Today we’re going to discuss options and the benefits to trading them. This is very important because if you’re not using options in your trading you are leaving a LOT of money on the table.
Let’s start out with the written definition:
An Option is a contract that gives the owner the right to buy or sell a stock at a set price on or before a set date, when the contract expires.
So there it is….Options are tied at the hip to Stocks & ETFs.
Believe it or not, even if you’ve never traded before, you’ve already used Options Contracts in your daily life. If you’ve ever received a coupon in the mail, it generally provides you with the Option to buy a specific product for a set price on or before an expiration date. And those of you who have dabbled in Gift Cards understand that there’s an entire Market out there dealing with the buying and selling of that form of Option contract through a card.
So by now, if you’re confused about what an Option is, don’t worry. The term “contract” is not something that you normally think of when you envision trading something in the stock market. Think of this, though: many of you are just as comfortable buying and selling shares of stock, as you were trading marbles on your childhood playground. Shares of stock somehow feel “tangible” as if you were actually buying and selling a minute piece of the company. We don’t think that we are dealing in the actual stock certificates, which somehow seem like an arbitrary transaction that gets “settled” days later.
The point here is that many of us are comfortable buying and selling stock shares, and you’ll soon see that buying and selling Options contracts is just as simple.
Buying vs. Selling Options
If you have traded Stocks before, did you ever “Short” or “Sell Short” a Stock? It’s a somewhat convoluted process where you actually have to borrow shares from your broker in order to sell them at what you hope is a “high” price, in order to “buy to cover” the shares later for a profit.
Sell high, buy low. But there’s more to it than that….sometimes you might not be able to borrow the necessary shares to sell short. And there are Dividend obligations to pay if you happen to hold short shares on the ex-Dividend date.
The point here is that Selling Stock is different than Buying Stock. And this is certainly the case when it comes to buying and selling Options. You can open an Options position by buying one, or you can open an Options position by selling one. There are fundamental differences between the two in which will be discussed in future lessons.
I’m going to use a couple of new terms through some of the lessons I have planned for you that we don’t normally use in everyday life, “right” and “obligation”:
Right – a legal principle of entitlement.
Obligation – a legal requirement to take some course of action.
They’re quite different, aren’t they? We don’t have to be attorneys to recognize the difference between the two. And it matters tremendously in the world of Options trading, so we’ll need to get used to using those terms.
Here are some of the initial differences between buying and selling Options:
Buying an Option gives you the right, and not the obligation, to “exercise” an Option. When you buy an Option your risk is limited to what you paid for the Option.
Selling an Option creates an obligation to complete the terms of the contract at the exercise price specified. When you sell an Option your risk could be unlimited.
Whoa! Sounds like there is a huge disadvantage to selling an Option, yes? If you don’t understand how to trade Options, the answer would be a huge YES. If you have the knowledge and experience to sell Options, there can be a huge ADVANTAGE to learning how to sell Options.
The main point that I want to leave you with in this section is that Buying an Option gives you Rights but with no Obligations, and Selling an Option gives you Obligations and not a lot of Rights.
I am really enjoying the course! I have read several books and even taken one of the snake oil courses on trading options. Nowhere do they explain the why and how like you do. I can’t just blindly follow a recipe. I need to understand why, and you are doing a great job with that. I am following your daily report and find it very helpful.
Have a fantastic day and hope this trading lesson helps you in your trading.
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