Disclaimer: We here at skillbuilderdad.com are neither financial advisors nor professionals. This article expresses the opinions from the personnel at skillbuilderdad.com, and is for inspirational and educational purposes only. The investment decisions you choose to make are 100% YOUR responsibility. Investing of any kind involves risk, and options trading can involve BIG risk with BIG losses. It is recommend that you consult a financial advisor before making any trades.
If you are like me and trade stocks on TD Ameritrade, Fidelity, E-Trade, Vanguard, or with some other online brokerage company, then congratulations! You are more financially savvy than the average person! If you have been trading stocks long enough, you have probably heard someone mention that you should start trading options. They tell you this like it’s so EASY to learn, and make you feel that a caveman could probably do it. So you look into it by watching a few videos on YouTube, read a couple articles on Investopedia.com, and get even MORE confused, right!? Well I am here to tell you that this is perfectly NORMAL.
It took me awhile to gain the confidence to make my first stock option trade. The part that kept me curious about stock options was a statement my father made to me, saying that he knew someone who became a millionaire overnight by trading stock options. This had my attention, and I could not stop researching until I learned how to trade them. My father handed me the book that helped this person make his millions, and I read this book from cover to cover. If you are interested in reading it, feel free to buy a copy if you can still find it somewhere: Sure Thing Options Trading, by George Angell, first published in 1984. This book is older than me (and the pages are vintage yellow!) but all the principles are still applicable to today. I get it, most people are not willing to read a boring book about options (especially one that is older than them), which is why I would like to help explain options trading to you.
Learning the basics:
I have always enjoyed the more hands-on approach and learn-by-doing method over anything else. For this reason, I believe the first thing you need to learn about options trading is how to actually make a trade. Since you already know how to buy a stock, I will help you with learning how to buy a stock option. It is similar to buying a stock in which you find a symbol such as BAC (Bank of America), put in a “buy order” for let’s say 100 shares, and set a limit or market order for how much you want to pay, such as $25/share. You know that this will cost you $2500, and you click through the buttons, to agree to buy 100 shares of BAC @ $25/share. Easy, right? How about an option, how do you buy one of these? The trade all starts on a screen called the “Option Chain”, which is a fancy term for “Table”. It actually looks very intimidating when looking at it for the first time:
If this is the first time you are seeing an option chain, please don’t give up. Once you understand it, it will be as easy as buying 100 shares of BAC @ $25/share. Ok, now the explanation. The first thing I want you to do before you keep reading, is to find the “option chain” within your brokerage account. This one happens to be a screenshot from TD Ameritrade, because there’s nothing more American than trading Bank of America on TD Ameritrade (AMERICA!!!). Once you find a table that looks like the one above, give yourself a pat on the back. You are VERY close to making an options trade.
Before we move on to making a trade, let’s learn a few (boring but useful) things about option chains:
- There is a different option chain for each EXPIRATION DATE
- The center column is known as the STRIKE price
- The left columns are for CALLS
- The right columns are for PUTS
Confused yet? Don’t worry, i’ll explain:
Expiration date:
Stock options are different from stocks, in that they have an expiration date. Yes, at some point in time, the stock option you buy will expire worthless.
Think cars and car insurance. Pretend your stock is the car, and the option is an insurance policy. Let’s say you want to buy a 12-month insurance policy for your car. If something bad happens to your car within that 12-month time-frame, your insurance policy has you covered. at the end of the 12-months, if nothing bad happened to your car, then you didn’t have to use your insurance, and it expires worthless. Same goes for a stock option. Bottom line: Stock options have expiration dates.
Strike price:
This is what ties a stock option into the stock itself. The image above is a screenshot of BAC which is trading at $24.98/share if you wanted to buy the stock today. Looking at the table, this is between 24.50 and 25.00. You will notice that the blue/white backgrounds transition at this point, when looking to the left and right of these two numbers. As the stock price moves up and down, the transition lines will move too. For example, if BAC stock when up in price suddenly, and started trading at $27.25/share, the background transition would be between the 27.00 and the 27.50 in the chart above. I will explain more later when talking about strategies, but for now just remember: strike price at the transition is where the stock price is trading at today.
Calls:
When buying a call option, you click on a number in the “ASK” column. When selling a call option (similar to shorting/selling a stock), you click on a number in the “BID” column. I usually remember this as if I’m going to buy or sell a guitar at the music store. If I’m selling my guitar, I have to sell for less than retail (so the store can make a profit). If I’m buying, I have to pay full retail price. Don’t worry, when you set your limit prices, the buyer or seller will usually meet you in the middle, right between the “BID” and “ASK” price. When buying one call option, you are buying one contract to “call away” 100 shares (of stock) from someone for the agreed-upon strike price. As the price of the stock moves up, the value of the call option increases. Also, when you click on a number, let’s say the number in the “ASK” column, and in the “STRIKE” row 25.00, you will be buying a call option @ 25 strike, which shows as a cost of 0.77. This is where things get extra confusing, but stay with me here: Option contracts are for 100 shares, so move the decimal to the right a couple notches, and you will actually be paying $77 for this contract. Going back to the car analogy: The policy costs are shown for 1 car ($0.77) , but you have to buy the insurance policy in 100 car increments, so you will have to multiply the cost by 100, to cover all of your cars ($77). We will get into the strategies of buying and selling call options later. Just remember for now: When buying a call, click in the “ASK” column, when selling a call, click in the “BID” column, and the cost shown needs to be multiplied by 100 to get to your actual cost for one stock option.
Puts:
Buying and selling a put option is similar to a call option. If you want to buy a put, you click in the “ASK” column, and if you want to sell a put, you click in the “BID” column. When buying one put option, you are buying one contract to “put” 100 shares (of stock) to someone for the agreed-upon strike price. As the price of the stock moves down, the value of the put option increases. Referring to the chart above, let’s say you own 100 shares of BAC and you paid $23/share. If you buy a put option for the “ASK” price, at a “STRIKE” price of 23.00, you will pay $22 (remember, 0.22 x 100 = 22). If the stock price drops to $1/share tomorrow, you can choose to exercise your put option contract, and put your 100 shares to someone for $23/share (agreed-upon strike price). The $22 insurance policy in this case saved your skin and allowed you to sell back your shares for exactly what you paid for them. Pretty cool, right? This is a strategy you can use as an insurance policy for your stocks, but all you have to remember right now is: When buying a put, click in the “ASK” column, when selling a put, click in the “BID” column, and the cost shown needs to be multiplied by 100 to get to your actual cost for one stock option.
Go forth and prosper:
You have now learned all about an option chain. I recommend you login to your brokerage account, find your favorite stock, and look at option chains for different expiration dates. Observe how prices generally increase for expiration dates further into the future. Also look at how call options are cheaper at higher strikes, and how put options are cheaper at lower strikes. Then try to buy a call option for .01, which will cost you only $1. If you get an error, you might need to ask your brokerage account company for permission to trade options.
In my next posts, I will talk about different strategies you can use to make money with trading stock options. Good luck, and have fun!
Update – Click any link below to read more about options trading strategies:
Options Part 2: How To Buy Lottery Tickets In The Stock Market (Buying Calls)
Options Part 3: How to collect better dividends on the stocks you own (Writing Covered Calls)
Options part 4: Get paid to buy stocks (selling puts)