Options Trading Basics, by me. Pt. 1

Options Trading - in stupid terms

Options Trading isn't hard.. it's very easily actually.. and I still think it's the best way to play the market if you have a general idea which way the market is going to go. That being said, it can be expensive if you want to limit your risk, and it can be expensive if you're wrong. No question.

I'm going to start off with a concept that I'm all to familiar with... gambling. ;-)

Most people know how to gamble.. risk money, to try to win. In Vegas, and in all casinos.. the house has the edge. In Stocks, I believe the investor has the edge, however you have to know what you're doing.

An option is nothing more than a contract that you buy (or sell, but we won't cover that), to own shares of a security at any given time. For example, if I think that Google stock (GOOG) is going to go 620 next month (August '08) at the time of this writing, I can purchase that option for $5.20. Doesn't sound like much does it?

No, it's not, however you can't just buy 1, you have to buy 100. So we're talking $520. As of todays close the share price, was sitting at $533.44. So, if I purchase that contract, I'm thinking that GOOG is going to dramatically rise in price by about 87 points (dollars) by August 15th, options always expire on the 3rd Friday of every month..... am I crazy???

Well, yes.. I sort of am.. but the truth is, GOOG doesn't have to get to 620 for me to make money, all it has to do is rise. Optimally, it will rise quick, and rise big. Because for example if 2 days from now, GOOG went up $20 (which it's been known to do), to 553.77, well.. now that 620 is a lot closer, and as such, the price for that contract is going to go up.. how much?? Well.. likely around the $9.00 mark, or $900. And at that time, what we have bought, we can sell. We would sell it for $900, and pocket ourselves a nifty little $350-ish profit, less commissions. How do you like %62 in your portfolio?

Sounds easy right? Well, as I said.. it is, but there are a LOT of factors here to consider.

1. May not go the way you want.. obviously, your $520 option can turn worthless if GOOG goes straight down and never recovers, or doesn't move at all for the rest of the month.
   
2. GOOG stalls. Meaning, it doesn't move anywhere. Say a week goes by, and GOOG stock is still at 555? Well, what's called 'time decay' kicks in, and is always there.. time decay means that you have less time for it to move to $620, which affects the options price. Even though it hasn't gone down, it hasn't moved up! which is what we want, so the price will go down slightly, and much more dramatically as time gets closer to the 15th of August or expiry date
3. Earnings. Stocks move on earnings.. as I write this Blog entry, GOOG missed their earnings report, and the stock has plunged 50 points. Yes.. 50 points. Ha! So now, instead of having to go up 87 points, GOOG now has to hustle up and go over 137 points! Good luck!!
   

There are other options to consider, but that is the general idea on how it works. Now this is what I like about it, if you know of a stock that's going to go down big soon.. you can purchase what's called a 'put'. This is the opposite of a 'call'. A Call means you think the stock is going to go up, and a Put means you think the stock is going to go down. But all the same factors are the same.

I think that's where I'll cut it right now, and I'll resume with Pt. 2 soon.