Options Trading Explained-Buying Stock Options

As I have used this site to simply explain stock options to beginning investors, I’ve also been asked from time to time to take a slightly different direction by readers who would like to get options trading explained to them. I’ve been a little bit reluctant to extend the scope of this site beyond its title–stock options explained–because of the risky nature of options, especially in the hands of neophyte investors for whom buying, or going long, puts and calls is the most natural way to approach options trading. Providing basic education to investors  on stock options is one thing, but I would hope that no one would interpret their understanding of options basics as an indication that trading them successfully is anywhere near as simple, because it is not.

Still, I thought there might be some benefit in explaining basic trading strategies we have available to us in trying to successfully invest with options, over a series of articles. At this stage I’ll focus less on specific options trading tips and options trading systems than generic options strategies. The first two articles will contrast buying puts and calls with the relatively conservative strategy of selling, or writing, puts and calls; my aim is to get trading explained easily to options investors in terms of managing risk as opposed to making a quick killing. All in all, if the purpose of this site is to explain stock options, leaving actual options trading strategies out of my explanation seems incomplete.

In subsequent articles I will also get some of the more complex options trading strategies explained, involving combinations of buying and selling options contracts, often of different strike prices and expiration dates, as part of the same transaction. There are spreads, straddles and 100 variations of more sophisticated ways to play options, strategies that aim to profit not simply from the direction in which a stock or the overall market moves, but rather from things like changes in a stock’s volatility over time. Understanding the risk involved in simple long options positions will hopefully motivate readers to learn about these other types of trades; professionals and sophisticated options traders use them to manage risk, especially relative to an existing portfolio via hedging with options, and a responsible investor would do well to learn about them too.

But first, the simplest options trade–simply buying puts and calls–with emphasis on a couple of points that trip up most people as they learn options investing.

Buying Stock Options–Long Puts And Calls

People unfamiliar with stock options often equate them with risk, and leverage. It’s probably natural enough, as stories of making or losing a lot of money quickly are a lot more interesting than the subtleties of using options to achieve returns of say 4% to 15% on a trade one has on for a few months or more. Certainly the concept of buying something whose value changes rapidly is much easier to understand than the other, sell side of the transaction (which I will cover in the next article on selling options). The most basic way to trade stock options–and the way in which inexperienced investors most frequently lose a lot of money–is by buying options, or ‘going long’ puts or calls. We’ve covered simple long positions extensively, how one uses a relatively small amount of money (per contract) to purchase the right to buy 100 shares of the underlying by a certain future date. A long options position could pay multiples of your investment if you are correct about the movement in a stock; remember though that with this trade time is not your friend and you want the move to occur as quickly as possible so as to avoid time decay in the value of your put or call contract.

I’ll refer you to the following article for an easy explanation of stock options basics from the very beginning. Now, I have learned from comments on this blog that there are two points that I should attempt to clarify to clear up confusion that exists around simple long options transactions.

Buying either puts or calls is synonymous with taking a ‘long’ option position. It’s easy enough to understand that when you buy a call you’re hoping that the price of the underlying stock increases. However, if you buy a put hoping that the price of the stock decreases you are still taking a long position in the option.

When we begin to talk about writing, or selling, puts and calls in explaining options trading it’s easy to confuse the concepts, but the basic idea is that ‘buying an option’ does not equate to you being optimistic or pessimistic about the future movements in the stock price, rather it indicates how much risk you are willing to take on as a result of your bullish or bearish conviction. You could be optimistic and buying calls, or you could be pessimistic and buying put options. The point is that if you try to profit by going long options you are choosing to purchase leverage and assume much more risk than if you were simply buying or shorting a stock (or if you take the other side of an option position for that matter); it’s not about your directional preference in the underlying stock. I hope that’s clear now.

The second point that I should address succinctly is the confusing correlation–or more specifically the lack of a direct correlation–between the price fluctuations of an underlying stock and the price movement of its options. I remember long ago my first experience of having correctly anticipated an upward stock move and discovering that not only did the price of the calls that I bought not rise, they were worth a lot less than they had been one day before!

In this case I bought my calls right before the company’s earnings were announced (I’ve forgotten the stock), expecting them to be very good. Well they were good earnings, and while the stock only rose a little bit after the announcement, my calls, which had maybe a month or so remaining on them, inexplicably (to me at the time) dropped in value.

What happened? It was an expensive lesson that help me understand the importance of expectations and volatility in options trading.

Just as there is often a disconnect between the fortunes of a company and the day-to-day movements in the price of its stock, there can be even more pronounced discrepancies between the stock price and the movements of option contracts corresponding to the stock price. Just as the stock price is an expression of collective opinion by market participants as to the overall future performance of the company, option pricing can be seen as the market’s assessment and anticipation what a stock’s price will do. It should be clear that with options you are investing in something that is twice removed from company fundamentals. Anticipating expectations of expectations are doubly hard to pin down and profit from, and my anecdote is just the tip of the iceberg.

Stated differently: stock pricing is a continual re-setting of the markets expectations as to a company, expressed by stock price; if the stock price ultimately follows company performance, the path it takes as it does so fluctuates, often dramatically based on market expectations. Stock options pricing involves a similar dynamic relative to stock price, but expectations of stock price movements are prone to wilder swings , especially as market participants take into account an option’s expiration date and other factors.

Simple long options positions expose us to these vagaries, with little room for error, especially with little time remaining on contracts that we own. The more risk we assume with options the more we stand to profit, and greater are the ways we may lose much or all of our investment too.

So if we do not wish to gamble, are options an investment with which we should bother? Yes they are, and in part two of the Options Trading Explained series, Writing Options, we will look at more conservative options strategies like selling options.