I get asked this question often so today I decided to answer it here just in case others are wondering. I talk about options a lot on this site because that’s the main security I trade. I do buy stocks too but only after I get enough proceeds to buy a hundred shares. At the moment, the largest position in stocks in my portfolio is GRPN (Groupon) and the largest option contracts are Google and Priceline.
Options can be a bit complicated to explain but easy to understand if explained properly. When I started trading years ago, it was hard for me to find a tutorial that explained the difference or the likeness of them properly. It wasn’t until I met a gentleman from Germany at my university. I had known him for a bit over a year before we had the discussion on trading. I didn’t know he was a trader too. But then I only traded stocks. He said to me,
“stocks are boring, you need to get into trading options. You will make more money if you learn well”.
Since I didn’t know what options were all about I started scouring the internet and learning little by little and when I didn’t understand something I asked him. And it became much easier to explain options to others.
What is a stock?
A stock is simple. It’s like buying something that you don’t want to use right away. You can but the longer you own it the better it gets in that it makes you wealthier (hopefully). It’s like buying gold at $4 and hoping that with time, the price of that gold will only increase because the demand for it will increase.
When you buy a stock, you are buying a part in a company. You are literally buying into a company. The better the company does, the higher your stock goes and the more money you make.
So let’s say you buy the stock in Microsoft or any other company at the exact position the arrow is pointing. Then the company comes out with a new product, the stock goes up, the company acquires another company that does something better than it does at the time, the stock goes up and they just keep improving things and improving things sending the stock higher and higher. That’s how stocks work.
Of course the opposite can happen too. The company can make some bad business decisions and send the stock falling and you can lose money as well (if you sell it as it’s falling ….not recommended). But as you can see on the chart, stocks don’t always go in one direction, they zig zag, they fall and rise and fall and rise. Eventually they rise to were people are happy to sell some shares and collect cash and then maybe buy again when it falls and repeat the process. Let’s look at options in more detail.
What is an option?
Options work the same way as stocks. The difference is, with options you can make money if they go up or down. I will explain this in a little bit. An option is essentially the shadow of a particular stock.
Whereas a stock’s value comes from the company whose stock you own, an options value comes from the stock of that company. The value of the stock determines the price of the option and the value of the company determines the price of the stock. Does that make sense? Okay then let’s move on.
The time value
Since the option gets its value from the stock, an option has another dimension, time. There is a time value in options. The longer you own them, the less valuable they become and eventually expire. That’s why it’s good to make a plan and set a target price when buying and selling options so that when your target has been met by the option, you sell it and pocket your money.
weekly options – expire within a weeks time (my favorite types to trade)
Mini options – smaller amount shares in each contract
6 months options – you can buy them 6 months in advance and sell within that time
Yearly options – you can buy some a year in advance. I have never done this.
And all of these operate under the same rules of time value. Time value is also known as decay. And you know what happens to something that is decaying! It eventually becomes nothing.
The Delta of an option is very important. Why? Because that’s what determines how quickly your option will go up or down in price. The higher the delta the better or the faster the price of the stock (body) will determine the price of the option (the shadow of the body). If an option has a delta of 1.00 this means it has 100% delta. This in turn means, if the price of the stock is $30, and it moves to $31, your option will also move up by $1. And you will gain $100 because each option contract has 100 shares and $1 X 100 = $100.
If an option has a delta of .50 then the price will only move $.50. So if we use the same stock price of $30 above and it moves to $31 then you would only make $50 and not $100. So that’s why the delta is so important.
Keep in mind
Options only trade during market hours.
Options expire (sometimes worthless) at some point in the future unlike stocks (unless the company goes under).
Owning options doesn’t mean you own a part of the company like a stock does.
Options only give you the right to buy or sell the company stock that’s it. You can exercise that right or not.
Options only derive/get their value only from the stock the option is a shadow of.
Types of options
If a stock is trading at $10 example
There are two types of options.
Owning a call option with a strike price of $10 allows you to buy that stock at $10 no matter what price it is in future. However, owning the option is not owning the stock. It only gives you the right to buy the stock at a specific price if you want to.
When you buy a call option, you are betting that the stock will go up therefore it’s shadow (the option) will move with it.
Owning a put option with a strike price of $10 allows you to SELL that stock for $10 no matter what price it is in future. However, owning the option is not the same as shorting the stock. It only gives you the right to sell the stock at a specific price if you want to.
When you buy a put option, you are betting that the stock will drop in price therefore it’s shadow (the option) will move with it.
Whereas with stock you can only make money if the stock goes up, with options you can make money if the stock goes up or down by simply buying a call or a put option. Cool huh!
And that pretty much explains it. If you are have any questions, the comment form is below.