1. Options Basics: Introduction
  2. Options Basics: Call and Put Options
  3. Options Basics: Why Use Options?
  4. Options Basics: How Options Work
  5. Options Basics: Types of Options
  6. Options Basics: How to Read An Options Table
  7. Options Basics: Options Spreads
  8. Options Basics: Options Risks
  9. Options Basics: Conclusion

Speculation

Speculation is a wager on future price direction. A speculator might think the price of a stock will go up, perhaps based on fundamental analysis or technical analysis. A speculator might buy the stock or buy a call option on the stock. Speculating with a call option – instead of buying the stock outright – is attractive to some traders since options provide leverage. An out-of-the money call option may only cost a few dollars or even cents compared to the full price of a $100 stock. As an example:

XYZ stock is $100 per share. An investor who wants to buy 100 shares will do so at a cost of $10,000. An XYZ 102 call option with one month till expiration may hypothetically be priced at $2 per contract. One contract equals 100 shares of XYZ stock, so the total premium spent is $200. With leverage, spending $200 vs $10,000 to potentially control the same amount of stock is a huge difference.

The leverage component of options contributes to their reputation for being risky. It is important to understand that when you buy an option, you must be correct in the direction of the stock's movement, and also the magnitude and timing of this movement. In other words, to succeed, you must correctly predict whether a stock will go up or down, and you have to correctly predict the magnitude of price change. You also need to accurately predict the time frame within which all of this will happen.

Hedging

Options were really invented for hedging purposes. Hedging with options is meant to reduce risk at a reasonable cost. Here, we can think of using options like an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn. Critics of options may say “if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment.” In reality, there is plenty of evidence that hedging strategies can be useful. This is especially true for large institutions. The individual investor can also benefit from hedging. Imagine that you want to buy technology stocks. But you also want to limit losses. By using put options, you could limit your downside risk and enjoy all the upside in a cost-effective way. For short sellers, call options can be used to limit losses if wrong – especially during a short squeeze. (See also: Bill Ackman's Greatest Hits and Misses.)

Spreads

Spreads use two or more options positions of the same class. They combine having a market opinion (speculation) with limiting losses (hedging). Spreads often limit potential upside as well. Yet these strategies can still be desirable since they usually cost less when compared to a single options leg. Vertical spreads involve selling one option to buy another. Generally, the second option is the same type and same expiration, but different strike. Spreads really show the versatility of options. A trader can construct a spread to profit from nearly any market outcome. This even includes markets that don’t move up or down. We will talk more about basic spreads later in this tutorial.

See below an excerpt from my Options for Beginners course where I introduce the concept of spreads:

Combinations

Combinations are trades constructed with both a call and a put. There is a special type of combination known as a “synthetic.” The point of a synthetic is to create an options position that behaves like an underlying asset, but without actually controlling the asset. For example, if you buy an at-the-money call and simultaneously sell an at-the money put on stock XYZ with the same expiration and strike, you have created a synthetic long position in XYZ stock. You don’t actually own XYZ because you never bought it. But the combination of your long call and short put behaves almost exactly like owning stock.

Why not just buy the stock? Maybe some legal or regulatory reason restricts you from owning it. But you may be allowed to create a synthetic position using options. A synthetic might also be useful if the underlying asset is something like an index that is difficult to recreate from its individual components.


Options Basics: How Options Work
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