Chapter 1: Introduction to Options Trading
Welcome to the world of options trading! If you’re completely new to this, don’t worry. By the end of this chapter, you’ll have a strong understanding of the basic concepts and key terms that are essential to trading options successfully. We’re going to start with the fundamentals, so that you can build a solid foundation as you begin your trading journey.
1.1 What Are Options?
An option is a type of financial contract that gives you the right, but not the obligation, to either buy or sell a stock at a specific price before a set date. Unlike trading stocks directly, where you own shares, options give you the power to control or influence the price movement of a stock without actually owning it. This makes options a flexible and powerful tool for traders who want to benefit from price changes while risking less capital than would be required to buy the stock outright.
There are two types of options contracts:
- Call options: Give you the right to buy a stock at a specific price (called the strike price) within a certain time frame.
- Put options: Give you the right to sell a stock at a specific price within the same time frame.
1.2 Basic Terminology: Calls, Puts, Strike Price, and Expiration Date
Now that you know what options are, let’s break down some of the key terms you'll need to understand before placing your first trade.
Key Options Terminology
| Term | Definition |
|---|---|
| Call Option | A contract that gives you the right to buy a stock at a specific price (strike price) before the expiration date. |
| Put Option | A contract that gives you the right to sell a stock at a specific price (strike price) before the expiration date. |
| Strike Price | The price at which you can buy (call option) or sell (put option) the underlying stock. |
| Expiration Date | The date by which the option must be exercised or it will expire worthless. |
| Premium | The price you pay to purchase the option contract. This is the cost of the contract itself. |
| In-the-Money (ITM) | A call option is ITM when the stock’s price is above the strike price. A put option is ITM when the stock’s price is below the strike price. |
| Out-of-the-Money (OTM) | A call option is OTM when the stock’s price is below the strike price. A put option is OTM when the stock’s price is above the strike price. |
Example: Let’s say you buy a call option with a strike price of $100 and the stock rises to $120. You now have the right to buy the stock at $100, even though it’s trading for more. This is how you profit from a call option. For put options, it’s the opposite. If you bought a put with a strike price of $50 and the stock drops to $40, you can sell it at the higher strike price of $50, gaining a profit.
The expiration date is crucial because it determines how long you have to act on your option. If the stock moves in your favor before expiration, you can profit by exercising the option or selling the contract to another trader.
It’s also important to note the concept of premium. The premium is what you pay for the option contract itself—similar to paying for insurance. Whether you choose to exercise your option or not, the premium is a non-refundable cost of entering the trade.
Understanding the relationship between the stock price and the strike price is key to identifying whether an option is profitable. When the stock price moves favorably beyond the strike price, your option is in-the-money (ITM). If the stock price hasn’t yet moved in your favor, the option is out-of-the-money (OTM), though it still could become profitable before expiration.
Next Steps
Now that you understand the basics of options and the key terms involved, you're ready to move on to the next chapter, where we’ll explore naked call and put options in more detail and how to trade them.