Hello Option Traders,

Introduction

            I am officially declaring today (11/12/2008) 'basics day' in OptionsLand. Option basics are some of the most important concepts in the equities market. Without a firm understanding of how options move, there would be no point in trading them. Many theory concepts go into understanding stock options since a large amount of their value comes from theoretically calculated price data.

            This segment is broken up into three parts and will be posted through out the week. Enjoy the training and feel free to contact me if you have any questions.

Back to Basics pt. 1

            An option is the right, but not the obligation, to purchase a specified stock for a specific price by a specific time. An option is a way for a trader to rent the stock’s movement, but not actually own it. I think of an option in the way we rent dvds from a movie rental store. Let’s say a new release comes out and I want to see it. I may not want to pay $25 for that movie, but I’ll pay $3 to rent that movie for 2 days. By leveraging the position and renting the stock for only the time we need it, traders can control a massive amount of stock for a small fraction of the overall cost.

The Four Cornerstones

Any trader in the stock market needs to be aware of all the tools they have at their disposal. Think of options as a way to get a ‘one-up’ on the market in favorable and unfavorable conditions. The original intention of stock options was to be used in conjunction with a stock position. Options originally offset a losing position so a trader could be slightly profitable even when his stock position was negative. This concept is known as a ‘hedge’ trade. As any trader becomes more knowledgeable, combinations of options are easily constructed for a variety of hedge trades.

There are four distinct ways to trade an option contract. If traders can understand these ways, options can give an investor complete leverage no matter the market condition. These four ways are called the Four Cornerstones of Options.

The fifth cornerstone the underlying equity.

Long Call: A trader will purchase a long call if they think the underlying stock will increase in value. The call will increase in value as the stock goes up. The trader will then sell the option at a higher value than it was purchased. Buy low, sell high.

“Call me up!”

Long Put: A trader will purchase a long put if they think the underlying stock will decrease in value. The put will increase in value as the stock drops in value. The trader will sell the put at a higher price than it was purchased. Buy low, sell high.

“Put me down!”

Short Call: A trader will sell a call and collect the premium (cost of the option) upfront. If the stock goes down in price by the expiration date, the trader will be able to keep the entire premium and not have to pay a commission to the broker to get out of the trade. This is a very risky trade since the profit is limited and the loss is unlimited.

Short Put: A trader will sell a put and collect the premium upfront. If the stock goes up in price by the expiration date, the trader can keep the entire premium and not pay a commission on the exit. The same risk applies to the short put as the short call, limited profit, but unlimited loss.

Conclusion

            This concludes the first of a three part segment on reviewing the basics of options. Stay tuned for updates through out the week.

Tim Truelove

National Trainer II, Wizetrade Options