Learn Option Trading
The Bricks & Mortar of Options

Take a moment to learn the basics of options trading. Even if you are familiar with this material, it is a good idea to review it.

Building Blocks

There are only two types of options - calls and puts. Calls and Puts form the basic building blocks of all variations of option trading. One option unit is equivalent to 100 units of the underlying stock. Every trade is built using only calls, only puts, or a combination of the two.

Every call or put must have a seller and a buyer.

Option SELLERS have OBLIGATIONS;
Option BUYERS have RIGHTS.

CALLS

A CALL is a contract that gives the BUYER the right to purchase stock at a certain price (strike price) at a certain date (Expiration, or the date on which the contract expires). The SELLER has the obligation to sell the stock at the strike price.

For Example: A call option for ABC stock may look like this:

If you bought the following:
ABC June 32.5 Call
It means that you have acquired the RIGHT to purchase 100 units of ABC stock at $32.50 upon expiration, which will be the third Friday in June. If ABC is above $32.50 on that day, the option will be "In-the-Money" (ITM), and you effectively buy the stock at a discount. If ABC is below $32.50 at expiration ("Out-the-Money", or OTM), you would not exercise the option, because you would effectively be buying the stock at a higher price. In this case, the option expires worthless.

When to use:
BUY a call when you are sure that the underlying stock will INCREASE in price. If the price increases, sell the call before expiration to take your profits, or exercise the call to buy the stock at a discount if the price of the stock has moved above the strike price (i.e. ITM).
NOTE: Only buy calls when you have thoroughly learned the principles of swing trading.

SELL a call if you ALREADY own the stock. If the price of the stock goes above the strike price, you will be obliged to sell the stock at the strike price. If the price of the stock stays below the strike price until the option has expired, you keep the stock and may sell another call.
NOTE: Sell calls only when you actually own 100 units or more of the stock, and are reasonably certain that the stock will not move above the strike price (see Trend Analysis)

PUTS

A PUT is a contract that gives the BUYER the right to sell the stock at the strike price upon expiration. The SELLER has the obligation to BUY the stock at strike price. Buying Puts is the equivalent of short-selling stocks.

For example: A put option for ABC stock may look like this:

If you bought the following:
ABC June 32.5 Put
It means that you have acquired the RIGHT to sell ABC stock at $32.50 upon expiration, which will be the third Friday in June. If ABC is below $32.50 on that day (ITM = "In-the-Money", you effectively sell the stock at a premium. If ABC is above $32.50 upon expiration (OTM = "Out-the-Money"), you would choose not to sell the stock, because you would make a loss (you would effectively sell the stock at $32.50 and have to buy it back at a higher price to cover your trade). The option would expire worthless.

When to use:
BUY a put when you are sure that the underlying stock will DECREASE in price. If the price decreases (resulting in an increase in the price of the put), sell the put before expiration to take your profits.
NOTE: Buy puts only when you have thoroughly learned the principles of swing trading

SELL a put if you are certain that you want to OWN the stock. You can sell a put for a strike price lower than the price of the stock. If the price of the stock is above the strike price at expiration (OTM = Out-The-Money), the put will expire and you get to keep the price of the sold put. If the price of the stock is lower than the strike price (ITM), you will be obliged to buy the stock at the strike price, thus making a potential loss.
NOTE: Sell puts only when you actually want to own 100 units or more of the stock, and are wanting to buy the stock at a discount. Your broker requires that you have enough cash to buy the stock if the option is ITM (ITM=In The Money). Or sell puts when you are reasonably certain that the stock will not move below the strike price (see Trend Analysis)

Keep it Simple:
BUY a Call to buy a stock; SELL a call to sell a stock
BUY a Put to sell a stock; SELL a Put to buy a stock

Other Option Trading Methods

Options can be traded in various combinations, with fascinating names that are intimidating to many people, such as Credits and Debit Spreads, Ratio Spreads, Iron Condor, Butterfly etc. On this site, I mainly focus on Credit Spreads, because they are easy, cheap (from a paying broker fees point of view), profitable, safe, risk averse and fun.You can learn all that here.

But first, get your head around Option Pricing, a concept you cannot afford to not learn in order to be successful at option trading.
Option trading strategies
Trade Strategy Direction Option Strategy Requirement Profitability Potential for loss
Trend or Momentum trading
Positive (Bull)
Sell PUTS
High Margin
Medium
Medium
Sell CREDIT PUT SPREADS
Low Margin
Medium
Minimal
Negative (Bear)
Sell COVERED CALLS
Must own underlying stock
Medium
Medium
Sell CREDIT CALL SPREADS
Low margin
Medium
Minimal
Swing Trading
Positive
Buy CALLS
None
Very High
Very High
Negative
Buy PUTS
None
Very High
Very High

 

Smart Option Trader

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  • Learn Option Trading - On this page learn the basic building blocks of options trading. Get to understand calls and puts, and how they are traded. It is a little tricky, but you need to know the differences between the types of options, and their related obligations rights.

    Many people get bogged down with this info, especially when dealing with option combinations like credit spreads, so print your self out a cribsheet!


    Needing to learn more? The Options Industry Council is a collaborative effort by several brokers, and provide lots of detail information and tutorials. Here is the link:
    Options Industry Council (OIC)

    On this site, my focus is on trading - I favour quick in, quick out, using a simple strategy. It is not so much investing as it is making your money actively work hard for you. This should be one portion of your wealth building strategy, but not the whole - you need to think broader, and use multiple strategies. You might want to look at this great introduction to option trading strategies for long term investors, such as Leveraged Investing, for some alternative approaches.