Often I feel like stock traders are lucky. Explaining what they do is easier than explaining options trading. Heck, I would even go so far as to say that investing in stocks is easier than options trading, but that's another argument for another day.
People, for the most part, understand investing in stocks. If you were to tell them you are a stock trader, they would at least have a vague idea of what you do, but when I tell people I trade stock options I get blank stares more than anything else.
If they are aware of stock options, they either think I'm talking about employee stock options or have heard of the apparent risk of options trading.
Stock options are gaining popularity, but the mass population is still not fully aware of their existence. I've decided that my first few post are going to be educational overviews of options trading.
If my simplicity offends you educated folk, I give you my apologies up front. This is for the newbies and the uninformed (smile).
Stock options are versatile and can be quite complex. There are numerous trading strategies and trading combinations that one can use. I'm just going to give a very basic and simplified idea of what I do as an options trader, but first let me give you my overview of trading stocks.
Buying Stocks for a Profit
Stock Options
A stock option is not a physical thing like owning shares in a company. Instead, it's a contract between two parties.
When you own stock (or shares), you actually own a piece of the company. An option is an agreement, or contract, where one party agrees to deliver something to another party within a specific time period and for a specific price.
Now let me explain option trading (the buying side only):
"Real estate investors" buy and sell homes. "Option traders" buy and sell contracts.
Stock Option Definition: If you buy or own a stock option contract it gives you the "right", but not the obligation, to buy or sell shares of a stock at a set price on or before a given date.
It's merely a contract that grants you certain rights. Having a membership to the gym gives you the right to go to the gym, but you're not obligated to go.
Stock options are called derivatives. That's actually their proper name.
Children are derived from their parents. Cheese is derived from milk. Stock options are derived from stocks. You can't have the latter without the former.
Technically speaking, the term derivative refers to how the price of these contracts is derived from the price of the stock. Their value is dependent on the price of the stock it was created for. IBM stock options are created for IBM the stock. Generally, the option's value will rise and fall in sync with the stock price.
Okay, I assume you understand how buying shares of stock can be profitable, but how can buying contracts be profitable?
Buying Contracts for a Profit
Let's assume you find a house you want to buy for $100,000. You go to a realtor and submit a contract to the sellers, and it's accepted. Let's say the closing date is 3 months away. Within those three months Donald Trump announces he's going to build a high end golf course down the street from that house. Lucky you, you have a contract that says you get to buy the house for $100,000.
My assumption is that property values in that area would most likely increase. So let's say the house increased in value to $130,000. Once you buy the house you could immediately turn around and sell it for a $30,000 profit. Or you could take the approach of an options trader.
That contract now has more value because the underlying asset it's attached to has increased in value. So you could sell or assign your contract to someone else easily for $5,000 because that still leaves $25,000 equity left over in the deal.
So that's my over simplified example of how buying and selling contracts can be profitable. Stocks work essentially the same way.
Let's say that back in March you purchased a stock option (contract) that gives you the right to buy Goldman Sachs (GS) for $70. Now 3 months later GS is trading for $143, but you hold a contract that gives you the right to purchase it for $70. Do you think your contracts perceived value has increased? Yup, it sure has. So essentially you turn around and sell it for more than you paid for it.
The option contract went up in value because the underlying asset (stock) it was attached to went up in value.
I hope these examples at least gave you a better understanding of stock options. Next time I'll talk about the two different kinds of stock options, Puts and Calls.
Happy Trading, Travis
http://www.pursuingwealth.com/
P.S. On a side note, these stocks triggered for long trades (AAPL, BIDU, AMG, QQQQ), but I'm not taking the trades because the stock market has risen too sharply in too short of a period of time. I am leery of a pull back in prices as people take some profits. I put these stocks on my watch list. I will merely watch and see what they do. There are a few more market conditions I want to see met before I enter any more long positions.
People, for the most part, understand investing in stocks. If you were to tell them you are a stock trader, they would at least have a vague idea of what you do, but when I tell people I trade stock options I get blank stares more than anything else.
If they are aware of stock options, they either think I'm talking about employee stock options or have heard of the apparent risk of options trading.
Stock options are gaining popularity, but the mass population is still not fully aware of their existence. I've decided that my first few post are going to be educational overviews of options trading.
If my simplicity offends you educated folk, I give you my apologies up front. This is for the newbies and the uninformed (smile).
Stock options are versatile and can be quite complex. There are numerous trading strategies and trading combinations that one can use. I'm just going to give a very basic and simplified idea of what I do as an options trader, but first let me give you my overview of trading stocks.
Buying Stocks for a Profit
- You buy shares of a company's stock. A share is a small piece of ownership in a company. You're "sharing" in that ownership with other investors. This share (piece) is assigned a value
- The shares increase in value (the company's perceived value increases)
- You sell your shares (sell your piece of ownership to someone else) and pocket the difference between what you paid for them and what you sold them for
Stock Options
A stock option is not a physical thing like owning shares in a company. Instead, it's a contract between two parties.
When you own stock (or shares), you actually own a piece of the company. An option is an agreement, or contract, where one party agrees to deliver something to another party within a specific time period and for a specific price.
Now let me explain option trading (the buying side only):
- You buy a contract
- Your contract goes up in value
- You sell your contract for more than you paid for it and pocket the difference
"Real estate investors" buy and sell homes. "Option traders" buy and sell contracts.
Stock Option Definition: If you buy or own a stock option contract it gives you the "right", but not the obligation, to buy or sell shares of a stock at a set price on or before a given date.
It's merely a contract that grants you certain rights. Having a membership to the gym gives you the right to go to the gym, but you're not obligated to go.
Stock options are called derivatives. That's actually their proper name.
Children are derived from their parents. Cheese is derived from milk. Stock options are derived from stocks. You can't have the latter without the former.
Technically speaking, the term derivative refers to how the price of these contracts is derived from the price of the stock. Their value is dependent on the price of the stock it was created for. IBM stock options are created for IBM the stock. Generally, the option's value will rise and fall in sync with the stock price.
Okay, I assume you understand how buying shares of stock can be profitable, but how can buying contracts be profitable?
Buying Contracts for a Profit
Let's assume you find a house you want to buy for $100,000. You go to a realtor and submit a contract to the sellers, and it's accepted. Let's say the closing date is 3 months away. Within those three months Donald Trump announces he's going to build a high end golf course down the street from that house. Lucky you, you have a contract that says you get to buy the house for $100,000.
My assumption is that property values in that area would most likely increase. So let's say the house increased in value to $130,000. Once you buy the house you could immediately turn around and sell it for a $30,000 profit. Or you could take the approach of an options trader.
That contract now has more value because the underlying asset it's attached to has increased in value. So you could sell or assign your contract to someone else easily for $5,000 because that still leaves $25,000 equity left over in the deal.
So that's my over simplified example of how buying and selling contracts can be profitable. Stocks work essentially the same way.
Let's say that back in March you purchased a stock option (contract) that gives you the right to buy Goldman Sachs (GS) for $70. Now 3 months later GS is trading for $143, but you hold a contract that gives you the right to purchase it for $70. Do you think your contracts perceived value has increased? Yup, it sure has. So essentially you turn around and sell it for more than you paid for it.
The option contract went up in value because the underlying asset (stock) it was attached to went up in value.
I hope these examples at least gave you a better understanding of stock options. Next time I'll talk about the two different kinds of stock options, Puts and Calls.
Happy Trading, Travis
http://www.pursuingwealth.com/
P.S. On a side note, these stocks triggered for long trades (AAPL, BIDU, AMG, QQQQ), but I'm not taking the trades because the stock market has risen too sharply in too short of a period of time. I am leery of a pull back in prices as people take some profits. I put these stocks on my watch list. I will merely watch and see what they do. There are a few more market conditions I want to see met before I enter any more long positions.
5 Comments:
I've been curious about options trading since I read "Fooled by Randomness," which talked about it but didn't explain it. You do a good job of explaining it here, but I'm still not totally clear on why there would be any reason to trade options instead of stocks. With house contracts, it makes more sense, because you may not want to actually ever have to deal with the physical thing. But a stock to me seems about as theoretical as a stock options, except that an option is less direct. If the stock's value is going to go up, why not just have the stock and sell it when you would have sold the option? Maybe you'll address this in a future post. Anyway, good job explaining something that was completely alien to me before. I think you're right to take the overly simplistic approach with this one. I wish more people would take the time to explain aspects of the financial industry in clearer (non-jargony) terms. If small talk can save your life, as the authors of The Power of Small pointed out ( http://tinyurl.com/csd7je ), maybe small talk could have saved our economy.
Thanks! I really appreciate the simplicity of your explanations. I'm looking forward to your further blogs on this same subject.
Rhys,
1 Option contract controls 100 shares of stock.
Many people who can not afford 100 shares of a stock, ie AAPL, will buy an Option.
I hope that helps?
Travis,
I agree with Ian - terrific post! Thank you!!!
TG and Ian, thanks for the compliments.
An extra thank you TG for answering Rhys questions.
Rhys you gave me my material for my next few posts, so yes I'll be sure to address your questions in my next post or two.
Thanks for the Youtube link.
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