Options 101

Dear Strategic Intelligence Reader,

While we prefer to make stock recommendations, we recently offered a few bonus recommendations that involve stock options.

And since not everyone understands how options work, we’ve created this special guide for you. We’ll cover everything you need to know, from what an option is to how to trade one.

As you’ll see, they’re not too difficult to grasp. And they can help you unlock large profits with relatively little risk.

So let’s start with the very basics.

I must caution you: Options plays can be volatile, and all involve plenty of risk. And although these ideas are well researched, nothing is guaranteed. Don’t bet the mortgage money here. And remember, it’s up to you to decide how much you’d like to put into each play. Please be sure to diversify your risk, and don’t put all of your money into one play.

What Is an Option?

An option is a tradable contract that gives you the right but not the obligation to buy or sell a specific underlying financial instrument at a specific price within a set period of time.

Let’s break down that definition piece by piece.

First, a tradeable contract means it’s a standardized contract that you can buy and sell. In fact, stock options trade alongside stocks, meaning you should be able to buy them from any stockbroker. Their prices fluctuate just like stocks, too, meaning you can buy one now and sell it either at a profit or loss down the road. The price you pay for an option is called the premium.

Options give you right but not the obligation to buy or sell a specific underlying financial instrument. The underlying instruments of the options we’re recommending are stocks and exchange-traded funds (ETFs). Each options contract give you the right to buy or sell 100 shares of the stock or fund.

When you buy an option, you have the right to buy or sell the underlying shares for a specific price, known as the strike price. But those rights expire after a set period of time. The day the option expires is its expiration date.

There are two types of options contacts: calls and puts.

What Are Call and Put Options?

A call option gives you the right to buy the stock at the strike price. You buy call options when you expect the stock’s price to rise.

For instance, if you buy, say, a call option on HSBC Holdings (HSBC) with a $30 strike price, you have the right to buy 100 shares of HSBC for $30 each — no matter what the current price is.

If HSBC is trading for $35, you can use your option to buy the shares — meaning you’ll pay just $30 a share for a stock that is trading for $35.

But you don’t have to actually buy shares of HSBC to make money from this trade. As I explained, stock options have their own value. And as HSBC’s share price increases, the price of your HSBC call option will, too. You can sell your call option at any time before its expiration date for a profit or loss.

A put gives you the right to sell the underlying instrument at the strike price. You buy put options when you expect the stock’s price to fall.

For instance, if you were to buy, say, a put option on HSBC Holdings (HSBC) with a $30 strike price, you have the right to sell 100 shares of HSBC for $30 each — again, no matter what the price is.

If HSBC is trading for $25, you can choose to sell 100 shares of HSBC at your option’s $30 strike price — receiving $30 a share for a stock that’s trading at $25.

But once again you don’t actually need to sell shares of HSBC to profit from this trade. In fact, you don’t even need to own shares of HSBC at all. Instead, the value of your put option will increase as HSBC’s share price falls. You can choose to sell your put option any time before the expiration date for a profit or loss.

But always keep the option’s expiration date in mind. If you haven’t exercised your option’s rights or sold your option before it expires, your rights disappear and the option becomes worthless. That means you stand to lose every cent you paid for an option if you’re not careful.

On the other hand, that means your risk is always known and under your control. And those risks tend to be low.

Why Trade Options?

You can often buy options at a fraction of the cost of the underlying stock they give rights to. And as I said, their price fluctuates alongside the price of the underlying stock. A call becomes more valuable as a stock’s price rises, and a put gains in value as a stock falls.

But since each option is worth 100 shares, their prices react sharply to changes in the stock price. A 10% change in a stock’s price could translate into a 50% price change in the option.

Almost all of the risk from options comes from the fact they can expire worthless. But outright buying and selling options is still better than other options strategies you may have heard of, like covered calls and naked puts. I don’t want to confuse you by explaining how these strategies work, so I will just caution that these plays often involve extra out-of-pocket cash and extra risks.

That should be all you need to know to get started with options. The bottom line is that we buy options hoping to sell them for a profit before they expire.

Now, here’s how we’ll use them…

What Does Your Recommendation Mean?

Here’s an example of what our typical options recommendation looks like:

In this example, we are betting that shares of HSBC Holdings (HSBC) will fall below $30 before the option expires in January 2018. (Most stock options expire the third Friday of their expiration month, meaning this option expires on Jan. 19, 2017.) 

The phrase “buy to open” simply means we are taking a new position. You may see it on your broker’s website or may need to say it to your broker if you make this trade by telephone.

To make this bet, you will need to buy the options contract from your broker. Every broker is different, so the exact steps you take to enter the trade will be different.  Luckily, the recommendation contains all of the information you will need for your broker to find the correct option.

   (1)          (2)             (3)      (4)
HSBC January 2018 $30 Put Option

(1) Underlying Instrument
(2) Expiration Date
(3) Strike Price
(4) Type (either call or put)

Remember, the price you’ll pay for the option is called the premium. It depends on several things, including current market conditions. Just like a stock’s price, an option’s premium can change minute to minute.

A put’s price will increase as the share price of the underlying stock falls. Of course, that also means the put option’s price will fall if the underlying stock’s price rises.

But that’s the only thing that will change. An option’s underlying instrument, expiration date and strike price will never change.

The most important part is the expiration date. Past that date, the option becomes worthless -- and the rights to the stock that the option gives are no longer valid. So you must decide what to do with your option before it expires.

Our goal is for your option to increase in value so you can sell it for a profit. But keep in mind you may need to sell your option for a loss.

Now that you know what an option is, there are some steps you need to take before you can trade them.

How Do I Trade This Option?

If you have a stockbroker, you should be able to trade options. Depending on your broker, you may need a margin account. You may also need to apply for permission to makes option trades.  

Brokers have a responsibility to make sure their clients don’t get in over their heads. So they require investors to satisfy certain requirements to make certain kinds of trades. They often break options trading into different levels or tiers based on complexity and risks. Those levels or tiers differ from broker to broker.

To make the kinds of trades we recommend, you’ll need permission to “buy puts and calls” or “trade long puts and calls.”

In general, you’ll need to fill out a quick three- or four-page form that your broker will provide you. It asks a few questions about your financial situation, investment background and what your interests are.

Be sure to check the boxes that say “buying calls and puts”.

Once you submit this form, your broker will typically give you approval within two or three days.

If you don’t already have a broker, I can’t give you specific advice. (It’s a legal thing.) But I can point you in the direction of a few brokers you can use. They can handle all your equities, options and bond needs.

The four main players are:

• TD Ameritrade -- (800) 454-9272
• Fidelity -- (800) 343-3548
• Charles Schwab -- (877) 832-4330
• Scottrade -- (800) 619-7283

Remember, every broker is different. They have their own fees and trading platforms, so do some research to find the brokerage that best fits your needs.

How Do I Track This Trade?

Once you buy a stock option, it will show up in your brokerage account. Simply log-in and look for your personal portfolio page.

If you prefer, you can keep an eye on your option on other financial websites. Some of them will require the option’s formal symbol -- a 16-digit code that identifies every option. Not every site uses the official symbol, but we include it in our recommendations just in case.

And that should be all the information you need to get started.

Regards,

Dan Amoss, CFA
Analyst, Rickards’ Strategic Intelligence