Introduction to Stock Options

People are funny. Sometimes the best sales pitch that a salesman can make to a customer is, “Oh you mean this? No, you don’t want to buy this! In fact, stay completely away from these all together; you don’t know what you’re getting yourself into…”

Nothing makes people more curious and more interested than a secret. I’ve written several times on Trading Common Sense about stock options, and every time I issue a variation of the same warning: options are extremely risky and volatile, and I do not recommend that inexperienced traders trade options at all! And then what do I hear from readers? “Hey Wayne! Great article on beta today, I really learned a lot. Hey, listen: if I buy October calls for Netflix, what strike price do you think would be the safest price that I could still make a decent amount of money?”

I get it. I’ve made options the forbidden fruit, so today I’m going to do my best to shed some light on the topic of stock options for those out there who need an introduction. But I will start out by saying that options are too complicated for most people (including myself) to understand from an 1000-word article. That being said, I have an entire chapter of my book, Beating Wall Street with Common Sense, devoted completely to explaining how stock options work and how I have been able to make huge returns trading options when the opportunities were right. Since I see no harm in plagiarizing myself, I’ll go ahead and let the book speak for itself:

A derivative is a financial instrument whose value is derived from an underlying asset in some way, but whose value does not directly correlate to the price of that asset. One of the most commonly traded derivatives used to gain leverage in the stock market is called a stock option, or just “option.”… trading options is a very easy way to lose all of your money quickly if you do not know what you are doing.

Before you buy a single option, make sure you fully understand how options trading works. First of all, what is an option? An option is typically a contract to buy or sell 100 shares of a stock at a certain price on a certain future date.

For example, let’s say that company X is trading at $500 per share and you believe that in six months it will be trading at $600 per share. Let’s say that you have $1000 to invest in company X. You can choose to buy two shares of stock, and if you are right you will make a profit of $200 over six months. Let’s say, however, that you decide to purchase option contracts instead of shares. You can purchase options that expire in six months that give you the right to purchase 100 shares of company X stock at $550 per share, and each contract costs you $10.

Options such as these that grant you the right to buy shares are called call options or “calls” The price at which you are entitled to purchase the shares is called the strike price of the option. In our example, since each contract represents 100 shares, you can purchase one $10-dollar call option in company X with a strike price of $550 and an expiration date of six months in the future for $1000 ($10 per share times 100 shares). Now if the stock goes to $600 in six months, each option will be worth the difference between the $600 and the strike price of the option. In this case, the difference would be $600 minus $550, or $50. Since each option represents 100 shares of stock, the value of the option is now $50 times 100 or $5000!

Regardless of whether you bought shares of stock or call options, the price of the stock moved up 20%. If you bought shares of stock, you made a 20% profit. If you bought a $550 call option for $10, you made a 400% profit because of the leverage the options provided!

Got it? If not, you’re in the exact same boat that I was when I first started reading about options. It isn’t exactly “common sense” at first. But once you take the time and effort to understand exactly how options work, they actually do make sense. A great indication that you are starting to understand how options work is when you start to comprehend how dangerous they can be. As I said before, when you are purchasing an options contract, you must know that, statistically, there is a three in four chance that what you are buying will end up being worth nothing. That’s right, worthless. There’s a greater than 75% chance overall that you are turning over your hard-earned money in exchange for something that will not end up worth the figurative paper it’s figuratively printed on.

That’s exactly what happened to me, the guy that Motley Fool deemed a “financial sector specialist,” in the summer of 2012. Since I’m a numbers guy, I sometimes like to think about life like an algebra problem. In my book, I tell the full story of how and why I bought x number of Morgan Stanley call options for y dollars about a month before expiration. And a month later, they expired and I sold them for 0x per option for a total of 0y dollars. So it can and does happen. More than 75% of the time.

But despite the rather bad 100% loss on the Morgan Stanley options, I’ve had more than enough great options trades to make up for it, including a 100% gain from J.P. Morgan calls, a 170% gain on (a different) batch of Morgan Stanley calls, and a 412% gain on some Bank of America calls.

I’ve barely scratched the surface on stock options today. If you are interested in a full, detailed introduction to options, the chapter in my book devoted to options tells the whole story. I’ve said repeatedly that I only trade options under very specific circumstances. Every single options trade I’ve made and the reasons why I made it is detailed in my book.

Want to learn how and why I made a 287% gain on my very first options trade in just a week? Or maybe you just want to be able to look sophisticated in front of your coworkers when they ask you what you are reading on your Kindle, and you’d prefer to tell them “Oh, I’m just reading a book about stock market analysis,” rather than the usual “Oh, I’m just looking at pics of my ex-girlfriend on Facebook.” For these reasons and more, check out my book, Beating Wall Street with Common SenseI don’t have a degree in finance; I have a degree in neuroscience. You don’t have to predict what stocks will do if you can predict what traders will do and be one step ahead of them. I made a 400% return in the stock market over five years using only basic principles of psychology and common sense. Beating Wall Street with Common Sense is now available on Amazon, and is always available on your local internet!