Options Trading Tutorial | A Day Trading Primer

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Options contracts are like a monetary lever – a really long lever for trading profits. Place your fulcrum (strike price and expiration date) in the right spot and your profits can make planet sized movements. Let’s take a look at how contracts create leverage.

One note to make is that we do not discuss transaction costs in our examples. Transaction costs at these minimal amounts discussed ($100) would completely eat away profits. Trades in excess of $1000 net investment typically are of large enough scale to overcome the transaction cost efficiency hurdle – so bear that in mind as you make your first trades. Invest at least $1000 per trade.

Trading Options Is about Owning and Mastering Leverage

Leverage Turns Small Capital Investments into Huge Gains

If you’re new to the concept of trading options, you are probably here trying to learn the basic mechanics of an option trade, what the basic terminology is, and most importantly – how to profit from this knowledge.

What I will tell you is that amazingly, the options market is not rigged against the individual investor. Quite the contrary – getting into the options trading market and making some trades is actually a great way for a person with a modest sum of money ($2000 to $10000 depending on the broker) to significantly and quickly multiply it. I personally have made around 25% of my income this year trading stock options. There is no particular special formula – it is only a question of understanding what are the positions you can take and what circumstances lead to profit for you. With that, I’m going to take you through some basic examples.

Glossary for this Basic Options Trading Tutorial

There are a few terms you need to know to be able to understand stock options and how to make your first trades. I will be referring specifically to American options, and I will note later some of the differences between American options and European options.

Terms You Need to Know:

Call Option (or contract): The right to buy a specified amount of shares (usually 100) at a specified (strike) price on or before a specific date. Contracts may be executed any time prior to expiration (American options only).

Put Option (or contract): The right to sell a specified amount of shares (usually 100) at a specified (strike) price on or before a specific date. Contracts may be executed any time prior to expiration (American options only).

Underlying Security: The actual stock (or equity position) on which the option contract is written. A call option written on Google stock is the right to buy shares of Google stock.

Strike Price: The ‘contract’ or ‘specified’ price of the option. This is the price where a transition from loss to profit takes place on a contract. If the price of a call option rises above the strike price the trader has a profitable position (considered “in the money”). A call option which has a strike price above the current spot price of the underlying security is considered “out of the money” and can not be executed profitably at present.

Call Premium: The price per contract paid for the right to buy a stock. A $1 call premium on a contract (representing 100 shares) will result in a payment of $100 ($1 x 100 shares) just to own the right to buy those 100 shares at the strike price at a future date.

Put Premium: The price per contract paid for the right to sell a stock. A $1 put premium on a contract (representing 100 shares) will result in a payment of $100 ($1 x 100 shares) just to own the right to sell those 100 shares at the strike price at a future date.

In the Money Options: Options which can be executed profitably – where the spot price on the underlying security is in a favorable position relative to the strike price of the contract. In the case of a call option, the spot price would have to be above the strike price. In the case of a put option – the spot price would need to be below the strike price.

Out of the Money Options: Options which can not be executed profitably – where the spot price on the underlying security is NOT in a favorable position relative to the strike price of the contract. In the case of a call option, the spot price would have to be below the strike price. In the case of a put option – the spot price would need to be above the strike price.

Making Money Trading Options

A Favorable Call Option Trade Example 

(download call option payoff worksheet ExcelOpenOffice)

I like to work with the most intuitive of the trades – the call option first. We’ll pretend that we’ve bought a call option with a strike price of $25.00 on Microsoft stock (let’s presume someone simply gave it to us for the moment). It just so happens Microsoft is trading just below $30/share today so we’ll pretend it’s trading at $30.00 even for simplicity’s sake. Given the circumstances we describe – what is our potential payout position?

We own 1 call option of MSFT with a strike price of $25/share. If we were to execute the contract today, we would pay $2500 ($25.00/share * 100 shares) and be immediately able to sell those shares directly in the stock market for $3000 ($30/share * 100 shares) = an instant profit of $500. Pretty kewl, huh?

Let’s go one step further. Let’s presume we paid $1.00 call premium for the contract – meaning we paid $100 ($1 call premium per share * 100 shares). This means we invested $100 and earned $400 net profit ($500 profit less $100 cost) – a 400% gain!

What would our return have been if we had used our $100 initial investment to buy share directly?

Well – we’d only be able to buy 4 shares (presuming we could buy shares from someone at $25/share) – so when we sold those shares later at $30 per share our profit would be only $20.00 (4 shares * $30 share – 4 shares * $25/share). This represents a 20% profit! 20% is a great return on investment for a short period but $20 in profit simply won’t even buy you and your date dinner!

See why option trading is better for the small cap investor? The amplified gains on even relatively small price movements create worthwhile income gains for the fortunate trader.

A Favorable Put Option Trade Example

A Downward Movement in Share Price Makes Money (download the worksheet)

Now we look at the less intuitive trade scenario – the put option. We’ll pretend that we’ve bought a put option with a strike price of $25.00 on Microsoft stock (again let’s presume someone simply gave it to us for the moment). Let’s presume Microsoft is trading at $20/share today. Given the circumstances we describe – what is our potential payout position?

We own 1 put option of MSFT with a strike price of $25/share. If we were to execute the contract today, we would go into the market to buy 100 shares of MSFT for $2000 ($20/share times 100 shares) and force the counterparty to pay $2500 ($25.00/share * 100 shares) for an instant profit of $500. We owned the right to SELL the MSFT shares at $25, regardless of what the market price is for MSFT. The person or company that issued the put option to us MUST buy the shares we sell at the specified strike price ($25) despite the fact they could go into the market and buy them directly cheaper. The put option CONTRACT binds the issuer (or writer) of the contract to our DEMAND to sell the shares of Microsoft ABOVE the present actual price of the common stock of MSFT.

Let’s go one step further. Let’s presume we paid $1.00 put premium for the contract – meaning we paid $100 ($1 put premium per share * 100 shares). This means we invested $100 and earned $400 net profit ($500 profit less $100 cost) – a 400% gain!

What would our return have been if we had used our $100 initial investment to sell shares directly?

Well – we’d only be able to acquire 5 shares directly in the market ($20/share * 5 shares = $100 initial investment) – so when we sold those shares later at $25 per share (presuming we could force someone to buy shares from us at $25/share) our profit would be only $25.00 (5 shares * $25 share – 5 shares * $20/share). This represents a 25% profit! 25% again is a great return on investment for a short period but $25 still won’t buy you and your date dinner!

See why option trading is better for the small cap investor? The amplified gains on even relatively small price movements create worthwhile income gains for the fortunate trader.

Binary Options – A Simplified Version of Option Trading

Another much simpler, but similar type of options trading is called a binary option. What makes it simple is that the binary option eliminates the call and put premium as well as the transaction cost (commission). It also eliminates the SCALE issue relative to trading – meaning it does not matter whether the Microsoft shares in our example go up $5.00 (as in our call option example above) or only a nickle. The payout is the same. Likewise for the put option example. In our put option example we care HOW MUCH the shares move. In a binary put option trade, only the downward direction matters.

In a binary option only the direction of movement matters – not the size of the movement. Learn more about binary options trading.

3 thoughts on “Options Trading Tutorial | A Day Trading Primer

  1. Typically the yields on the index binary options are higher, if that is what you are asking. The more liquid the investment, the higher the yield on the binary option – usually. Forex markets are the most liquid but their binary option contracts pay less than indices-based binary options.

  2. My father invested in options and is making a good side income with it. My parents were able to go on a nice cruise with his option investing. Clearly, I think it is a great opportunity to make money.

  3. Good options trading results in lifestyle improvements. Working for a living simply doesn’t.

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