below the current stock price. When in doubt as to what option to buy, always look at the volume that is happening in the real market and go where the volume is (I call this following the "smart money").

To learn more about trading options, try the Options 101 course risk-free for 30 days from Options University.

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