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Stock Options Trading Basics

By Edited Nov 13, 2013 0 0

Since the 1970's when the stock option was conceived the option industry has exploded. The first day of option trading for the Chicago Board Options Exchange (the first options exchange) saw only a couple hundred contracts traded for the day. Today there are several options exchanges and approximately 15 million or more option contracts traded each and every trading day. If you are new to stock option trading below you will find a quick course on options trading basics.

 At its very basic level, options trade in contracts. Stocks trade in share. When you own a share of stock you actually become a part owner of the business. In other words you have a share of the company. Options have contracts because you are entering a contract when you buy an option. There is an obligation on the behalf of each part in this contract.

Trading Options: Class Symbol

An option contract is comprised of four essential pieces of information. The first piece of information is the class symbol. Now today after the completion of the Options Symbology Initiative it is much simpler. Most class symbols today are simply the underlying stock symbol. That wasn't the case until mid year 2010. Prior to that there could be numerous class symbols for each stock symbol. However, today the only time that you will see a class symbol that is different than the underlying is when there has been a corporate action such as a stock split, merger, etc. There are a few other instances where the symbol will be different (FLEX options, etc) but we will not touch on these here since the majority of traders will never trade such options. Just remember that the class symbol identifies the stock that you are buying or selling the option of.

Trading Options: Expiration Date

The second piece of the option contract is the expiration date. Since this is a contract, it only makes sense that it will expire at some point in the future. Stock option contracts expire on the Saturday following the third Friday of the month. But since the option exchanges are not open on Saturday the last official day to trade an expiring option would be the third Friday of the month. Some products will have different expirations (VIX, FLEX products, etc) but we are only dealing with the standard stock option in this article. The expiration date tells you when you have to take some action on your option.

Trading Options: Exercise Price and Put Call Code

The third piece of information is the exercise price or strike price. This is the price around which your option contract revolves. This will become a little clearer in a second.

 The fourth and final piece of information is the put call code. There are two basic types of options: puts and calls. A call (if you buy) gives you the right to buy shares of a stock and the put gives you the right to sell shares of a stock.

Trading Options: Example

These four pieces of information make up what is called the option series. There will be many different stock option series for each underlying stock. There is one other piece of information to pass on before looking at an example. Options provide leverage. Normally, each option contract represents 100 shares of stock. So if you bought 10 contracts this would actually represent 1000 shares of stock. Let's take a look at an example.

 Let's say that you are bullish on DELL Computers. You believe that their stock price is undervalued and expect an increase in the share price at some point in the next few months. If this is the case then you could buy a call option on DELL. Let's assume that DELL is trading at $14 per share at this current time. You could buy a $15 call option with an expiration date of a couple of months from now. This is February 2011 as of this writing so let's say you wanted to have an expiration in May. The Saturday following the third Friday in May 2011 is May 21, 2011. This would be your expiration date. If you bought 5 contracts of the DELL May 2011 15 Call then you would have the right to buy 500 shares of stock at $15 between now and May 21, 2011. If DELL was trading at $18 then you would still have the right to buy at $15. If DELL was trading at $12 you still have the right to buy at $15 but it would not make any sense since you could buy it on the open market cheaper.

 Let's take a look at a Put example. Suppose you were bearish on McDonald's (MCD). You feel that there is going to be a move away from fast food and think that their stock price might suffer as a result of it. Let's assume that MCD is trading at $32 per share. You can buy a put option on MCD and have the right to sell the underlying stock at a set price. If you bought a MCD May 2011 30 Put you would have the right to sell shares of McDonald's at 30 at any point between now and May 21, 2011. Puts are often used as a hedge to a stock position. If you were to exercise the put option would would obviously need the shares of stock to sell.

However, you don't need to own an underlying stock to trade a put option or call option for that matter. You can simply trade the options. The option will fluctuate in price as the stock fluctuates in price. You can buy the option for one price and sell it for another price one week later (just a hypothetical day; you can sell at any time).

This is just beginning to scratch the surface of stock options. There are many other things to consider but since this is just touching on options trading basics we will deal with those in a later article.



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