Option Trading Basics: You Have To Know This Stuff!

| January 16, 2015 | 0 Comments

Back To BasicsOption Trading 102: Further Your Knowledge!

As you may remember, we discussed some of the basics of option trading in a recent article.

Since option trading is the prime focus of my premium trading service, the Options Profit Pipeline, I feel potential subscribers should be able to find everything they need to know about options, right here on Commodity Trading Research.

So let’s pick up where we left off a few days ago… 

Last time we discussed what options are, and why investors use them. I also explained how to read an options quote. I finished by explaining why your trading risk is limited to the amount of premium you pay for an option.

Now let me go into a little more detail about the difference between calls and puts…

Option Trading: Calls vs. Puts

There are two types of option contracts: calls and puts.

If you buy a call option, it gives you the right, but not the obligation, to buy a stock within a specific time frame, at an agreed upon price.

When you are buying calls, you expect the price of stock, commodity, or ETF to RISE. That’s because a call option contract gains value as the price of the underlying asset appreciates.

On the other hand, if you buy a put option, you have the right, but not the obligation, to sell a stock within a specific time frame, at an agreed upon price.

When you’re buying puts, you expect the price of a stock, commodity, or ETF to FALL. A put contract gains value as the price of the underlying asset depreciates.

Here’s an example…

Let’s say you purchase an Exxon Mobil (XOM) April 2015, $95 call option for $3.00. At the time of your call option purchase, XOM stock is trading at $90.

Buying this call option means you believe XOM will rise above $95 by the third Friday in April. 

If XOM is still trading below $95 (the strike price) at expiration, you’ll lose the entire premium you paid for the option. However, if XOM does rise above the strike by expiration, say to $100 a share, you will have the right (but not the obligation) to purchase the stock for $95.

It works the opposite for puts…

Say you purchase the Exxon Mobil (XOM) April 2015, $85 put option for $3.00. At the time of your purchase, XOM is trading at $90.

In this case, you believe XOM shares will fall below $85 by the third Friday in April.

If XOM is trading above $85 (the strike price) at expiration, you’ll lose the premium you paid for the put. However, if shares do fall below the strike by expiration, say to $80, you’ll still have the right (but not the obligation) to sell XOM at $85.

Now this brings up some important option trading lingo…

When a stock is trading above your call option’s strike price, it’s considered in-the-money. If shares are trading below your call option’s strike price, it’s out-of-the-money. Lastly, when the stock is trading at the same price as your call option’s strike, it’s considered at-the-money.

Of course, the lingo is reversed for puts. If the shares are trading above your put option’s strike, the contract is considered out-of-the-money. If the stock is trading below your put strike, it’s in-the-money. When shares are trading at your put option’s strike, it’s at-the-money.

Knowing whether your option is in-, out-, or at-the-money is very important when you’re making option trading buy/sell decisions!

When buying an option contract (call or put), in-the-money contracts will always have a higher premium than out-of-the-money. (I will explain why in a future article.)

And when expiration is near, you must know if the option contract you own is in-the-money. If it is, and you don’t close it before expiration, you’ll wind up owning 100 shares of stock for every option contract you purchased.

Whew! That Was A Big Dose Of Option Trading Basics…

As you can see, there’s plenty of concepts and trading lingo to grasp when it comes to options. Whatever you do, don’t let the complexity frustrate you! With time and perseverance, anyone can profit from options.

Remember, you can always visit the Chicago Board Options Exchange’s education section to further enhance your options knowledge.

That’s it for Option Trading 102. In coming articles, I’ll explain additional concepts including:

  • Option Spreads
  • Intrinsic value vs. time value
  • Option Greeks: Delta, Gamma, Vega, and Theta
  • Money management techniques 

Until Next Time,

Justin Bennett
Commodity Trading Research

BIO: Justin Bennett is the head commodity research analyst at Commoditytradingresearch.com. With over a decade of real world trading experience, he finds ways for you to consistently profit from movements in commodities and the companies producing them. Sign up for our free reports and commodity newsletter at http://commoditytradingresearch.com/free-sign-up.

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Category: Commodity Options Trading

About the Author ()

Justin Bennett is the editor of Commodity ETF Alert, an investment advisory focused on profiting from the ebb and flow of important commodities via ETFs. The commodity veteran and options specialist is also a regular contributor to the Dynamic Wealth Report. Every week, Justin shares his thoughts with our readers on a variety of commodity-related topics. Justin is also a frequent contributor to Commodity Trading Research’s free daily e-letter. And he’s the editor of another highly successful and popular investment advisory, the Options Profit Pipeline.

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