Options Trading Tutorial

I want to learn about buying stock options. Is my idea (below) correct on how it works?

I have a stock trading account and I have been playing around with "day trading" stocks for about 2 years. I've taught myself certain strategies that I use and I am now pretty comfortable that most of my picks will increase soon after buying a stock. I am now interested in stock options. Here is my understanding... If I find a stock currently trading at $30 and I think the stock will increase 10% in the near future, I can either buy, say 100 shares at $30 ($3000) and hope for a 10% increase, or I can buy an option to buy (100 shares) at a fraction of the $30 - maybe for $1 per share = $100. This option gives me the right to purchase the 100 shares at $30 even if/when the price increases 10% to $33. At that time, I then can buy the 100 shares at $30 ($3,000) and immediately sell the 100 shares at $33 ($3,300). I loose the $100 for the option purchased, but I make the $300 difference with a net of $200. I stand to loose the original $100 if the price doesn't go up, but I don't have to invest the full $3,000 until it is a sure profit maker. Is this the basic idea of stock options?

Public Comments

1. I don't know a thing about stock options except that my husband lost close to $20,000 mucking around in them a few years ago.
2. Yes I think you get the jist of call options.
3. You must be approved for options trading on most online brokerages. I'm familiar with E*Trade and to write calls you must be approved to level 1 (instant approval upon request) and to buy calls or puts you must be approved for level 2, it goes to level 4. Writing a call is where you own 100 shares of a stock and you write the call option for a specific strike price and receive the price for that option times 100 (or however many contracts you write, 1 contract = 100 shares) Then if someone who bought that actual option decides to exercise it before expiration you are required to sell your stock to him for the strike price. That's all you can do with level 1 options trading. To buy a call or a put for just the strike price (times 100) you must be approved for level 2 options trading. E*Trade requires you to read Characteristics and Risks of Standardized Options before requesting for options trading.
4. You are partly right, partly wrong. In your example, if you buy a call option and the stock goes up above the strike price, you do not have to execute the option and buy the stock in order to make a profit. You can simply sell the call option (close the position), which should increase in value if the stock goes up. The problem is that a person buying a call pays a premium and that premium tends to erode or loose a little value each day as it gets closer to the expiration date of the option. A much safer way to 'play calls' is to sell the calls against stocks which you already own. You can generally sell one call against every 100 shares of stock that you own. You receive the premium and if the stock trades above the strike price the stock is sold for you and you get the amount of the strike, minus of course the commission to sell. I have read that 90% of gamblers who buy naked call options lose money on the options. I was one of those and I lost $90,000 before I stopped gambling. Good luck -- you will need it!
5. <<<I want to learn about buying stock options.>>> I strongly encourage you to learn about them before trading them. I suggest you start at the CBOE Learning Center http://www.cboe.com/LearnCenter/default.aspx and the OIC Options Education site at http://www.optionseducation.org/ There a a lot of good, accurate, free, well written education material at both sites. Then, if you are still interested in trading options, I suggest you read at least one good book about options. <<<Is my idea (below) correct on how it works?>>> Your idea is one possible way to use options. There are hundreds of other ways, including a lot that most people would consider much safer than what you suggested. ------------------ Successful option traders almost always trade volatility more than stock direction. Until you understand what that means, and why it is true, you are likely to lose money if you try trading options.
6. You're kind of right, but don't be deceived! Options are a different animal than plain stocks because you have a whole different variable to deal with. When options come in the picture you have something called "Implied volatility" which stocks never have to deal with at all. Yes stocks have "historical volatility" (which has to do with the movement of the underlying asset) but they do not deal with "implied volatility" (which has to do with the price of the option which may be over or under the theoretical value of the option ((T-value)). The t-value is what historical volatility says the option should be price at, but the option is almost always priced higher or lower than this). Given this, you may buy an option believing that the price of the stock will go up, and indeed as you forecasted, the stock price goes up. But to your amazement and horror, your option value has gone down. How is this possible? Well, it's that variable I was telling you about. You may have purchased the option when its implied volatility was very high (and therefore expensive) and then - say on a stock's earnings release- the stock makes a large upward move, but your options value has fallen. This is because it's implied volatility has fallen, bringing down the value of the option though it's underlying asset has gone up in value. Do not get into options thinking that it is another way to play the stock market. It is very different... though similar.
7. Your idea is pretty much correct, except that you don't need to hold an option to expiry date. It is better to sell the option for a profit, which is what will happen if the stock price goes in the direction you expected. But simply buying an option is not all that's available to you. You see, with options, you can combine various simultaneous buy AND sell combinations, as well as expiry date variables. To take your own example, you could also buy a $30 call option and simultaneously SELL (write) a $32.50 call option. The money you receive from the sold position, offsets the cost of the bought position. You can also eliminate the "time" premium and volatility factors when you do this. They are called "debit spreads" because they result in a net debit from your brokerage account. The beauty of debit spreads is that, for around the same cost, you can give yourself plenty of time to be right - say, at least 90 days. If the price goes against you, you can often buy back the "sold" position for virtually nothing and wait to make a profit, or at least break even, on the bought position, should the stock rebound a little. I'm not a fan of simply buying options in the hope of selling them for profit. Been there, done that, without much success. But spreads are a different ballgame and you can do quite well with these. But if it's short term option trading you want to do, there's an online class you might find useful that I've seen at http://optiontradingfortune.com/stock-market-online-classes This guy is a successful short term options trader, who shows you exactly what he does in real time ... for a fee of course :-) They've got a whole lot of stuff about spread trading there as well.