Puts, calls, strike prices, expiration. If you don’t get options, I don’t blame you. But if you shy away from these instruments out of fear, you’re missing out on a rare chance to increase your trading gains.

Let me show you how…

Yes, option investing can be intimidating. After all, the financial press blames derivatives (like options) for a major part of the financial crisis of 2008. Options move violently — and they can expire completely worthless. It’s no surprise, then, that most investors avoid options at all costs.

But when used intelligently, options can significantly increase your profitability by magnifying stock gains while limiting risk to your initial investment (unlike traditional leverage, which can actually leave you owing money).

To be sure, options can be incredibly complex. Today, we’ll just look at an overview of how options work — and how they apply to your next trade.

How Options Work

Basically, an option is a contract that gives its owner the right to buy or sell a stock at a predetermined price on a predetermined date. Buying call options gives you the right to buy shares of a stock at that price, whereas buying put options gives you the right to sell them at that price.

Time is an important factor for options. Options expire on the third Friday of each month (unless it’s a holiday, in which case they expire on the preceding Thursday) — that date, known as the expiration date, is a major contributor to the option’s value. The further that date is from now, the longer the stock (known as the “underlying”) has to increase in value. That potential value (known as extrinsic value) decreases as time passes.

An option’s real value is the difference between the strike price (the price you can buy or sell on the contract) and the price of its underlying stock. For an oversimplified example, let’s say that today is Jan. 1, and you own $10 March call options on General Electric. If GE currently trades for $15, the difference between the $10 strike price and $15 share price is the stock’s intrinsic, or real, value.

It’s the option’s real value because it’s the gain you’d book if you exercised the option today — think about if you use the option to buy GE shares for $10 and then resell them on the market for $15. That’s a $5 per share profit. But that option doesn’t trade for just $5 — because GE still has months to appreciate, the option may cost closer to $6. That possible extra dollar is the extrinsic, or time, value.

Options are interesting because of the size of their moves. If GE moved $2 higher, the company’s stock would have gained 13% — not bad for a blue chip. But our $6 option would have gained more than 33% in real value alone.

There’s a difference between being an options investor and being an options trader. Generally speaking, traders have little interest in holding onto options plays until expiration — I’m a fan of that camp myself. Instead, we aim to buy for a jump in our options’ prices and then sell for a gain…

So, how do you get started in the options game?

To start, look back at your trading portfolio and see what would have happened if you’d bought an option instead of a stock. By experimenting with how options would have impacted your profits after the fact, you can get a much better idea of how different strike prices and expiration dates impact option prices.

I would strongly advise against adding options to your portfolio until you have some experience paper trading them and understand more of the technical features of options. But as a starting point, experimenting with your past real world trades is a great way to flatten the learning curve.

I’ll show you some more options tricks in the coming weeks. If you have any options questions for me, send them to editor@pennysleuth.com.

Cheers,

Jonas Elmerraji
for The Penny Sleuth

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• May 27, 2011 -- Options Rundown: Producing Large Gains from Small Market Movement
• September 17, 2009 -- Three Must-Know Rules to Profit from Options
• May 24, 2012 -- Your Three Biggest Binary Questions… Answered
• June 27, 2011 -- Why Wait? How You Can Collect “Weekly” Profits…

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.

View articles by Jonas Elmerraji