The Smart Investors

What is Options Trading?

I would like you to imagine that you could lock in a price to buy or sell a stock probably in the future, without anyone forcing you to do so. That is actually where the power of options trading lies.

Let me explain further, an option is just like a contract that gives you the right but not the obligation to buy or sell an underlying asset like a stock at a predetermined price like the strike price on or before a specific date, that is the expiration date.

You need to pay a fee for this contract as a trader and it is called the premium. Think of it like you paying a deposit to hold a price.

The Two Types of Options: Calls and Puts

1. Call Options: This is the Right to BUY
You buy a Call when you actually think the price of a stock is definitely going to GO UP.
In the actual sense, it gives you the right to buy 100 shares of the stock at the strike price before expiration.
Here is a simple example: Let's assume you buy a Call option for Apple with a $150 strike price for a $5 premium. That shows that if Apple's stock rises to $180, you can still buy it at $150, therefore, you would make a profit. But if it stays below $150, you only lose the $5 premium you paid.

2. Put Options: The Right to SELL
You buy a Put when you think that the price of a stock will GO DOWN.
It actually gives you the right to sell 100 shares of the stock at the strike price before expiration.
Simple Example: Let’s assume that you buy a Put option for Tesla with a $200 strike price for a $8 premium. Then if Tesla's stock crashes to $150, you can still sell it for $200, thereby making a profit. But if it stays above $200, you only lose the $8 premium.

Key Takeaway: As a buyer, your risk is limited to the premium you pay. Your profit potential is theoretically unlimited for calls or very large for puts.

Basic Options Strategies for Beginners
1. Covered Call: Generating Income
What it is: This is when you own 100 shares of a stock and sell (or "write") a Call option against those shares.
Why use it: The major reason for using it is to earn extra income (the premium) from the stocks that you already own.
How it works: You are going to collect the premium. If the stock stays below the strike price, you will keep the shares and the premium. If it rises above, your shares might be sold ("called away") at the strike price, and you keep the premium too..

2. Protective Put (Married Put): Buying Insurance
What it is: This is when you own 100 shares of a stock and buy a Put option for protection.
Why use it: This acts as insurance against a drop in the stock's price. In this, you get to keep the upside potential while limiting your downside risk.
How it works: If the stock price plummets, your Put option will increase in value, which will offset the loss in your shares. The cost of this insurance is the premium you paid for the put.
Your Risk: The premium paid for the put acts like an insurance deductible, slightly reducing your overall profit if the stock goes up.

3. Spreads: Limiting Your Risk (A First Look)
Spreads is when you simultaneously buy and sell options of the same type (calls or puts) with different strike prices or expiration dates. They actually define your maximum profit and maximum loss upfront.

Bull Call Spread : You are to use this when you're bullish. So, you buy a call option and sell another call option with a higher strike price. This lowers your initial cost (this the net premium paid) but also caps your max profit.
Bear Put Spread: You use this when you're bearish. You just need to buy a put option and sell another put option with a lower strike price. This also lowers your cost and defines your risk/reward.

Key Terms to Know Before You Start

Strike Price: This is the fixed price at which the option holder can buy or sell the underlying asset.
Expiration Date: This is the last day an option can be exercised. After this, it becomes worthless.
Premium: This the price the buyer pays to the seller for the rights conveyed by the option contract.
In-the-Money (ITM): This is an option that has intrinsic value (e.g., a call option when the stock price is above the strike price).
Out-of-the-Money (OTM): This is an option with no intrinsic value( a call option when the stock price is below the strike price).
Assignment: This is when the seller of an option is obligated to fulfill the terms of the contract (buy or sell the stock) because the buyer exercised their right.

Final Word of Advice

Options trading is one of the powerful ways to generate income and hedge portfolios. However, you need to know they it carries significant risk, especially for strategies that involve selling options which can lead to unlimited losses. So, because of this you need to:

Start Small: I will advise to use paper trading account to practice first.
Define Your Risk: Always know your maximum profit and maximum loss before entering into a trade.
Keep Learning:.You need to keep learning continuously. You must understand the "Greeks" (Delta, Gamma, Theta, Vega) for more advanced trading.

Wow! I have never seen such a breakdown of Option trading in such a simple way. Before now, I didn't have enough experience on option trading and reading this thread has made me have a clue of what option is all about. The way you explain calls and put with real life examples, makes it so easy to follow. Thank you for this great thread.