Am I understanding buying options on stock correctly?

Question

I'm just wondering if I am understanding stock options correctly.

Basically if I am watching stock XYZ. It's currently at $10 per share which I believe is low and should raise to 20 within 1 month.

If I buy this option while the stock is at $10 (is this the stake?) for 30 days, and the stock price rises to 20, I can choose to sell it back to the market and earn the difference between stock prices minus option cost and commissions? ($20 x 100) - (10 x 100) - (option price x 100) - commissions.

Any any quick tips for trading with options?

Answer 1

Options have legitimate uses as a way of hedging a bet, but in the hands of anyone but an expert they're gambling, not investing. They are EXTREMELY volatile compared to normal stocks, and are one of the best ways to lose your shirt in the stock market yet invented.

How options actually work is that you're negotiating a promise that, at some future date or range of dates, they will let you purchase some specific number of shares (call), or they will let you sell them that number of shares (put), at a price specified in the option contract. The price you pay (or are paid) to obtain that contract depends on what the option's seller thinks the stock is likely to be worth when it reaches that date. (Note that if you don't already own the shares needed to back up a put option, you're promising to pay whatever it takes to buy those shares so you can sell them at the agreed upon price.)

Note that by definition you're betting directly against experts, as opposed to a normal investment where you're usually trying to ride along with the experts. You are claiming that you can predict the future value of the stock better than they can, and that you will make a profit (on the difference between the value locked in by the option and the actual value at that time) which exceeds the cost of purchasing the option in the first place.

Let me say that again: the option's price will have been set based on an expert's opinion of what the stock is likely to do in that time. If they think that it's really likely to be up $10 per share when the option comes due (really unlikely for a $20 stock!!!), they will try to charge you almost $10 per share to purchase the option at the current price. "Almost" because you're giving them a guaranteed profit now and assuming all the risk. If they're less sure it will go up that much, you'll pay less for the option -- but again, you're giving them hard money now and betting that you can predict the probabilities better than they can.

Unless you have information that the experts don't have -- in which case you're probably committing insider trading -- this is a very hard bet to win. And it can be extremely misleading, since the price during the option period may cross back and forth over the "enough that you'll make a profit" line many times. Until you actually commit to exercising the option or not, that's all imaginary money which may vanish the next minute.

Unless you are willing and able to invest pro-level resources in this, you'd probably get better odds in Atlantic City, and definitely get better odds in Las Vegas.

If you don't see the sucker at the poker table, he's sitting in your seat. And betting against the guy who designed and is running the game is usually Not a Good Idea.

Answer 2

Here is a quick and dirty explanation of options. In a nutshell, you pay a certain amount to buy a contract that gives you the right, but not the obligation, to buy or sell a stock at a predetermined price at some date in the future.

They come in a few flavors:

• Call Option - You can buy a stock at a predetermined price (higher than the current price) sometime in the future. You are betting that the stock will grow beyond that price by the expiration date of the contract.

I'll give you $100 if you let me buy 10,000 shares of XYZ for $10 more per share than it is trading at today any time before August 10th.

• Put Option - You can SELL a stock at a predetermined price (lower than the current price) in the future. You are betting that the stock will drop lower than that price by the expiration date of the contract.

I'll give you $100 if you promise to buy 10,000 shares of XYZ from me for $10 less per share than it is trading at today if I ask before August 10th.

There are also two main types based on the expiration behavior:

• European Style - You have to execute the option on the expiration date, and not before.
• American Style - You can execute the option any time up to the expiration date.

There are lots of strategies that employ options, too many to go into. Two key uses are..

• Leverage: Buying Call options can give you a much higher return on your investment than just investing in the actual stock. However, with much higher risk of losing all of your investment instead of just some of it when the stock drops.

• Hedging: If you already own the underlying stock, put options can be used to buy down risk of serious drops in a holding.

Answer 3

There is a reason why most professional option traders are sellers instead of buyers. Option sellers IMO are analogous to insurance companies that come out ahead in the long run. That is not to say if you are bullish about a stock then you should not buy it. I personally would never buy an option outright and look to reduce my cost basis by selling options around it such as:

• Buy 1 XYZ call option at $10
• Sell 1 XYZ call option at $17.50
• Sell 1 XYZ put at $7.50