Explaining Options Trading: The Basics of Trading Options For Short Term Profits

Stock options trading can seem intimidating and hard to understand when you don't understand the terminology or the concepts. But they're actually pretty simple once you learn the language and a few basic ideas.

How to explain options trading? An option is given this name because when you buy one you are buying the right to buy or sell a stock at a predetermined price, which in options language is called the striking price, within a specified period of time. But here's where it gets interesting - you have the right to buy the stock at the striking price, which is called exercising the option, but you don't have to. That's why it's called an option, it's a right but not a contract. Instead, you can sell the option back to the marketplace, and take your profit or loss directly without ever purchasing any stock.

A couple of basics to explain options trading: options are traded in contracts of 100 shares. One option is the right to buy or sell 100 shares. The right to buy shares is what you want when prices are rising, and this is what a call option is. A put option is the right to sell 100 shares, and this is what you do when share prices are dropping.

By buying an option, you are buying the right to buy or sell shares, and if you choose you can exercise the option at your striking price - but again, you can simply sell the option instead.

Let's take a concrete example: a stock is trading at $20 today and you anticipate that in three months the price will rise. You can buy a call option that locks in the price you choose, your striking price. You decide on a striking price of $17.50. The cost of this striking price on the stock with an expiration in three months is listed at $3.50. This is the cost per share, so multiplied by 100, one call option will cost $350. As the owner of the call option you now have the right to purchase 100 shares of that stock at your striking price before the option expires.

Now your call option is 'in the money' by $2.50, as your striking price is $2.50 below what the stock is currently trading for. If you'd chosen to buy a call at $22.50, you'd be $2.50 'out of the money'.

With your $17.50 striking price, If the stock rises to $30, at expiration your call option will be $12.50 in the money. Now you may have noticed that while your call option was $2.50 in the money, the price was $3.50. The extra amount is the 'time value' of the option. Options have intrinsic value, which is the worth based on the difference between the striking price and share price, and extrinsic value, which is what you're paying for the time. So in this case, you're paying $100 for the three months of time.

Time value does decay, the closer you get to the expiration date of your option, more of the option value is intrinsic, and less extrinsic. If you sell your option the day before expiration, it's likely that the time value will have disappeared, and you are now banking on the intrinsic value, the difference between your striking price and the current share price. However, if you sell several weeks before expiration, which often happens in the case of swing trading, your option will retain much of its extrinsic value.

Back to our example, if you sell this option in three months, just before expiration, and the share price is at $30, you are making $12.50 per share, multiplied by 100 which is the size of one contract, and you see you have a profit of $1250,

Without ever having bought the stock, you have been able to profit from its price movement through your purchase of a call option. As you can see, having only invested $350, your money is highly leveraged. If you'd bought 100 shares of the stock instead, you'd have to invest $2000, and you'd actually make less if you sold at $30, $1000. On this $10 movement, the option has a 357% return, while the stock has a 50% return

There's more to be said to explain options trading, which is why this article is part one of a short series. But for now you realize the powerful potential of trading options. The next step is the really important part: how to make money at it? The answer? You don't have to become a technical analysis guru, or even understand all of the fundamentals - that is, IF you have access to a good advisor, one who has great technique, years of expertise, and knows how to maximize the potential and explode profits. You can simply follow along with their recommendations to start and continue to learn at your own pace, but you can start making money right away.

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