An Introduction to Options

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Mar 22nd, 2013 | By | Category: Investor Education, Trend Playbook

We’ve been getting a lot of questions about options here at Trend Playbook, so I wanted to cover some of the basics today…

In the world of finance, “options” isn’t just a word for your investment choices — options are financial instruments that Wall Street gurus and individual investors can use to make substantial gains. Most people don’t use options — in fact, most individual investors don’t understand how they work — but we can solve the mystery for you so you can profit…

What Are Options?

Options are investments that give you the ability to buy or sell a specific stock at a specific price (the strike price). In other words, buying an option gives you the ability to buy or sell a stock for a locked-in price…I’ll get into the specifics in a minute.

Options are derivatives, which means that their values are tied to other securities…in this case, stocks. So when a company’s stock price changes, so will the prices of the stock’s options.

Just as with stocks, you can buy and sell options through your online broker. It’s important to keep in mind, though, that your broker likely uses a different commission structure for buying or selling options than they do for stocks — you’ll have to ask to find out.

Unlike stocks, however, the company doesn’t issue the options that trade on the open market. Instead, options are issued (or written) by other traders. That doesn’t mean that you’re opening yourself up to extra risk (known as counterparty risk) by buying an option from a small-time trader — major options clearinghouses are on the hook for trades that go sour, so they have strict rules in place to keep risks minimized. Since options were introduced, there has never been a failure of an options clearinghouse in the U.S.

What Kinds of Options Are out There?

There are basically two different kinds of options out there — call options and put options. Call options give the owner the right to buy shares of a stock at a predetermined price, and put options give the owner the right to sell them at a predetermined price.

If you think that Apple (AAPL:NASDAQ) is going to see $500 again in the near term, you could buy a call option with a strike price of $450 and own the right to buy Apple at $450 after it hits $500 — that’s a nice locked-in gain!

If your hunch was wrong and Apple slides to $400, you could choose not to buy the shares at $450 and be out only what you paid for the option. Currently, AAPL $450 April 2013 calls will run you $21.70. That price (or premium) factors in the probability that shares of Apple will trade above $450 before the options expire.

As I mentioned, put options give you the right to sell shares of a stock you believe will decrease in value, but, in this case, at a higher price. Going back to the same example…

If you think Apple’s set for a fall, you could buy a put option with that same $450 strike price and own the right to sell Apple shares at $450 per share after it falls. As I write, those $450 puts for April currently cost $17.55. Because option prices are a fraction of the price of the underlying stock, options provide magnified risk/reward trade-offs. That means that if you make 10% on shares, you could potentially make 100% or more by trading options instead.

Remember, though, options give you the right, not the obligation to buy or sell a stock at a specific price…You’re not required to exercise the option. If a stock doesn’t end up doing what you expected, you can still just let your options expire and be out only the price you paid for the options themselves.

That’s significant — unlike other complex investments, it means that you can’t lose any more than you invest with options.

Option prices also aren’t stagnant. If you buy an option and watch it climb in value, you can sell it long before the option expires and you’re forced to either exercise it or let it expire worthless.

Who Uses Options?

These days, everybody uses options — and for good reason…

Options are a great way to hedge, or insure, your investments against downside. If you like Apple for a long-term play, but aren’t so sure about its short-term risks, you can buy AAPL stock alongside put options for the company. That way, if the stock does take a hit, you can offset your losses on the stock with the money you make on the options.

If you end up not needing the option play, you’re still out only the price of the option. Just consider that cost an insurance premium for your portfolio.

In the big leagues of investing, plenty of portfolio managers use options to hedge against losses, but don’t think that only financial companies use hedging!

Southwest Airlines (NYSE:LUV) has long been a favorite stock in an industry that’s seen crippling losses. How’d they do it? Southwest saved their skin by making prescient investments in derivatives that were tied to oil prices. Southwest limited their exposure to soaring jet fuel prices while other airlines saw their margins collapse.

An Experiment You Could Profit From

Options are a stellar choice for investors who want to ramp up their risk/reward trade-off but still keep their risks limited. That said, they do have a steep learning curve — and this basic primer barely scratches the surface of what you need to know to trade them successfully. But I want to change that…

Next month, I’ll be conducting an exciting options trading experiment.

It’s designed to give you a crash course on options investing, and it’s completely free. All I ask is that you help me prove to my publisher that I can teach any investor how to effectively trade options in just a single week. The experiment may sound familiar to some Trend Playbook readers — we did the same thing with trading stocks in late 2012, taking the average experiment participant from earning a C on our trading quiz to earning an A.

The options experiment doesn’t start until next month. I’ll send you instructions on how you can join the test group here in Trend Playbook when we’re closer to going live with it. In the meantime, send me any questions you have on options to trendplaybook@agorafinancial.com

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Author Image for Jonas Elmerraji

Jonas Elmerraji

Jonas Elmerraji, CMT, is the co-editor of STORM Signals and Penny Stock Fortunes, and a contributor to Agora Financial’s Trend Playbook. Jonas got his start on the fundamental side of the market, poring over financial statements and valuations to find sound investments – today, he specializes in blending fundamental and technical analysis. Jonas is a senior contributor to TheStreet.com, and has been featured as an investment expert in Forbes, Investors Business Daily, and CNBC.com among others. 

Jonas holds a degree in financial economics from UMBC and the Chartered Market Technician designation.

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