Basic Options Trading Tutorial | Option Trading Terms

If you're new to the concept of trading options, you are probably here trying to learn the basic mechanics of an option trade, what the basic terminology is, and most importantly - how to profit from this knowledge.

What I will tell you is that amazingly, the options market is not rigged against the individual investor. Quite the contrary - getting into the options trading market and making some trades is actually a great way for a person with a modest sum of money ($2000 to $10000 depending on the option broker) to significantly and quickly multiply it. I personally have made around 25% of my income this year trading stock options. There is no particular special formula - it is only a question of understanding what are the positions you can take and what circumstances lead to profit for you. With that, I'm going to take you through some basic examples.

There are a few options trading terms you need to know to be able to understand stock options and how to make your first trades. I will be referring specifically to American options, and I will note later some of the differences between American options and European options.

I like to work with the most intuitive of the trades - the call option first. We'll pretend that we've bought a call option with a strike price of $25.00 on Microsoft stock (let's presume someone simply gave it to us for the moment). It just so happens Microsoft is trading just below $30/share today so we'll pretend it's trading at $30.00 even for simplicity's sake. Given the circumstances we describe - what is our potential payout position?

We own 1 call option of MSFT with a strike price of $25/share. If we were to execute the contract today, we would pay $2500 ($25.00/share * 100 shares) and be immediately able to sell those shares directly in the stock market for $3000 ($30/share * 100 shares) = an instant profit of $500. Pretty kewl, huh?

Let's go one step further. Let's presume we paid $1.00 call premium for the contract - meaning we paid $100 ($1 call premium per share * 100 shares). This means we invested $100 and earned $400 net profit ($500 profit less $100 cost) - a 400% gain!

What would our return have been if we had used our $100 initial investment to buy share directly?
Well - we'd only be able to buy 4 shares (presuming we could buy shares from someone at $25/share) - so when we sold those shares later at $30 per share our profit would be only $20.00 (4 shares * $30 share - 4 shares * $25/share). This represents a 20% profit! 20% is a great return on investment for a short period but $20 in profit simply won't even buy you and your date dinner!

See why option trading is better for the small cap investor? The amplified gains on even relatively small price movements create worthwhile income gains for the fortunate trader.

Learn more about high leverage margin trading

Now we look at the less intuitive trade scenario - the put option. We'll pretend that we've bought a put option with a strike price of $25.00 on Microsoft stock (again let's presume someone simply gave it to us for the moment). Let's presume Microsoft is trading at $20/share today. Given the circumstances we describe - what is our potential payout position?

A Put Option Payoff Example

We own 1 put option of MSFT with a strike price of $25/share. If we were to execute the contract today, we would go into the market to buy 100 shares of MSFT for $2000 ($20/share times 100 shares) and force the counterparty to pay $2500 ($25.00/share * 100 shares) for an instant profit of $500. We owned the right to SELL the MSFT shares at $25, regardless of what the market price is for MSFT. The person or company that issued the put option to us MUST buy the shares we sell at the specified strike price ($25) despite the fact they could go into the market and buy them directly cheaper. The put option CONTRACT binds the issuer (or writer) of the contract to our DEMAND to sell the shares of Microsoft ABOVE the present actual price of the common stock of MSFT.

Let's go one step further. Let's presume we paid $1.00 put premium for the contract - meaning we paid $100 ($1 put premium per share * 100 shares). This means we invested $100 and earned $400 net profit ($500 profit less $100 cost) - a 400% gain!

What would our return have been if we had used our $100 initial investment to sell shares directly?
Well - we'd only be able to acquire 5 shares directly in the market ($20/share * 5 shares = $100 initial investment) - so when we sold those shares later at $25 per share (presuming we could force someone to buy shares from us at $25/share) our profit would be only $25.00 (5 shares * $25 share - 5 shares * $20/share). This represents a 25% profit! 25% again is a great return on investment for a short period but $25 still won't buy you and your date dinner!

See why option trading is better for the small cap investor? The amplified gains on even relatively small price movements create worthwhile income gains for the fortunate trader.

What many people don't know is that one of the best and cheapest sources of information about options trading can be found at reputable brokerage firms. Given the heavy regulations of the financial industry you'll find the most legally sound training tools and guidance at one of these major brokerage firms.

Learn more from a reputable broker about how to trade options on stock

Another much simpler, but similar type of options trading is called a binary option. What makes it simple is that the binary option eliminates the call and put premium as well as the transaction cost (commission). It also eliminates the SCALE issue relative to trading - meaning it does not matter whether the Microsoft shares in our example go up $5.00 (as in our call option example above) or only a nickle. The payout is the same. Likewise for the put option example. In our put option example we care HOW MUCH the shares move. In a binary put option trade, only the downward direction matters.

In a binary option only the direction of movement matters - not the size of the movement. Learn more about binary options trading.