Oct

5

Options Trading 101 From Theory to Application

Filed Under Option Trading Articles 

by Bill Johnson

As a gift to our readers, we will be presenting the running serial version of the popular book “Options Trading 101 From Theory to Application”. Once finished with this serialized book, readers should be ready to take the Mastery Options Course offered at Option University.

Part 1

Introduction

Chances are you’re reading this book because you’re brand new to options. You’ve heard about them but can’t really explain to someone else what they are. You’d like to start trading them, but you have lots of questions and nobody seems to have the answers you’re looking for. This book is for you!

At Options University, we believe there is only one way to teach; you must start by learning the most fundamental concepts. While it is possible to provide a quick overview and send you on your way with a false sense of confidence, we know that will only be detrimental in the long run. That is the “ready, fire, aim” approach often used by most books and instructors. Instead, we make sure you truly understand the essence of an option and what makes it different from stock. Once we examine these core competencies, we will then introduce you to some basic strategies that you can use immediately. But don’t underestimate these strategies just because they’re labeled as basic. On the contrary, the basic strategies are what often pack the most punch and are most widely used – even by professional traders. Advanced strategies, even though they appear far more complex, are just moderate extensions of the basics. If you understand the concepts presented in this book, you will make a smooth transition into advanced strategies should you choose to continue further with options trading. Most important, you will have enough knowledge to confidently use the most powerful trading tool ever to hit the financial markets.

Before we get started, let’s clear up the one unfair misconception that you have probably heard: Avoid options because they are too risky.

As you will find out, options were created to manage the risks and rewards of stock investing, which is certainly a good feature. However, if you talk to investors or traders about options you will find there are a myriad of opinions. To some investors, the word “options” suggests feelings of risk, gambling, speculation, and reckless investing. To others, options mean hedging your bet, insurance and good money management. How can the same asset cause two opposing views? The reason is that both can be correct. It depends on how you’re using the options. Credit cards are a good analogy. One person can use them to spend excessively and end up in bankruptcy while another uses them to pay for an emergency car repair after being stranded on a deserted road. Are credit cards good or bad? Just as with options, the answer depends on how they are used and managed. Be wary of people who tell you to not waste your time with options because they are too risky, because we can show you strategies that completely eliminate risk. What’s important is that you are able to separate which feature of an option is a benefit for you and which is a risk for you. A risk to someone else may be a benefit for you, and the options market will let you earn money for assuming that risk.

After reading this book, you will know which strategies are right for you and which are too risky. It all depends on your goals and risk tolerances. We want to show you how options can be used to enhance and strengthen your current investment style.
Those who choose to not learn about options may be overlooking the most important and powerful investment tool available. It is our experience that the people most skeptical of options are the ones who often see the most benefits. We believe, by the end of this book, you will find at least one new strategy that appeals to you, and that means you’ll be a little bit better than you are at this point. And that’s how good investors eventually become great – by continually getting a little bit better. At least take the time to understand options; you can always decide to not use them. But our guess is that this book will only open the doors to a new and exciting investment world you never thought possible. So let’s begin our journey and answer a frequently asked question: Why is there an options market?

Why is there an Options Market?
New traders and investors are often overwhelmed by the different financial products available. They are kept busy enough trying to understand and choose between stocks, preferred shares, bonds, mutual funds, closed-end funds, ETFs (Exchange Traded Funds), UITs (Unit Investment Trusts), REITs (Real Estate Investment Trusts), and CMOs (Collateralized Mortgage Obligations).

And now you want to add options?

You must understand that whenever a new product is created, there are always new variations designed to fill slightly different needs. For example, when the Model T was first invented, it solved the broad problem of transportation. People didn’t really care what it looked like. In fact, it is rumored that Henry Ford once quipped, “Customers can have any color they want as long as it’s black.” The Model T was only meant to solve the broader issues of transportation, namely, getting from Point A to Point B.

But once the Model T appeared, others soon came to market with modifications to solve different problems. Today we have many variations such as SUVs, vans, four-wheel drive trucks, extended cabs, crew cabs, compacts, hybrids, and convertibles. While they are all forms of transportation, they fill different needs.

The financial markets are no different from any other product. As problems arise, new financial products are developed to handle them. The stock market was created as a way for publicly-traded companies to raise cash. For example, in March 1986, Microsoft had its IPO (Initial Public Offering) and sold 2.8 million shares for $21 per share. That amounted to an instant check for $58,800,000 for Microsoft. In a relatively short time and very efficiently, Microsoft created nearly 59 million dollars with which the company could grow.

The creation of the stock market solved a very important problem of raising capital but it also introduced a new problem. That problem is risk. If you buy shares of stock you are buying a piece of the company, and that purchase creates the potential for high rewards. Many investors who bought shares of Microsoft in 1986 are millionaires many times over today. But that potential for high reward comes with the potential for high loss. In early 2001, Enron was regarded as a market leader in the energy trading business and one of the largest corporations in the world. Later that year, it filed for what was to become the largest bankruptcy in United States history. Many investors lost their life savings by investing in Enron. So are stocks good or bad? Obviously, it depends on what happens to the stock’s price – and that is something we cannot know beforehand. In other words, there is risk associated with stock investing. In order to make the financial markets run smoother, it would be nice to invent ways to manage the risk involved with stock investing. And that’s exactly the problem that options solve.

To be continued…

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