Nov 212012
 

HEY! I SAW THAT LOOK! That look of boredom mixed with contempt mixed with a little sexy eyes because you secretly want me but are too shy to admit it. You’ve practically already clicked the back button, on the way back to Tumblr or Lolcats or whatever it is you kids do on the interwebs these days. But dammit, learning a little bit about trading stock options is important, uh, dammit. I promise, it’ll only be slightly boring.

Basically, there are two kinds of stock options, puts and calls. Each type gives you the right (but not the obligation) to buy or sell a certain underlying stock on a certain day at a certain price. To do so, you have to pay for the privilege, because the only people who get free things are girls with nice boobs. That’s called the premium.

Let’s look more closely at call options first. Say you wanted to own shares in Shaw Communications, but you didn’t have the $2130 needed to buy 100 shares in the company. You think it’s going up, possibly because they show a lot of porn and porn is a profitable business. So instead of buying 100 shares, you buy a call option that gives you the right to buy 100 shares at the end of March 2013 at $22.00 per share. I consulted the Bourse de Montreal website (all Canadian options trade on the Montreal exchange, not the Toronto one) and found out that such an option would set you back $0.41 per share. So instead of paying $2130, you’re only out $41, plus trading commissions.

That option gives you the right to buy Shaw at $22.00 per share at the end of March, 2013. You would have paid $0.41 per share for that right. That means that if Shaw has moved past $22.41 per share at any point between now and then, your options would be in the money. That’s the actual technical term. At that point you could either exercise the option (meaning you’d buy your 100 shares) or you could sell that option to someone else since it would have gone up in value.

There are some pretty major advantages and disadvantages to calls. They allow an investor to make a large bet on a stock without tying up too much capital. If the bet does well, the return could easily be several times the original premium paid to enter into the option in the first place. If the stock falls in value you’re going to be losing all of your premium. Options are more risky than doing a hooker sans condom.

You’d buy a call option when you’re bullish on a stock. If you were bearish on a stock you’d use a put option, which is pretty much the opposite of a call. When you buy a put you’re betting on the underlying stock to go down, meaning you’d have the right to sell the stock at the strike price on or before the expiry date.

Puts are primarily used for two reasons – for hedging and for shorting. If you owned 100 shares in Shaw, you might want to buy a put to make sure that you had the right to sell them in March for $21.00, thus limiting your downside. You’d know the least you’d get for the shares is $21.00, and you’d pay $77 for that protection. The other use would be to use puts to bet on a stock going down without actually owning said stock. Don’t worry if you don’t really understand that, we’ll be looking at an actual example of how to do that on Friday. OOOH, FORESHADOWING.

Are you guys bored? I bet you’re bored. Here’s a picture of a kitten and a puppy.

That even warms my cold, cold heart

Just to complicate things further, you can take the opposite side of both a put and call option. Let’s not get into the complexities of that. If will make your brain hurt.

Commodity options are a little less complicated, you’re either long (a buyer) or short (a seller) of the commodity. The big difference is that actual producers use commodity futures to lock in the price they’d pay for the commodity, and they’ll physically take delivery of it at some point. A farmer might use futures to ensure he knows what he’ll pay for feed corn 6 months out. Or, an oil producer might sign a contract stipulating that they’ll sell a portion of their oil for a certain price, thus protecting the company if the price of oil falls down the crapper.

Unlike the options discussed above, both parties are obligated to fulfill their side of the contract.

American options let you exercise your option at any time before the expiry date, while European options make you wait for the special day when the option expires. Meanwhile, dinner options are that you can either take it or leave it. I’d recommend taking it. It’s dinner after all.

There’s also something called counterparty risk. It’s not something you or I would have to worry about, but there’s always the risk that the person on the other side of the contract won’t have the money to exercise their end of the bargain.

Remember all the fun of the financial crisis of 2008-09? A big part of that was counterparty risk, meaning banks weren’t sure other banks would have enough money to pay each other as their derivatives came due. (Think of derivatives as put/call options, except exercising is triggered by an event, not because of a day on the calendar.)

Okay, that’s probably enough. Trading stock options can be incredibly complicated, I’ve barely scratched the surface of the surface. There are all sorts of complex models to predict the prices of these things, as well as formulas to determine the risk. If you don’t want to go to all the work of learning this crap, don’t worry. You can use just the basics to do some pretty interesting stuff, like short a stock without actually having to short it, and make a whole lot of money doing so. Assuming, of course, you get it right.

So won’t you join me on Friday as we look at doing just… yeah, you left a while ago, didn’t you?

Tell everyone, yo!

  6 Responses to “The Basics Of Trading Stock Options”

  1. You lost me at “The Basics. . . ”
    How does anyone work with this terminology and rules?

  2. Ummmmm So….. your recommending Shaw at $22.00? Is that your point here? What’s all that other drivel you wrote about? Does this have anything to do with high fee mutual funds? Can’t wait for your next post.

  3. Great introduction to options! Where can I learn more about this and the complex models you mentioned? Is there a book or website you can recommend?

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