Options are an incredibly simple concept with all the complexities that mankind can possibly add to them. For many, the simplicity is lost in the seas of complications and they end up losing money and failing on their journey. So let's break it down.
OPTIONS CONSIST OF 2 THINGS
AND BECAUSE WE LOVE A GOOD METAPHOR...
We use options in our everyday life. Most of us have insurance of some kind. Health, life, auto, home... What is the purpose of these insurance contracts? The purpose is to make us whole should some sort of big loss happen. We pay a premium each month for the right to be reimbursed or covered for something much larger.
This insurance contract is a put option. In the market, a put option doesn’t cover our car, but rather our stock. If we were to buy Apple stock, we could buy a put option to cover our losses should the stock plummet.
The put contract has a buyer and a seller, just like an insurance contract. I send my insurance company money, making me the buyer and the one who has rights. The insurance company accepts my money and takes on an obligation for a defined period of time. Put options are the same.
Call options differ in our analogy as those contracts ‘make us whole’ if the stock goes up rather than down. This can be a funny concept but since stocks can go up or down, we can insure them in both directions.
In the options world, we do not have to own the underlying stock to buy and sell these insurance or options contracts. These contracts are buyable with the click of a button and can be sold just as easy. Over 17 million options contracts are traded daily! And that number continues to grow.
Investopedia.com haș some excellent sources on understanding calls and puts. We can highly recommend it!
so what can options do for you?
- No. 01 — GIVE LEVERAGE
- Options allow us to make the gains of a stock for pennies on the dollar. This is the reason I trade options. I can lower my total dollar risk and increase my reward potential when compared to trading a stock.
- No. 02 — ALLOW FOR FLEXIBILITY
- Options give us the ability to bet on stocks going up or down without the massive capital requirements.
ARE THERE DANGERS TO OPTIONS?
YOU BETCHA THERE ARE!
- No. 01 — HIGHER TRADE COMMISSIONS
- Each time we make a trade, we pay more to the broker than we would in a traditional stock trade.
- No. 02 — TIME DECAY
- With stocks, we can hold forever. We can wait for our price to come. With options, the value decays a little bit each day. In order to offset this decay we need to be able to ‘forecast’ a stock's price movement.