Stock Option Basics - A Blending Of Investing & Gambling
The title of this post is "Stock Option Basics - A Blending Of Investing & Gambling". Now just to be clear, we sometimes hear about an executive at a corporation receiving stock options as part of his total pay package. Those stock options are completely different from the ones we will be talking about. The stock options we will be talking about are traded on major exchanges, just like stocks.
The purpose of this post is to teach you the hard and fast basics for learning to buy stock options. As mentioned, stock options are contracts you can buy and sell just like a stock or a mutual fund. Now buying them is not as simple as buying a stock, but it's not complicated either.
Buyers of stock options use them for different purposes. Some people, use them like insurance policies to protect existing gains they've made on stocks. Others use stock options as a high-payoff gambling opportunity - they are often referred to as speculators. And then there are many who use them as a high-payoff investing opportunity - that is a combination of an investment and a gamble. Those buying options as an investment or gambling opportunity are looking to make fairly quick profits by making bets on the direction of a stock's price by a certain date in the future. And this is what we are here to talk about. How to invest and/or speculate by buying stock options.
Investing & Gambling
Now when you hear the words speculate or bet you naturally think of Las Vegas ... and you should. In the world of stock options you can lose your shirt almost as quickly as you can in Las Vegas if you don't know what you're doing. But as the words speculate or bet imply, there is the opportunity to make substantial returns. What is especially attractive about stock options that many overlook is that you can choose how risky of an investment / gamble you want to make. Unlike at a roulette table, you truly have some control over the odds of the game. But again, just to be clear, you can also lose all of your money and if anyone tells you otherwise, they are lying.. no ifs, ands, or buts.
Additionally, another attractive feature when it comes to buying options is that your homework can improve your odds of a modest, favorable, or very favorable payoff. Yes there is still an element of gambling, however by doing research, like for an investment, you can make your option contract purchases more of a well researched investment opportunity and less of a speculative gamble.
Stock Options are contracts that you can buy and sell just like a stock. So when you buy stock options, you are buying what are called "option contracts". These contracts are very simple and straightforward. The same online services you use to buy stocks readily allow you to buy option contracts. E*Trade, Schwab, Interactive Brokers... all of the major online brokerage firms allow you to buy and sell option contracts.
There are only two kinds of option contracts. One is called a "Call Option Contract". The other is called a "Put Option Contract".
Concept 1: You buy a Call Option Contract when you want to bet that the price of a stock is going to go up. You buy a Put Option Contract when you want to bet that the price of a stock is going to go down.
Concept 2: A Call Option Contract gives you the right (you do not have to) to buy a specific stock at a specific price anytime before the option contract's expiration date. A Put Option Contract gives you the right (you do not have to) to sell a specific stock at a specific price anytime before the option contract's expiration date.
Concept 3: It costs money to buy a call or a put option contract. You are not required to do anything after you buy it. The contract can expire and be worth something or nothing.
Call Option Purchase Example 1 - An Introduction
Ok, so here is an introductory example. Let's say today is April 2nd, and suppose we did some research and are confident and that Microsoft's stock is going to go up over the next 2 Months. Since we expect the stock price to go up and we are looking for a fast and significant return, we then know we want to buy some Microsoft Call Option Contracts.
Next, we have to choose one of the many Microsoft Call Option Contracts available for sale. Well first off, we should know the current price of Microsoft stock is $40. Again, a call option contract gives you the right to buy a specific stock at a specific price before the option contract expiration date. The specific price is called the "Strike Price" and it does not change. So if we are going to buy an option contract for a particular stock, we have two additional choices to make (1) the option contract's expiration date(month), and (2) the option contract's strike price.
So stop and consider this for a minute. The option contract is going to have a certain cost right now. So the market price of a call option contract will go up if the stock price goes up - that is the stock price is moving further away from the Strike Price.
After the expiration date, if a buyer has not sold his/her option contract yet, the contract is either worth something or it is worth zero - nada - nothing. Now, what determines if it's worth something? Keeping it simple, it depends primarily on the change in the price of Microsoft from the time you bought the contract. So again, purchasing of a Microsoft call contract, specifically, gives you the right to buy Microsoft stock at a certain price before the option contract's expiration date.
Let's say the expiration date for some Microsoft call option contracts you bought is in June (in about 2 months). And let's suppose that the terms of the contracts you bought gave you the right to sell Microsoft at $45 (the Strike Price for the contract).
If the price of Microsoft is above $45 at or before the expiration date, then the value of the call option contract will be worth something above $0. How much will it be worth? It depends primarily on how much greater the price of Microsoft is above the $45 Strike Price. The greater the amount of Microsoft above the Strike Price the more valuable the price of the call option contract has become. However, if the price of Microsoft is below the Strike Price just before or on the expiration date, then the value of the call option contract is $0. The option contracts expire worthless.
Now just to be clear. After you buy an option contract, you can turn around and sell it at any time before its expiration date. It's really all about personal greed. Personally I have bought and sold many contracts holding them for as short as 5 days and others for as long as 4 months - sometimes expiring worthless, other times more than doubling my initial investment.
So to summarize, once you decide you are going to buy option contracts for a specific stock, you have 2 choices to make when selecting a contract: (1) the Strike Price and (2) the Expiration Date.
Call Option Purchase Example 2 - Real World
In this example, suppose Microsoft is trading at $40.25 and your research leads you to believe the stock is going to go up. You research also leads you to a recommendation to buy Microsoft Call Option Contracts with (1) an expiration date of July 2014 and (2) a strike price of $39.
When you go to place the order, you would find a bid price and an ask price for this option contract just as you would see a bid price (what you could sell it for) and ask price (what you can buy it for) as if you were buying a stock. For this option contract you would find the Bid-Ask at $2.44 and $2.47. So the cost to buy one call option is the ask price of $2.47.
Now another thing to know is that each and every option contract is only sold for control over 100 shares of a specific stock. Therefore, EACH option contract would cost you $2.47 X 100 or $247. So when you see the bid-ask prices, just multiply them by 100 in your head. This is the cost for one option contract.
Strike Price & Expiration Date Selections
Why choose a particular strike price and expiration? The short answer is experience. The longer short answer is risk and reward. Until an investor / speculator gets more experience, we recommend that the purchase of what are called "In-The-Money" stock options. This means that if the contract expiration date were accelerated to your purchase date, the contract would always have at least some value to it - in option text books this is referred to as "Intrinsic Value". For call option contract purchases, this means choosing an option contract with a Strike Price less than the current stock price. For put option contract purchases, this means choosing an option contract with a Strike Price greater than the current stock price.
Regarding which expiration dates to choose, we recommend choosing options that have an expiration date between 4 and 9 months. By purchasing contracts with longer times to expiration between 4 and 9 months, we think allows a tolerable level of volatility for a beginner or moderate risk option purchaser, while still allowing for large percentage increases (and possible large percentage declines).
Many investors / speculators can and do choose options that are not In-The-Money (referred to as Out-Of-The-Money) and may expire in weeks rather than months. However, the volatility of the value of these options are substantially greater - as is the potential payoff (or loss). These are truly Vegas style type bets.
If you are picking your own strike prices and expiration dates for a particular stock, a great resource for selecting them can be found at www.optionmonster.com. You can go to this website and put in the ticker symbol for a particular stock and you can see the option contracts that are available to buy and sell. You will find that strike prices are available at different incremental levels. You will also find that the expiration dates/months are not available for every month - but usually available for expiration dates within the next two months.
Additionally, here is something to know about expiration dates. The expiration date for options for a given month moves a bit from month to month. This is because, for any expiration month, the expiration date is the third Friday of the month. Most of the time, you won't need to know this date for placing orders. The assumption is that when you buy and sell stock option contracts, you already know this as part of the game.
Now everything we just told you about Call Option Contracts also applies to Put Option Contracts - however you are just betting for the opposite direction of stock movement.
Now listen closely. Investing in stock options really can be effective staying this simple. Many professionals and training organizations will try to convince you that if you invest in options you need to be familiar with option combination structures known as spreads and or straddles. These structures limit option contract payoff upsides and downsides. It is our firm belief that it is best to just "Keep It Simple". It is of our belief that if you cannot draw a clear conclusion from your homework and research to comfortably buy call options or put options, then just don't buy anything. Just wait for the clear / better opportunity.
Just in case you want to know... What makes us pick a particular stock? We use our self-developed proprietary algorithms to review, analyze, and rank over 6,000 stocks every week. We use a widely known investing approach called Value Investing - an approach used by Warren Buffett and many other successful investors. Those ranked among the best are great candidates for purchasing call options contracts. Those ranked among the worst are great candidates for purchasing put option contracts.
We hope you've found this post helpful and if you are looking for a source of specific weekly call and put option recommendations, please consider subscribing to CMG's Premium Newsletter. You can find out more by visiting us at : http://www.best-stockstobuy.com/premium-report/ .