there are two types of options, puts and calls. Call options give the holder of the option the right, not the obligation, to buy a stock at a certain time at a certain price. Once again, it gives the owner the right, but not the obligation, that is, if I own a call option, I have the choice, or one would also say "the option", to buy that stock at a certain price over a certain period of time. Understandable, isn't it? It's a little different with put options.
This gives the put holder the right, but not the obligation, to sell shares at a certain price at a certain time. I can enter into a new sale agreement and have the choice to sell shares at a certain price if it reaches or does not reach or breaks through that price and have the choice to enter into the contract with the person from whom I bought the put.
Imagine coupons, it gets less complicated. Suppose we had a cheeseburger voucher for 1 USD. This is the exercise price we already have of 1 USD. The burger shop and I have determined with this coupon that they will sell me a cheeseburger for 1 USD. Until when is this contract valid? This is the expiration date, let's say it's April. Consequently, we know that we can execute this agreement until April to receive the goods for the price mentioned. So this is a call option. If, for whatever reason, on the day I want to redeem this voucher, cheeseburgers cost 5 USD once, then thanks to the voucher, I can still buy the burger for 1 USD. In this case I would exercise my option to pay only 1 USD.
Now let's take a look at the other side. I don't have to redeem options if I bought them, but in this case it's an advantage for me. But let's take the other side of the example and let's assume that on that day I go to the Diner and cheeseburgers cost just 0.50 USD. In this case I wouldn't redeem the voucher because I wouldn't take advantage of it. In this case I would still have a call option on cheeseburgers, but I will not exercise this option as it is not in my interest. Why should I pay more than I have to? Just transfer this example to stocks like Apple or Amazon or whatever you have in mind. The exercise price, the expiration date and the way the logic works are the same for everything you would put in this place.
Once again, very briefly - it is really important that you internalize these basics. With a call option, you buy the stock at a later date at a fixed price (if you want to). It has an expiry date. So it's like a voucher you buy yourself. This concerns the calls. With put options, you sell shares at a later date at a fixed price. So it is exactly the same - only the other way around.
For newcomers, understanding these contractual relationships is really complicated at first, but once you get involved and the node is broken, option contracts are very easy to understand. Don't worry, we'll go into each component so many times throughout this book that it will become flesh and blood for you. You will see, the world of options is not rocket science.
Remember:
Options are a legally binding contractual agreements between a buyer and a seller to buy and sell shares at a fixed price over a specified period of time.
You can either buy or sell options.
As a buyer, you acquire rights; as a seller, you acquire obligations.
1.3 Stocks vs. Options
Now let's talk about the differences between stock trading and options trading. However, one thing must be clear from the outset. In no way am I going to try to denunciate stock trading here. This type of investment has its raison d'être and I also hold various stocks for various reasons. So there is no reason to demonise stocks. Nevertheless, I am of the opinion that trading options - bad wordplay - offers more options, more opportunities and less risk than trading stocks. However, this statement is only partially correct. Many will now argue with the danger arising from the leverage effect. Let's look at the whole thing together and then you can form your own opinion.
With options we have the possibility to use the leverage to our advantage - but it still holds a certain danger. The leverage effect can work for and against us, but if you are able to understand the mechanics behind it, levers are a great tool - not just in crafts. However, one of the most important advantages of option trading is exactly that - in leverage - because you can use it to increase your return and reduce your risk at the same time. Nevertheless, caution is advised. A hasty action transforms these advantages into disadvantages. However, we will discuss all this in detail. Another advantage of options over stocks is the following. If you trade stocks, you have only a very limited choice of options - you can buy or sell stocks (short selling not necessarily included). When you trade options, you have a huge toolbox from which you can serve yourself. This gives you the ability to create a strategy that exactly matches your assumptions about the stock, your risk appetite, your account size, etc.
Consequently, you are no longer limited to buying or selling, but can react depending on the situation.
There are many different ways to develop complex strategies that you can use to your advantage. They are not limited to deciding whether the stock price will rise or fall. You will also be able to make a profit if the stock just doesn't move at all. The toolbox gives you all these possibilities, which, once you understand them, can be chosen to suit any situation. But more about that later, let's take another look at the advantages of stocks first.
Figure 1 : CatchMark Timber Trust Inc. (CTT), Price in USD, date: 15.02.2019
Source: Yahoo Finance
Imagine you want to buy the above stock. The advantage of this is that you have unlimited time to be right. This means that you could buy the stock today and wait ten years to be right or you could be right overnight or never. In principle, however, you have an unlimited period of time as long as you keep the stock. From my point of view this is the biggest advantage of shares, apart from dividends or special distributions, with which you can generate a nice additional income over the years. Nevertheless, in order to acquire 100 shares in the example of CTT Inc. shown above, you would have to spend 935 USD. So buying shares is very capital-intensive. This is still a comparatively small stock, since companies like Amazon or Google are quoted at well over 1,000 USD per share. If you buy the stock now, you can only earn money if the stock continues to rise.
Well, when it comes to options, there are several ways you can approach this. Let's take another look at the chart. Depending on which strategy you choose, you can benefit from rising and falling prices. You could also choose an area where you would like to be profitable. Let's say that you don't care what happens to the stock - you don't put an increased value on whether it rises or falls. In such a case you set a highest and a lowest point, which must not be breached. If the stock is quoted within this price range at the expiration of the option, you will receive money. So you earn money regardless of whether the stock goes up, down or sideways. In this case one speaks of a strangle (but there are several strategies that work similarly). Sounds too good to be true, doesn't it? I will show you in the course of this book that this is easily possible and very profitable in the long run.
Hopefully this was a good example of why options trading should be considered and what explains the fundamental differences between stock trading and options trading. As I said, stock trading is justified, but for investors it is a binary event and very capital intensive. You have to buy the stock and choose a direction - up or down. By trading options you can use the leverage effect, which means that you can raise less capital and control many more stocks according to your own chosen strategy. This reduces the risk and increases the potential profit because you benefit from multidirectional stock movements. The stock goes a little up or a little down or stays close or runs sideways and simply does nothing. You can use a strategy at any time to profit from this scenario.
Please don't feel overwhelmed at this point or think of witchcraft because your world view has been turned upside down. We will deal with every tiny detail, so that at the end of the book you have a solid understanding and are able to hold your toe in the water. Trading options is a purely mechanical craft, free of emotion, as long as you stick to the mechanics.
Let's sum up the most important things.