Options Basics Free Report

What is an Option?

Options are one of many types of securities available in the financial markets. Stocks, bonds, mutual funds, ETFs (Exchange Traded Funds), and REITs (Real Estate Investment Trust) are some of the products you may be more familiar. While “options” are one of many choices in a long list of investment possibilities, they provide a unique advantage. Options provide investors the right, not the obligation, to buy or sell shares of stock. Because they convey rights, options cost far less than shares of stock. So rather than buy or sell shares of stock, you can simply buy an option and control the same number of shares for far less money.

If you buy an option, you are never required to buy or sell shares of stock at any time. Instead, investors buy and sell the options back and forth in the market to capitalize on stock price changes. Options provide investors and speculators advantages that cannot be realized from any other financial asset. Whether you feel stock prices will rise, fall, or even stay still, we can construct option strategies that profit from those outlooks. Options allow investors to choose which risks they want to accept and which to avoid thereby creating some of the most fascinating and unique investment opportunities found anywhere in the financial markets.

How Will I Benefit From Using Options?

There are many advantages in using options rather than stock. First, options cost far less than the underlying stock so they allow you to control shares of stock more efficiently. Second, the most you can lose with an option is the amount you spend so your maximum loss is far less when compared to investors who buy the actual shares. Third, because you can control the same number of shares for less money, options create financial leverage which means you get a larger return on your money for the same price change in the stock. Fourth, because you spend less money, you have more money available to diversify into other investments. In short, options provide opportunity and safety.

Options provide other advantages too. They are the only asset that allows the investor to select particular risks and rewards across various stock prices. Options allow investors to customize their risk-reward profiles, which is something that no other asset can claim. If there are risks you wish to avoid in the market, you can do so by using options. If there are risks you’re willing to accept (and may already be doing so), you can get paid to assume those risks.

What are the Risks?

Option buyers have the right to buy or sell shares of stock for a fixed period of time. In other words, options eventually expire at which point all rights cease to exist. It is this limited lifespan that creates the majority of the risks in options. The risk results from the fact that the buyer of the option must pay a price for the time remaining on the option, a price called the time premium. The time premium creates the need for a greater price movement in the stock in order to break even on the investment. For example, a “call” option gives the buyer the right to buy 100 shares of the underlying stock. If you buy a $50 call, you have the right, not the obligation, to buy 100 shares of the underlying stock for $50 regardless of how high the stock’s price may be.

For that right, you will pay a time premium, say $2, or $200 for the contract since each contract controls 100 shares of stock. If the underlying stock rises to $52 at expiration, the call buyer would just break even. He could buy shares for $50 and immediately sell them for the going price of $52 for a $2 gain. However, because $2 was paid to acquire the option, the investor would just break even on the investment. An investor buying the actual stock, however, would yield a $2 profit. In this case, the stock rising from $50 to $52 created a $2 profit for the stock investor but left the call option buyer with a wash. The risk of the option is that the underlying stock must get moving quickly and in the right direction in order to be profitable. If you buy a stock, you only need the price to rise; it doesn’t really matter how long it takes.

While this may sound like a convincing argument for not buying options, we haven’t revealed the other side of the story. Depending on the strike price you select (the fixed price on the contract), you can control the amount of stock price movement necessary to break even. But in addition, the option also allows you to select the risks you want to accept and that is something that stock buyers cannot do. Option trading is about tradeoffs. Option investors are willing to sacrifice a little bit of potential profit in exchange for not holding all of the downside risk of the stock. In the above example, the $50 call buyer can only lose the $2 premium while the stock holder has $50 worth of risk. So any “risk” in an option is exactly offset by another “benefit” and it is up to the investor to decide which is a risk and which is a benefit.

How Much Do Options Cost?

Options are much cheaper than stock (often a small fraction of the stock’s price) which is one of the major advantages. For example, at this time, Microsoft is trading for $29. The January ’08 $25 call option (328 days until expiration) gives the buyer the right, not the obligation, to buy 100 shares of Microsoft for $25. The price of that call option is $5.35, or $535 for the contract, which is certainly much less than the $2,900 the stock buyer must pay to control the same number of shares.

Because the call option buyer pays only $535/$2,900 = 18% of the stock’s price, the option buyer has more money available for other investments to thus diversify the portfolio.

The investor will break even on the option if the stock price is $25 + $5.35 = $30.35 at expiration, which is only $1.35 higher than the current stock price. In exchange for this disadvantage, the option investor gains a big advantage in knowing the most he can lose is $535 regardless of how far the stock’s price may fall.

Option prices are highly dependent on the volatility of the underlying stock. The volatility is a mathematical measure of the deviations from the stock’s average price. In other words, stocks that have large price swings through a given time period are more volatile that stocks that do not. The more volatile the stock’s price, the more you’ll pay for the option.

Who Can Trade Options?

Generally speaking, anybody can trade options by simply filling out an “option agreement” with their broker. However, brokers are allowed to have their own requirements and some may not allow you to trade options if you fail to meet certain criteria such as insufficient liquid net worth or limited investment experience. But even if that’s true, you can usually reapply at a later time after you’ve gained some knowledge or assets.

Brokers may also assign different “levels” of option approval to your account. The level determines the types of strategies you can use and the more experience you gain, the higher the level they will assign to your account.

What Kinds of Accounts Can Use Options?

Nearly all types of accounts can be approved for options trading provided you fill out an option agreement form. Personal brokerage accounts, IRAs (Individual Retirement Accounts), SEP IRAs (Simplified Employee Pension), Keogh accounts, custodial accounts such as UGMA/UTMA (Uniform Gift to Minors Act/Uniform Transfer to Minors Act), educational accounts such as 529 and Coverdell ESA, trust accounts, and many others are eligible.

Bear in mind that brokerage firms are allowed to make any regulation stricter. So, for example, just because option trading is allowed in an IRA account does not mean that your broker must necessarily allow it. Further, not all account types will be eligible for the same option strategies. For instance, most brokerage firms will approve IRA and custodial accounts for conservative type option strategies but be more flexible for individual brokerage accounts.

How are options similar to stock? / How are they different?

Similarities:

  • Options are securities.
  • Options trade on national SEC (Securities Exchange Commission)-regulated excha
  • Option orders are transacted through market makers and retail participants with bids to buy and offers to sell and can be traded like any other security.

Differences:

  • Options have an expiration date, whereas common stocks can be held forever (unless the company goes bankrupt). If an option is not exercised on or before expiration, it no longer exists and expires worthless.
  • Options exist only as “book entry,” which means they are held electronically. There are no certificates for options like there are for stocks.
  • There is no theoretical limit to the number of options that can be traded on an underlying stock (in practice, there is a limit though). Common stocks have a fixed number of shares outstanding.

 

What Makes Options University Different From Other Companies?

At Options University, we teach option fundamentals. In other words, we teach concepts that are essential for all option investors to understand if they are to succeed with options over the long run.

Other firms typically teach styles and strategies. That is, they put together “recipes” for trading options. They may say, for example, to buy a call option when the stock’s price meets some technical condition, place a stop order according to a prescribed formula, and then sell the option when if it meets another technical condition. While these courses may get you to start trading options sooner, they have a serious flaw in that the instructors have no way of knowing if a particular style fits with your risk tolerances. Just because a strategy appeals to them does not in any way mean it is correct for you.

We do not feel it is our right to tell you which style is right for you. Instead, we’d rather teach you all of the risks and rewards to help you confidently decide which strategy is right for you.

If you are taking courses from other companies, be sure they are clearly detailing the various risks including delta, gamma, vega, theta, rho, v-delta, v-gamma, t-delta, t-gamma, v-theta, liquidity, skew, assignment, pin, hard-to-borrow, and dividend risks. If the instructors are not making you aware of these risks and how they affect your position, you may only end up with learning a false sense of confidence and a recipe for disaster. And that is certainly no way to invest your hard earned money.


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