Learn Option Trading

The trading of options contracts on stock (and yes, on commodities, which can be much more complex) can be a seductive proposition. You can participate in the full upside of a stock's movement with only a fraction of the capital investment, and you can also lose everything with only a small downshift in the price of the stock.

It's very much like gambling, no way around it. Because you are betting on the direction and pace of movement for a given stock, and because those movements are linked to factors other than (and in addition to) fundamental news and performance of the underlying company, it becomes a bit of crap shoot.

Learning the Options Trading Ropes

There is much to learn in this realm. There are courses available, found online, in books and at workshops. Understanding the terminology and mechanics is critical, because the options trading realm moves fast and takes no prisoners.

Once you begin, you'll learn that each options contract covers 100 shares of the underlying stock, even though the quoted price is shown as a per share amount.

You'll learn that the strike price is the price at which the option holder can exercise the option (either buy or sell the underlying shares to someone else), and that how that strike price relates to the current market prices is what determines your profit or loss.

And, you'll learn that each contract has a specified term, which results in the exercise of the option at its conclusion (and usually, only at its conclusion; contract holders who wish to sell their contracts prior to the end of the term do so on regulated options markets).

How Call Options Work

If you purchased a $15 strike price call, the stock itself (selling at, say, $18) is already $3 in the money. The call has an intrinsic value of at least $3, because if the price doesn't change over the course of the contract, you'd be able to buy the 100 shares for $15 when they are actually worth $18, meaning you have a built-in $3 profit.

Hence, the price of the option is worth at least that much. If you buy it on the day before the contract expires, then chances are the price will be very close to $3. But if you buy it, say, six months prior to expiration, the market may have priced in an anticipated increase in the value of XYZ stock, called the premium.

The price of an option is the sum of the intrinsic value and any premium.

In this case, if the market is bullish on the underlying stock, they may assign a $2 premium, meaning the market believes the stock will go another $2 higher than its current intrinsic value. In the case of our $15 option, one with six months left to run, the price might be around $5 per contract, or the $3 intrinsic value plus a premium value of $2.

Which means, the underlying stock would have to be trading at $20 or higher by the end of the term for the contract holder to make money after a $5 buy at the $15 call price. Because the option, at its conclusion, would be worth precisely $5, or $500 per contract.

If the strike price is $20 instead of $15, the stock is not yet in the money, so 100% of the option price is a premium. The price here might be $2 per contract, meaning the stock needs to reach at least $22 to break even, or to drive the price higher than the $2 contract price for the option contract.

Upside Meets Downside

So why do this at all? Because if the stock goes very well, say, trading at $30 before the end of the term, the $15 contract holder will have at least a $15 intrinsic value, or a $10 profit on their $5 investment, a 200% return. And, given that momentum, probably even more in the form of premium value if there is time left in the term.

For the $20 contract holder, they'd have an $8 profit on their $2 investment, or a 400%.

Such leverage isn't available by buying the stock itself. Same stock, same price, but explosive returns if the option investor guesses right.

Which usually only happens if they know the options trading ropes.