Maybe you have read that an option is a right to buy a stock at a certain price at a certain point in the future. Maybe such a clinical definition didn’t get you any closer to understanding what stock options are all about. I believe any investor can grasp the concepts if they have stock options explained briefly and clearly to them. But please remember: understanding this game and winning at it are two very different things. Consult a licensed financial planner or broker before you invest with real money. Buying stock options can lead to the loss of your entire investment. Also, stock options given to employees as part of a compensation package are a subject for another tutorial, as are binary options–I’ll explain puts and calls in this article, buying stock options for one’s own portfolio. (I might cover writing or selling puts and calls in a future tutorial if there is enough interest)

To keep it simple I will cover only call options in this explanation, not puts-see this post to get put options explained. Calls give you the right to buy shares, while put options give you the right to sell shares, but just as I wouldn’t have to tell you how to do forearm curls with your left arm if I explained how to do them with your right arm, you will understand options mechanics–puts and calls–by simply understanding call option basics.

It is January 1 and the price of XYZ stock is $12 a share.

An options table tells me that an XYZ April 10 call option contract is trading at $3.  If I owned this contract I would have the right to buy 100 shares of XYZ at a price (the premium) of $10, until the call expires on the third Friday of the expiration month, April in this case. One option contact gives me the right to buy 100 shares of the underlying stock.

Since the stock is at 12 it is easy to see why this right would have value: if I exercised my right and bought 100 shares at $10, I could immediately sell the shares for $1200, for a net profit of $200. The definable, guaranteed, intrinsic value, the difference between the $10 strike price and the current stock price, is concept #1. (In practice, options contracts are not exercised before their expiration, they are simply bought and sold until they are exercised by the final contract holder at expiration)

In our example, why is the option contract priced at three dollars? The intrinsic value of the contract is two dollars–the difference between the price at which I have the right to buy the shares at where the shares are priced right now. But there’s another critical part of the contract’s value.

It’s January 1, so there is more than 3 1/2 months left in the life of the contract, until the third Friday in April. The price of XYZ, the underlying stock, will fluctuate in that time; the potential for appreciation in the underlying stock means that the option contract has time value, ($1 in our example), in addition to the intrinsic value ($2 in our example). Intrinsic value is a matter of simple math, but the time value is determined by the market. When I refer to time value and intrinsic value remember that they are simply components of the premium price. An option contract has only one price but it is instructive to examine the two components of that price.

Let’s tweak our example above to make this a little clearer. What if XYZ’s stock price dropped from $12 to $9 per share the day after we bought our option? The option was $2 ‘in the money‘ at 12; now it’s $1 ‘out of the money‘. With the stock at $9, the option to buy the stock at $10 has zero intrinsic value: you can buy the stock at a lower price than owning the option currently allows you to do.

But does this mean that the option has zero value? It is now January 2 and your April 10 call still has more than 3 1/2 months until expiration. A lot can happen in that time. Naturally the market will ascribe a value to the April 10s that is more than zero, and in this case the value will be 100% time value.

For a given amount of time left before expiration, the closer the stock price is to an out-of-the-money option’s strike price, the greater the time value. Also obviously perhaps, for a given price, the more time left until the contract expires the greater the time value. I want to only cover stock options basics now, and so I won’t address myriad subtleties that affect the time value of options contracts, except to say that everything else being equal, the higher the underlying stock’s volatility (propensity to change over time) the greater the time value, as determined by the marketplace, will be.

The important thing to remember about time value is that (everything else being equal) it is “decaying” all the time, as time passes and the days until expiration decrease. Time decay is one of the things that makes options trading tricky. While you could theoretically hold a stock position indefinitely waiting for things to move in your favor, stock option picks do not afford you this luxury. Getting options trading explained to you means grasping the implications of time decay.

Leverage: More Bang For The Buck

Maybe you’re wondering why a person would buy stock options instead of just buying the stock. Great question.

Let’s say you’ve been watching XYZ, and you have reason to think it is a good buy at $12 a share. For $1200 you could buy 100 shares. For the same $1200 you could buy four of the XYZ April 10 calls, presently trading at $3 (4 X $300– each contract covers 100 shares of stock).

Let’s say the stock goes to $15. If you bought 100 shares your position is worth $1500, and you made 25% on your original $1200 investment, whether it takes three days or three years to move to $15 per share.

What if, with the stock at $12, you had bought four XYZ April 10 options instead? If XYZ stock goes to $15 per share, the difference between the $10 strike price and the current stock price is $5. We know that owning these contracts gives us the right to buy the stock at $10, and that with XYZ at $15 we can sell them for five dollars ($500) each, plus whatever time value is contained in the option, as determined by the marketplace. Our $1200 position is now worth $2000, plus time value. Even if it is the Friday afternoon of the third week in April and there is zero time value left, our profit is 67%.

This is an illustration of leverage, which allows you to control an asset using less money than it would take to buy the asset outright and therefore enjoy the benefits of an upward move in the price of an asset for less money. In this way, if your position is a profitable one, your percentage gain will be higher. The downside of leverage is that you can also be hurt more by a given move in the price of an asset, in terms of a percentage of what you invested. Central to any explanation of stock options basics is the double-edged sword of leverage.

Per our example, let’s say that the price of XYZ after we purchased it at $12 per share simply drifts down to $11 per share. This gives each of our options and intrinsic value of one dollar ($100), so our four XYZ April 10 options are worth a total of $400, plus time value. As we get closer to the end of the third week in April, the time value slowly decays to zero. If XYZ is at $11 per share at expiration our contracts are still in the money, but we have lost 67% of our original $1200 investment.

And what if the price of XYZ goes to nine dollars per share, and we hold on watching the time value decay to zero? At expiration there is neither intrinsic value because the contracts are out of the money, nor is there time value left. Our four options contracts expire worthless, and if we are human will probably wonder at least once or twice why we did not sell earlier, or why we didn’t buy the stock. Options explained easy doesn’t mean trading miracles guaranteed!

A final scenario regarding trading options vs purchasing stock: What if XYZ moved very little after we bought it, but we held on to our four options contracts while the stock drifted up a bit from $12, to maybe $12.50 by expiration in April? What is the value of our position? As the stock is 2.5 points over the strike price, the math is 4 x 2.50 or $250 = $1000. This position cost us $200, even though we were right about XYZ! We just weren’t right enough. Owning the stock would have us at a $50 profit, and we wouldn’t be obligated to exit.

With options, even simply buying puts and calls, you can see how the challenge is more complex than simply being right about the direction that a stock will move. It gets more complicated from here, but many strategies allow you to reduce risk by not focusing on simple leverage to profit, i.e. by selling options. Hedging with options is covered here.

Question time:

What is so special about $10 a share, April, and the 3rd Friday of each month for that matter? Nothing. Strike prices, options expiration months, and the 3rd Friday are all arbitrarily set by the options exchange. Regarding strike prices, if XYZ is at $12 per share you might see contracts with strike prices in increments of one dollar between five and 20, and $2.5 or $5 increments higher than that. As the stock goes higher or lower, new contracts are created to trade as needed.

Am I obligated to hold my option contract(s) until the expiration date? Absolutely not. You may sell at any time. Holding contracts until expiration is rarely the motive for buying options. In fact, because the time value of an option is usually decaying, you must constantly reassess whether you think the stock will move in your favor, and move fast enough, to outweigh the time decay that will occur in the contract over time (the ways in which volatility or lack of volatility can bloat or reduce time value of premiums is beyond the scope of this tutorial). Most people “trade” options for the short term and sell their contracts well before expiration, simply trying to capture the move they hoped would occur, to avoid the additional time decay in the premium. With options, you want not only to be right, you want to be right as soon as possible! ‘Buy and hold’ is usually not a strategy that works with options (though there are option trading strategies involving long term options, called LEAPS, that we can cover in another article). Also, you should know that there are myriad free and subscription stock option software packages useful to help you determine just how long to hold your contact.

Having said that, you are entitled to hold your position until expiration day, at which time you are obligated to exercise your right to buy 100 shares of the underlying stock at the strike price. “Exercising your option” at expiry, which the final holder of an in-the-money option contract is required to do, will require additional funds to buy the shares of course, and you will have to pay commissions when you do sell later. The savings that you realize by buying shares at the strike price, which would be lower than the current stock price, can be had by selling your contracts immediately before expiration for just their intrinsic value (as all time value will be gone).

It may have only taken 10 minutes for you to have stock options explained to you. There’s admittedly more to it than explaining how to learn the stock market. Still, I hope I did a good job presenting stock options basics – the concepts, the potential rewards, and certainly the risks. If you are intent on having options trading explained to you that’s admirable, but I cannot emphasize strongly enough how hard it is to consistently make money by going long stock options. I’ve certainly heard estimates of more than 90% of put and call trades losing money. Writing or selling covered options, which is the other side of the more risky long call or put option position, is a stock option explanation for another day and if there’s enough interest I might cover writing options (ie selling options) in another tutorial.

Obviously no one knows if the market is at the beginning of a new bear market phase for the stock market, but one thing is for sure: if you would like to hedge yourself against the possibility that July 2011 marked the beginning of a downtrend, stock options–specifically put options–offer many opportunities for protecting yourself against losses. In this article Stock Options Explained will cover the simplest one of all: simply buying puts on stocks that you own.

Investors and short-term traders often attempt to use the outright purchase of put options to make money in a bear market or to protect their stock investments against potential losses. Either way, one favorable aspect of purchasing puts is that your risk is completely defined; in other words you can lose no more on a long put option than the purchase price that you pay for it. Of course, if the market does not reverse as you fear you could very well lose the entire purchase price of your put options. In this case presumably the appreciation you see in the stocks in your portfolio, against which the puts were meant to function merely as a hedge, will outweigh the losses you experience with your put contracts.

If the value of a given stock in your portfolio does fall in value though, the purpose of the purchase of your put contracts is to provide you with some profits to offset the paper losses you are experiencing with the stock. The idea here is that the puts are relatively short-term investments and you are not pessimistic enough to sell your stock positions outright. It has to be said– sometimes simply selling is a better strategy than trying to construct a hedge and augment it with hope.

The way the mechanics of this trade would work is that when you buy shorter-term puts, say with one to three months until expiration on them, most likely at the money or out of the money, you can either hold until expiration or until you suspect that the downward move is finished. Note that if the downturn is prolonged, you could potentially buy a whole series of puts against your long stock positions, though again if the market is experiencing a prolonged downtrend you would be thinking about selling those positions instead.

Many investors have never even heard of stock options selling. For most people options trading is synonymous with risk and potential big profits or losses, using leverage by buying options. However, a lot of savvy investors use strategies involving selling options, also known as options writing, to hedge existing positions against the possibility that the stocks that they already own, or are short, will move against them.

Now hedging with options is nowhere near as exciting as leveraging with options and doubling or tripling your money quickly. Perhaps this is the reason you don’t get the details of options selling explained as frequently in books or on websites on stock options basics. It certainly is a lot more exciting than losing all the money that you have put into a long option position though, which happens all too often unfortunately!

Selling Options Equals Writing Options

Before we proceed it must be clear to you that writing options is the same as selling them. Got it? Great! Now, by writing puts and calls you can benefit from the fact that the great majority of long put and call positions, i.e. where put/call contracts are bought, are losing bets for the buyers. When an investor engages in writing options, he attempts to make money in a way that is exactly the opposite of buying options. In a nutshell, the options seller takes the other side of the buyer’s much riskier position. Perhaps it makes sense that selling options in this way he has an inverse likelihood of profiting. The risk, as well as the potential gain, is smaller. However, the potential for gain is greater, and many good investors will take consistent gains over a mix of big wins and frequent losses of an entire position.

Example time. I will talk here about writing calls against stock that you own. The mechanics are the same if you write puts against stock that you are short, only the directional movements are reversed for writing puts.

It is April and you own 100 shares of ABC, which is trading at the moment at $33 per share. You feel good because you were right about the stock, having bought at $25. You don’t think it’s done moving up though, and you have no intention of selling at $33. At the same time you recognize that a pullback or some consolidation might be in order, and you would appreciate a way to reap some of the benefit from this position without actually selling your shares. Selling options against your shares is the perfect way to do this. You can sell one ABC August 35 call, at $1.50, let’s say. You are selling someone the right to buy 100 shares of ABC at 35 by the end of the third week in August, and for this you are paid $150 in this case ($1.50 X the 100 shares that the contract represents).

The person on the other side of the transaction, the call buyer, has paid a relatively small amount of money for an out-of-the-money option that may very well expire worthless, in the hope that the stock will continue its upward rise and give him a very high percentage gain. In addition to the possibility that the option will become in-the-money and have intrinsic value, he also would benefit by having the stock move as soon as possible so that he may sell before time decay hurts the value of his option too much.

As the option seller you accept an amount that is small relative to the size of your position ($3300 at the moment), but it functions as a small insurance policy protecting you in case the stock does have a pullback from $33, temporary or otherwise. The $150 premium you receive lowers the cost basis of the position for you. You bought at $25, but now this position has cost you $23.5, or $2350.

If the stock is below $35 per share on expiration day, roughly 4 months from now in August, you keep your ABC stock as well as the premium amount. Over the four months that premium represents approximately a 13% annualized return (150*(12/4)/3300=~13%).

What if the stock price is above the strike price on expiration day? Well, you must deliver 100 shares of ABC at $35 per share. Having bought the stock at 25, you are still pretty happy, but the critical thing to recognize is that if the stock keeps going past $35 a share you would have missed out on any move above $35 directly because of the insurance that you purchased to guard against a drop back in the price of the shares. Still, another thing in your favor is also the premium amount that you get to keep.

Note the clean inverse relationship between the motivations of the options buyer and option seller, and the ways in which each stands to benefit.

The option seller wants to hedge and is happy with a small return relative to the size of his existing position. Time decay is his friend; all else being equal, the price of closing his position before expiration goes down each day, until expiration when the option expires worthless (if it’s out of the money) and he keeps 100% of the premium and his shares, or (if the option is in the money) is forced to sell his shares at a gain while still keeping the premium he received.

The options buyer uses leverage for a possible large percentage return. The passage of time will work against the value of his position (notwithstanding volatility and other factors beyond the scope of this article).

That is the basics of stock options selling explained. If you do your homework you might find that writing covered options gives you a fairly good shot at making relatively small but consistent gains over time.

Why do I say “covered” options? What are covered calls and puts and why the qualification?

A covered call writer owns 100 shares of the underlying security against which the call is written, for each call that he has written. (A covered put seller is short 100 shares of the underlying security for each put he writes) You could establish a covered options position by selling a call or put contract against a stock position (long or short, respectively) that you already have established, as in our example, or you could buy or short shares at the same time as you write an option against them.

Writing uncovered or naked options means that you do not own the underlying shares, if you are writing calls, or you are not short the underlying shares if you are writing puts.

So what’s the big deal about naked puts and calls? In a word, risk. There is a huge difference between selling “covered” options versus selling “uncovered” or “naked” options, in terms of risk between the two. A risk continuum is a good way to explain option trading.

As a call option contract gives you the right to buy 100 shares (or for puts, to sell 100 shares) of the underlying security at a given price on a given date in the future, there must be a place from which these shares are delivered (or a counterparty who will buy the shares, for puts) if the option is in-the-money on expiration day.

As the options writer or seller, you have been paid an amount of money, a premium, to assume that responsibility. If the option is exercised and you do not already have the shares in your account as a call seller (or if you are not already short the shares as a put seller), delivery of 100 shares for every call contract that you have written (or purchase of 100 shares for each put you wrote) would be a relatively large, immediate expense to you.

But the real problem here, for a naked call position that goes against you, is that you would be forced to purchase shares at the current market price and sell them immediately at the strike price, which would be below (and maybe far below!) the current price of the stock in the case of an in-the-money call. For a naked put position whose strike price is higher than the stock price by expiration day, you would have to buy 100 shares for each contract that you have written, at a higher price at which you can currently buy the stock.

For calls, you would immediately lose the difference between the strike price and the price at which you may currently buy the shares in order to fulfill your obligation to deliver. For a naked put position that goes against you, you must buy the stock that the put buyer owns the right to sell (a terrible sentence I know; I hope it makes sense). The bottom line is that no one should ever tell you that option trading strategies involving selling options are always safe.

This is one case where writing naked puts and naked calls have different outcomes if the trade goes against you: when your naked put position concludes at a loss it is only a paper loss. Buying the shares at the strike, higher than the current market price, leaves you with those shares. With naked calls, immediate delivery equals an immediate loss.

Either way, if you have many contracts this could add up to a lot of money, especially when compared to the relatively small amount that you received for writing the options. Brokerage firms will require that you have money enough in your account to cover (literally) naked options positions that go against you, in lieu of owning the shares. There is a possibility that even a option contract that was far out-of-the money when you wrote it could expire in-the-money. You must show a way to address this possibility, whether through cash in your account, equity, or by simply owning (or having short) shares of the underlying stock equal to the shares represented by the contract(s) that you have written (i.e. covered puts or calls).

To circle back a little, hopefully you can see clearly now why writing covered puts, against shares that we are short, provides us with a little safety against an upward spike, by effectively raising the cost basis for our short. And, if the share price plummets and if we are forced to buy shares at the (higher) strike price at expiration, we are simply covering an existing short position at a profit. It’s the inverse outcome of a covered call position where the stock price rockets higher. We have lost only the opportunity cost of missing the big move, in return for the insurance of the call, or put, that we would have been better off not writing. Having naked options positions go against us leaves us facing a very different type of music, though maybe slightly less dire in the case of naked puts, as we can theoretically hold our newly purchased stock until it comes back…

So to recap, the options seller, as he is hedging with options, normally trades away the prospect of benefiting if his underlying long or short position runs far in his favor, i.e. beyond the strike price of the option he writes. In return he receives the premium from the options buyer, which can be though of as insurance against a the stock moving against him (as it reduces his cost basis), and a simple windfall if the stock trades sideways. Keeping the proceeds from these premium amounts if positions work out in your favor can give you very respectable gains, though really never triple-digit home runs as can happen with long option positions. Sometimes sophisticated investors establish naked options positions, but they are quite speculative and require sophistication and financial wherewithal. To be clear: selling options for safety means that you will always own the underlying stock.

In the real world, writing options is especially well-suited to investors with large portfolios who would like to protect paper gains that they might have, or reduce their cost basis when they open up a position. The benefits of selling options must always be weighed against the fact that they reduce the potential profit of a given long or short stock position. Sometimes letting a stock continue to move in your favor with a trailing stop is a good way to have a nice gain turn into a huge gain, even without leverage. Capping a position’s potential gains by selling an option against it is probably not a strategy you should use for every single stock that you buy or short. There are many strategies one may use with covered options; another good one is writing naked puts to buy a stock lower than its current price, or simply pocket the premium if it never gets there before expiration.

Even though writing options (at least covered options) is safer than buying options, it’s not for everyone. Having stock options explained to to you properly, as I hope I’ve done, does not reduce the risk of trading them. Please consult a financial professional before investing in them, and if you are of a conservative mindset get options trading explained to you with an emphasis on options selling.

You can get put options explained to you in a couple of sentences, as in: a put option is an options contract that gives the buyer of the put the right to sell 100 shares (per contract) of the underlying security at a given price, by a specified date in the future. The put seller, on the other hand, assumes the obligation to buy 100 shares of the underlying stock at a given strike price, by a defined expiration date in the future.

You may have a pretty good understanding of stock options basics in both buying and selling call options, which in their simplest forms usually involve assuming risk through leverage when buying calls, and alternately, offer opportunity to reduce risk by hedging, when selling calls (also known as writing calls).

For some people though, buying and selling put options is a little harder to understand. After all, how can the put buyer sell 100 shares of something he does not own? How in turn can a put seller fulfill his obligation to buy 100 shares of stock that the put buyer does not own? In this post you’ll get put options explained in such a way that even an options beginner can understand.

This confusion is easily cleared up when you recognize that this transaction is consummated simply by both parties fulfilling their obligations. In an effort to get put options explained for you once and for all, I will cover what happens both when the stock price is below the strike price and above the strike, at expiration.

If Stock Price Is Above Strike Price At Expiration

On the options expiration date, if the price of the underlying security is above the strike price, i.e. out of the money, then the put option will not be exercised because the right to sell shares (the put buyer owns this right) at a price that is lower than current market price would be worthless. The put would expire worthless and this would benefit the put seller, or writer, as he keeps the premium that he was paid upon entering the position. If the put seller had entered the position to hedge shares that he was short, keeping the options premium in this way will reduce his cost basis for the shares that he is short. The put buyer in this case would lose the entire purchase price of the put.

If Stock Price Is Below Strike Price At Expiration

On the other hand, if the price of the underlying stock at expiration is below the put contract’s strike price, i.e. in the money, the put option buyer will exercise his right to sell 100 shares at the strike price. If he was long shares of the stock, he has been protected by his put purchase from any decline in the stock price below the strike price. This is one way that buying puts function as insurance if you are long the underlying stock: for the premium that you paid you are protected until expiry from a fall below the strike. (Another way that puts can function as insurance is if we see a sudden appreciation in the put contract price because of a decline in the stock price, and we sell. In this case the profit from selling our put would reduce our cost basis of being long the stock, as it declines) If the put buyer was not long shares, exercising his option will leave him short 100 shares (per contract he owns) at a higher price than where the stock is currently trading: a good outcome. If this is hard to understand, just think of it this way: it is exactly the same as a call buyer exercising his call when the price of the stock is higher than the strike. His position will no longer be leveraged, but he owns the shares with a paper profit of the difference between the strike and the (higher) stock price, times 100. Ironically, in many ways getting put options trading explained to you will conceptually echo call options trading.

In this scenario, the put seller is forced to buy 100 shares of the underling stock at the strike. This means he has an immediate paper loss of the difference between the current stock price and the strike price, times 100 shares, unless he was hedging a short stock position (in which case he simple covers his short at the strike). If he is not short the shares, buying 100 shares for each of the multiple contracts that he might have written would represent a very large out-of-pocket expense.

When would you sell puts? When would you buy puts?

If you are short the underlying stock but fear that there might be a short-term increase in the price, you could sell one put contract for each 100 shares that you are short, as a hedge. If the stock price at expiry is above the strike, you keep the put premium and your cost basis for your short shares is reduced, as previously stated. Of course, the downside is that if the stock continues to go down and its price is below the strike price at expiration, as the put seller you will miss out (relative to the shares that you are short) on any downside move beyond the strike price of the put, as you are obligated to buy (in other words, cover your short in this case) 100 shares at the strike price for each contact you have written. There are other times when you might sell puts too, for instance if you decide that you like a stock but feel that it is currently too expensive. You could pick a price at which you’d like to own it, and write a put with that strike price for each 100 shares you are prepared to purchase. If it does not reach the strike you keep the premium you received, and if it does reach the strike you could buy it at that price. There is no guarantee that it won’t go still lower, of course!

You would buy puts if you are interested in taking advantage of a price decline that you’re expecting in a stock, using leverage, ie with less money than your broker would require you have in your account to go short. The potential downside of this leverage is that you could lose the entire amount that your put contract(s) cost you. The upside is that if you are correct, a given decline in the stock price will probably result in a much higher percentage gain on the money you have invested than if you had simply gone short. Stock options basics must absolutely be intertwined with an understanding of leverage.

Quality free stock option software can help you with the complexities of trading options. Also, if you feel you have not had put options explained adequately to you, or anything about stock options explained well enough for that matter, let me know in the comments, please.

I have decided that discussing stock options basics for beginning investors with no previous experience at stock options trading might be worthwhile. I’ve received a few comments that indicate that readers would appreciate if I could explain option trading with clearer definitions of options terminology, along with another explanation of the basics that is less wordy than the ‘stock options explained‘ article that leads off this site. I’ll do my best.

Stock Options Basics: Seeing Both Sides of the Trade

Financial exchanges created options as investment products which give people more choice as to where to put their money. Rather than simply buy or short stocks, options give you the chance to diversify by using investment funds in two primary ways.

Simply buying calls or puts is a way to leverage a relatively small amount of your investment portfolio towards a hunch that a stock will rise or fall. A call gives you the right to purchase one hundred shares of stock in a specific company at a given price point at a specific date in the future. In the same way, puts gives you the right to sell 100 shares of a company’s stock at a specific ‘strike price‘ at a predetermined future date. It’s important to recognize that you’re not trading shares of stock here; you are buying and selling the right to buy or sell shares of the stock. This is probably the most difficult concept for new investors to really understand.

Another way that stock options trading can be approached is by taking the other side of the trade from the person who buys (or “goes long”) the put or call. This is called selling, or writing, an option (you could think of it as going short the option, but let’s not get ahead of ourselves), and it’s normally a much safer trade than buying an option contract, as when you do this you are hedging with options.

The overall mechanics of an option trade will help you understand how the buyer and seller of an option take on an inverse amount of risk. This will give you a complete view of options transactions and hint at ways that they can be used as part of a conservative investment strategy as well as a leveraged financial tool. As with many things, I think a holistic overview is the best way to have stock options basics explained for inexperienced investors.

An option contract has no intrinsic value until the stock reaches the option’s strike price. The only value which the right to buy a stock at $10 has before it reaches $10 is the value of the time (time value) left before the contact expiration, during which the contract has a chance to reach the strike price. If the strike price is substantially higher than the current stock price (I’ll cover calls here) and therefore fairly unlikely to be reached by the stock before expiration, it would be unlikely for the call or put to ever have an intrinsic value, all else being equal.

If the call option is below the strike price at expiration it will expire worthless, as the value of an expiring right to buy something (today) at a price that’s higher than the current market price is zero. The option seller received money that the buyer paid for the option, known as the premium, and made the promise to deliver the 100 shares of stock at expiration. The option seller most likely owns that many shares, and if he doesn’t, his brokerage firm most certainly requires that he have funds/liquid assets with which he can use to deliver the shares. If the contract expires worthless, the option seller keeps the premium, and his 100 shares as well.

As unlikely as it may be that the option buyer will profit– and just how unlikely depends on how much time is left on the contract, how far away the stock price is from the strike price, and the stock’s volatility (propensity for the stock to move in either direction)–it is just as likely that the call or put seller will profit. Put very simply, there is an inverse relationship between the risk that option buyer assumes on one hand and the amount of risk that the option seller assumes.

It’s a truism in investing that greater risk implies greater potential rewards, but by seeing the option trade has two sides-buyer and a writer-we see that the statement that ‘options are risky’ is an overly simplistic statement. Buying puts and calls is relatively risky, but carries with it large potential rewards relative to the amount of cash one needs to buy contracts. However options selling is relatively safe–for covered options anyway–though the premium you stand to collect will be relatively small compared to the amount of stock that one promises to deliver should the contract expire in the money, ie above the strike price (in the case of calls). Less risk, less reward (though most likely more consistently achievable gains).

In other articles on this site we’ll talk in depth about using call or put purchases together with owning or being short the underlying stock, e.g using a protective put strategy to lock in stock gains.

(I should mention that I have been talking about covered calls in this example to keep things simple. Writing naked puts and calls is an extremely risky trade where the option seller does not own the underlying security. It hardly belongs in an article on stock options basics so I’ll save naked options for a separate post entirely.)

Stock Options Basic Definitions

The strike price is the price at which you have the right to buy 100 shares of the underlying stock, in the case of a call contract, or to sell 100 shares of the underlying in the case of a put contract.

The expiration date is the date on which a stock option contract expires, on Saturday after the third Friday of its expiration month. Normally options contracts for heavily traded stocks will be available to trade for the next few-or several-months from today’s date.

An in-the-money stock option is a call whose strike price is below the current price of the stock, or a put whose strike price is above the current price of the stock. We say that an in-the-money option has intrinsic value equal to the amount by which the stock price is over the strike price, times 100 (each contract covers 100 shares of stock). For example, if IBM is at $102 per share, then any of the IBM 100 series options (any expiration date) will have two dollars of intrinsic value, or be worth at least $200. Naturally the further out the expiration date of an IBM 100 series option is, the higher the value of the option will be; in this case we say that in addition to its intrinsic value it also has a time value. As you might guess, out-of-the-money options have a strike price that is below the current price of the stock in the case of calls, vice-versa for puts.

Exercising stock options is what occurs when an in the money option expires: the final holder of the option will choose to convert his contract into the 100 shares that gives him the right to purchase; in other words he “exercises his option” to purchase the shares. Remember that an out-of-the money contract will have no value at expiration and therefore cannot be exercised.

Stock options quotes are easily found in online and physical publications that focus on to the day or up-to-the-minute prices of frequently traded financial instruments. Familiar examples online are Google Finance, Yahoo Finance, and the Wall Street Journal would be a reliable place to look for options quotes if an Internet connection is unavailable.

Remember that employee stock options are issued by companies as a form of compensation, and are different from regular options that are traded on major exchanges such as the Chicago Board Options Exchange or CBOE. An overview of SFAS 123 and employee stock options basics can be found at the first link in this sentence. Also, a good review of stock option software can be found at the link.

Many visitors to this site are interested in getting the basics of stock options explained clearly to them, perhaps for the first time. While options are too risky for many new investors, for those readers who have decided that using leverage with a small portion of their investment funds is appropriate for them, it seems fitting for me to cover trading tools like stock option software in what might turn out to be a series of stock option software reviews. As difficult as options trading is, you can find lots of help via free stock options software in automating the process of sifting through potential opportunities, accelerating the initial process of culling your best possibilities for successful trades from myriad combinations of strike prices, expiration dates and underlying stocks, based on criteria that you determine.

There’s a wide range of stock option trading software available, and while you certainly can spend a lot of money on a sophisticated software package there is also excellent options software that is available for free download. Be aware that sometimes companies will offer what sound like stock option ‘systems’ that in fact involve pricey advisory services, subscription-based memberships or managed option strategies. It might be best to use some free software (freeware) for a while to see if it meets your trading needs, because depending on your level of sophistication, it just might. This is not to say that these paid programs do not have value of course, but in your search for free stock option software be aware that you will run across many expensive offers as well.

I’ve written these stock option software reviews for reference to help you in your trading, and I expect to add to it over time. If you have discovered a tool that has helped you in your options trading please let us all know in the comments. By the way, I have no connection to any of the companies mentioned. These are unbiased reviews.
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Option Edge is an outstanding piece of free stock option software that enables you to easily explore what-if strategies before you enter a trade, by typing the specifics of the position into an Excel spreadsheet format. The software can analyse more complex positions like spreads, etc. as it allows you to put in the particulars of each leg of your position then calculates outcomes for the entire position. This is a great time saver because instead of having to manually calculate your break-even point or maximum loss/gain for the trade, the process is automated for you.

In addition to the tabulated numbers, the software provides results in graph form, so that you’re presented with the entire range of outcomes in easy-to-understand picture. The format also shows stats like days till expiration, the Black-Scholes price, the Delta, dividend yield, volatility, functionality to graph options pain, the debit or credit at the position represents to your account, as well as the aforementioned max profit and max risk.

This software is so simple and intuitive that the documentation is only a few paragraphs! Did I mention it is free? Outstanding software, well-executed and a real time saver when you are comparing the relative merits of different positions you are considering entering or exiting.
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The OptionsOracle options trading analysis tool from SamoaSky is another outstanding free piece of stock-option software.

You begin by building an theoretical options position and then testing it using myriad graphs and analytical tools to determine how much risk you would be undertaking and to precisely quantify the potential outcomes of any trade. All you have to do is type in the symbol for the underlying stock and the software will automatically download real-time data for the stock and its entire option table, i.e. all of the strike prices and expiration dates. The goal here, as with most option trading software is to fully understand the position you’re thinking about entering by attaching numbers to different potential outcomes. You can gauge the relative merits of different combinations of strike prices and expiration dates for a give stock option, or a position in the contracts of an entirely different underlying stock, before you enter trades.

The amazing thing about Options Oracle is that it provides users with other advanced tools, integrated right into the platform. As everyone has different needs, there may be no single best stock option software package but having said that I am astounded at how comprehensive this software is, and it’s free. Amazing value:

There is an options trading screener that you can use to check pre-configured strategies over many stocks at the same time.

For more advanced users there is a volatility analyzer, an options calculator, a “maximum option pain” graph and a so-called volatility smile graph.

The volatility analyzer is a calculator that shows you in graphic form the historical volatility for an option in comparison with the actual implied volatility over a given time period.

You can use the Greeks calculator to get quick looks at delta, gamma, theta, and vega data for an options contract of a given strike price and expiration date. Loads of information here, even for sophisticated options investors, and an enormous timesaver.

The volatility smile graph will show you the volatility smile for different options chains on different expiration dates, i.e. the change in volatility of a particular option depending on its distance from the at-the-money money option.

Additionally there is a portfolio manager at strategy analysis tools.

OptionsOracle automatically supports downloads of options-chain information from over a dozen options exchanges from around the world. Windows XP/Vista/7 platforms only.
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The Visual Options Analyzer from Voptions is a sophisticated tool you can use to visualize in 3-D complex relationships between stock prices, expiration dates, and profit/loss scenarios built into any trade. The visualization capabilities here are valuable for getting a “feel” for every aspect of a trade through multicolored heat-map style 3-D chart that you can rotate and zoom in on as you do your analysis. With this stock option software you can easily calculate and graph options pain with 2-D charts that employ sliders to change parameters like the stock price, volatility, days until expiration, and interest rate, etc. One of the strong points of this software is that your data is all in front of you or just one click away; there’s a wealth of information presented in a very concise format. Just about all flavors of Windows are supported with minimal RAM requirements. Would definitely be a no-brainer for options trading if you are a TD Ameritrade customer as it is free if you are; $69 to non-customers.
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You’ll find plenty of free stock option software reviews online, but in my opinion these are three of the best pieces of stock option software currently available. Please let me know if you have used option trading software that has helped you; I would be happy to add it to this list of reviews. Tools that help options traders quickly calculate potential pricing scenarios, look at implied volatility vs. historical volatility, graph options pain, etc., help increase your odds of profiting with these investments, and we can all use all the help we can get in this game. Once you have researched trading software, make sure you also read up in an effort to get options trading explained adequately to you.

As I have used this site to simply explain stock options to beginning investors, I’ve also been asked from time to time to take a slightly different direction by readers who would like to get options trading explained to them. I’ve been a little bit reluctant to extend the scope of this site beyond its title–stock options explained–because of the risky nature of options, especially in the hands of neophyte investors for whom buying, or going long, puts and calls is the most natural way to approach options trading. Providing basic education to investors  on stock options is one thing, but I would hope that no one would interpret their understanding of options basics as an indication that trading them successfully is anywhere near as simple, because it is not.

Still, I thought there might be some benefit in explaining basic trading strategies we have available to us in trying to successfully invest with options, over a series of articles. At this stage I’ll focus less on specific options trading tips and options trading systems than generic options strategies. The first two articles will contrast buying puts and calls with the relatively conservative strategy of selling, or writing, puts and calls; my aim is to get trading explained easily to options investors in terms of managing risk as opposed to making a quick killing. All in all, if the purpose of this site is to explain stock options, leaving actual options trading strategies out of my explanation seems incomplete.

In subsequent articles I will also get some of the more complex options trading strategies explained, involving combinations of buying and selling options contracts, often of different strike prices and expiration dates, as part of the same transaction. There are spreads, straddles and 100 variations of more sophisticated ways to play options, strategies that aim to profit not simply from the direction in which a stock or the overall market moves, but rather from things like changes in a stock’s volatility over time. Understanding the risk involved in simple long options positions will hopefully motivate readers to learn about these other types of trades; professionals and sophisticated options traders use them to manage risk, especially relative to an existing portfolio via hedging with options, and a responsible investor would do well to learn about them too.

But first, the simplest options trade–simply buying puts and calls–with emphasis on a couple of points that trip up most people as they learn options investing.

Buying Stock Options–Long Puts And Calls

People unfamiliar with stock options often equate them with risk, and leverage. It’s probably natural enough, as stories of making or losing a lot of money quickly are a lot more interesting than the subtleties of using options to achieve returns of say 4% to 15% on a trade one has on for a few months or more. Certainly the concept of buying something whose value changes rapidly is much easier to understand than the other, sell side of the transaction (which I will cover in the next article on selling options). The most basic way to trade stock options–and the way in which inexperienced investors most frequently lose a lot of money–is by buying options, or ‘going long’ puts or calls. We’ve covered simple long positions extensively, how one uses a relatively small amount of money (per contract) to purchase the right to buy 100 shares of the underlying by a certain future date. A long options position could pay multiples of your investment if you are correct about the movement in a stock; remember though that with this trade time is not your friend and you want the move to occur as quickly as possible so as to avoid time decay in the value of your put or call contract.

I’ll refer you to the following article for an easy explanation of stock options basics from the very beginning. Now, I have learned from comments on this blog that there are two points that I should attempt to clarify to clear up confusion that exists around simple long options transactions.

Buying either puts or calls is synonymous with taking a ‘long’ option position. It’s easy enough to understand that when you buy a call you’re hoping that the price of the underlying stock increases. However, if you buy a put hoping that the price of the stock decreases you are still taking a long position in the option.

When we begin to talk about writing, or selling, puts and calls in explaining options trading it’s easy to confuse the concepts, but the basic idea is that ‘buying an option’ does not equate to you being optimistic or pessimistic about the future movements in the stock price, rather it indicates how much risk you are willing to take on as a result of your bullish or bearish conviction. You could be optimistic and buying calls, or you could be pessimistic and buying put options. The point is that if you try to profit by going long options you are choosing to purchase leverage and assume much more risk than if you were simply buying or shorting a stock (or if you take the other side of an option position for that matter); it’s not about your directional preference in the underlying stock. I hope that’s clear now.

The second point that I should address succinctly is the confusing correlation–or more specifically the lack of a direct correlation–between the price fluctuations of an underlying stock and the price movement of its options. I remember long ago my first experience of having correctly anticipated an upward stock move and discovering that not only did the price of the calls that I bought not rise, they were worth a lot less than they had been one day before!

In this case I bought my calls right before the company’s earnings were announced (I’ve forgotten the stock), expecting them to be very good. Well they were good earnings, and while the stock only rose a little bit after the announcement, my calls, which had maybe a month or so remaining on them, inexplicably (to me at the time) dropped in value.

What happened? It was an expensive lesson that help me understand the importance of expectations and volatility in options trading.

Just as there is often a disconnect between the fortunes of a company and the day-to-day movements in the price of its stock, there can be even more pronounced discrepancies between the stock price and the movements of option contracts corresponding to the stock price. Just as the stock price is an expression of collective opinion by market participants as to the overall future performance of the company, option pricing can be seen as the market’s assessment and anticipation what a stock’s price will do. It should be clear that with options you are investing in something that is twice removed from company fundamentals. Anticipating expectations of expectations are doubly hard to pin down and profit from, and my anecdote is just the tip of the iceberg.

Stated differently: stock pricing is a continual re-setting of the markets expectations as to a company, expressed by stock price; if the stock price ultimately follows company performance, the path it takes as it does so fluctuates, often dramatically based on market expectations. Stock options pricing involves a similar dynamic relative to stock price, but expectations of stock price movements are prone to wilder swings , especially as market participants take into account an option’s expiration date and other factors.

Simple long options positions expose us to these vagaries, with little room for error, especially with little time remaining on contracts that we own. The more risk we assume with options the more we stand to profit, and greater are the ways we may lose much or all of our investment too.

So if we do not wish to gamble, are options an investment with which we should bother? Yes they are, and in part two of the Options Trading Explained series, Writing Options, we will look at more conservative options strategies like selling options.

It’s a rite of passage, learning how to manage your own money when you get your first “real” job. From every direction people are offering suggestions as to investments into which you can put any extra money that you may have at the end of the month.

In all likelihood you’re thinking to yourself “what money?” But this simply confirms how careful you have to be in deciding how to invest, and underscores how vital it is to do the work of teaching yourself how to learn the stock market, about bonds and mutual funds, and even more sophisticated investments such as stock options.

Here at stock options explained we get questions quite frequently that do not specifically pertain to options, but rather from people trying to understand the stock market, which is after all the basis for options. In fact you can be sure if you have not yet learned how the stock market works, even stock options basics and certainly all options trading strategies will forever bewilder you.

Three tips for learning about the stock market

1) Learn from people with actual experience in the market. Perhaps you have an older relative or friend who is quite savvy financially, who seems to have a good handle on most investments. Don’t be afraid to ask detailed questions of them, because in addition to knowing the rules of the game as it were, you can trust them and be quite sure that they’re not trying to sell you on the particular investment.

2) Bookmark and frequently visit websites like Motley Fool and MarketWatch, as they give the opinions of a broad range of market analysts and vary their approach to cater to seasoned investors as well as neophytes. Sites like these and many others also function as educational portals, and if you’re interested in learning the stock market they’re a great place to start for this reason. Another good thing about many financial sites nowadays is that they incorporate a forum where readers of the site can participate in financial discussions and ask questions. Everyone was once a newbie investor, it’s nothing to be ashamed of, and you have a wealth of information in the form of other people that you can meet on financial forums who will be more than willing to help you learn the stock market.

3) Probably the very best piece of advice I can give for anyone who’s interested in becoming proficient in investing in stocks is to paper trade. If you’re not familiar with paper trading, you should know that most online brokers offer you a practice account online with an amount of virtual money that you can use to trade stocks, options and other investment vehicles. Your broker will keep track of how well you do on each trade and you’ll be able to keep very close tabs on just how well your hunches regarding stocks that you trade are translating into profits, or losses.

If you are wondering how to learn the stock market do yourself a favor and remember this tip: take your time, paper trade and find some good trading software to help you, and do not make the mistake of thinking that since you are understanding stock market basics you will easily be able to turn a profit in investing in stocks, or stock options for that matter. There is a huge difference between learning how the stock market works and applying your new-found knowledge to consistently make money in the market.

Here at Stock Options Explained we’ve gone to some length to describe stock options basics and the fundamentals of trading stock options. Since most investors trade ordinary ‘vanilla’ options on exchanges such as the CBOE, we have limited our discussion to standard stock options strategies such as buying puts and calls, and selling options, both covered calls and puts. I’d like to give a different type of stock options definition in this article.

Binary options, aka FROs (fixed return options), digital options or all-or-nothing options are a slightly different type of investment vehicle about which investors should be aware, as they provide a way to hedge against or purchase leverage on events that do not easily lend themselves to conventional options trading. The mechanics of binary options trading are very similar to options as you may understand them, but it is interesting and instructive to look at some differences in both types of options.

As you might imagine from the use of the term “binary”, a binary options contract either has a payout for the option buyer or nothing at all, depending on whether it is in the money at expiration or not. So far this sounds similar to conventional options, but the fundamental difference between binary options and standard equity options is that the amount that the option buyer, i.e. the person who is long the option, receives at the expiration date is defined and fixed with binaries, whereas with standard equity options trading the value of the option contract will continue to increase as the underlying stock price continues to move further and further beyond the strike price (i.e. higher in the case of call options and lower in the case of put options).

This description should give you a clue as to the type of occurrences that one uses binary options to invest in or hedge against.

Normally binaries are associated to events that either happen or do not happen, such as weather events, or the results of an election. Trade in binary options will frequently be offered based on the results of statistical data such as inflation figures, which may be reported only periodically (even though in reality they are continuously changing, just as a stock price is), and then either pay a fixed amount if they are ‘in the money’, or represent a total loss if they are ‘out of the money’.

The way in which binary options vary from conventional options notwithstanding, they are fundamentally similar in that the seller usually uses them to hedge against an event in which he is already explicitly or implicitly invested, such that selling the binary option serves to protect his existing position. On the other hand, the buyer uses these options to take a leveraged position on the outcome of an event as usual, with the only difference being that he will profit by some known amount should he be correct in taking the position in the first place.

This is the second article of our options trading explained series, in which I will attempt to help you learn options trading strategies as opposed to restricting myself to a generic explanation of stock options. In the earlier post I explained stock options trading in terms of simply going long, or buying, puts and calls as the simplest but most risky of stock options strategies. In this article I’d like to talk about selling or writing options as it opens up a range of possibilities for an investor to improve the overall performance of his portfolio.

When you move beyond thinking of options only as leveraged, risky investment vehicles you begin to understand them as savvy investors and professional traders do, ripe with opportunities for conservative option strategies. There are many ways to use them besides either making multiples of the premium you pay or losing most or all of that premium. I’ll cover options trading examples like writing puts and calls, which affords you hedging options (as it were) that can help you protect existing gains in open stock positions; you could sell options to create an ongoing income from your portfolio without having to sell stock at all; you can even offset losses in stock positions you are not yet prepared to close out, by writing contracts against those long or short positions. All these trading strategies involve simple options selling, and these are just a small fraction of the ways that you can use these incredibly versatile investment tools, once you get stock options explained to you.

Writing Options As A Simple Hedge

Let’s say that you have a nice profit in a stock that you would prefer not to sell yet. Maybe it’s had a run-up recently, and while you are still bullish on the company, your practical side tells you that the stock might very well be due for a pullback.

In addition to the optimism reflected in the stock price, it seems like the options associated with the stock have relatively pricey premiums, with even the out-of-the-money options costing more to buy than they normally might.

For an investor contemplating buying options, this is a risky situation. If you bought, or went long calls here, not only would the upward stock move have to continue, the volatility in the stock has to stay relatively high, or you will see time value decay eat away at the value of your long calls. Let me be clear: buying, or going long, calls after a vigorous upward move (or going long puts after a spike down), is a great way to lose money with options, as you are buying time value in the premium that is bloated by the general excitement surrounding the stock. Even if the stock continues upward, if it does so at a slower rate, you might even see the premium fall! Most options neophytes have a story like this, and unfortunately many of them are unaware of the dynamic that hurt them, i.e. the decreasing volatility, and how the trade had odds stacked against it from the beginning, just when they (and everyone else) thought they had a sure thing.

Could you still make money as a buyer in this situation? Can’t the stock continue higher? Who can say for sure that the stock rose so fast that the options premiums are too inflated for a user to make money? The answers are ‘Yes’, ‘absolutely’ and ‘No one’. It’s nearly impossible to quantify the odds of success for the buyer here; suffice it to say that it is a trade with a low probability for profit, from the buy side.

Why have I gone into such detail sketching a tough buy-side trade? Well, what if you could take the other side of the trade from excitable ‘retail money’ who saw a headline and threw some money at some calls or puts (depending on whether the stock has just moved up or down, respectively) just like they might in Vegas? Selling covered options, a conservative options strategy, is precisely how you can accomplish this, and as a person who owns shares that have already seen a run-up you are in a perfect position to do so.

You can sell, or write, covered calls. (For the sake of simplicity let’s talk about a stock you own that is rising. The dynamic for puts is the same for a stock you are short that is falling.) They are ‘covered’ because you own the stock that you would be obligated to deliver as the seller of the calls.

Here’s a real-world example. On October 12, 2010, NFLX stock closed at 155, having moved up from 95 in 10 weeks or so. Let’s say you bought 100 shares at 100 so you are ecstatic. While many people might simply sell or hope for the best, you could write a November 175 call, presently priced at 5.40, collecting $540 against the 100 shares that you own. If NFLX is at 175 or higher at the close of trading on November 19th, 28 trading days from now, you’ll be obliged to deliver your shares to the owner of the call you wrote for $175 per share.

It is certainly possible that this could happen. You would be left with a huge percentage gain that occurred very quickly, plus the $540 premium you collected from the call buyer.

On the other hand, selling the right to gains in the stock beyond 175 before November 19 for $540 might be something you’d be willing to do. After all, exiting the position after a further $20 run-up still leaves you with a big profit. And if the stock drops, this trade lowers your cost basis by about 5.5 points. Selling options involves diametrically opposed financial goals from buying them, as well as a distinctly different psychological relationship to the passage of time, for the investor. Every that the call buyer doesn’t get a move in the right direction is a day where time decay occurs, whereas for the option writer, even a flat day sees decay in the time value of the option, which for an out-of-the-money option with no intrinsic value means the contract’s value gets closer to zero.

You can see that with call writing as an options trading strategy you participate in a move higher, and you also buy protection against a move lower. This is a strategy where you limit your potential gains in return for buying protection. Writing covered calls in this way with a tight trailing stop loss would ensure that before November 19 you will do no worse than the value of your position right now, and you could do considerably better. Naturally you can close out the position any time you’d like to; if the stock simply lingers at 155 for instance you will see a drop in the premium as a result of decaying time value as well as declining volatility. Your likelihood of profiting one way or another from this trade is the inverse of what the call buyer needs to see as soon as possible to make money. In plain English this means that of all the things that could happen between now and November 19th, the call writer has a much better chance of waking up November 20 with a profit from his position than the buyer. The call seller doesn’t stand to make multiple of his investment as the buyer hopes to, but if you approach this transaction with a conservative mindset you’d very probably be on the ‘sell’ side of it.

Writing Options For Income

Now for the sake of argument let’s say that when November 19 rolls around FLX is trading at less than $175 per share. The calls you have written have expired worthless, out of the money. You get to keep that $540 premium that you received from the call buyer. Depending on what the stock has done you have a paper loss or gain relative to where it was trading on 12 October. Let’s say that the stock has been fluctuating and you still believe that it has further upside, so you do not want to sell yet. Why not employ the same trading strategy again? You could write another call contract, December for instance, and receive another premium amount. This further lowers your cost basis, which when added to the premium you’ve already received constitutes further protection. If the stock ends up being called away from you at whatever strike price upon which you write the new option, the situation will be the same as it was in the previous example, except that you have collected an additional premium.

Many savvy investors and professionals use this sort of ongoing protection/premium collection as a way to get an income from an existing stock portfolio in addition to any dividends one might accrue through stock ownership. This is definitely not a “set and forget” option trading strategy, and to do this indiscriminately with a large part of one’s portfolio is folly. One of the oldest trading adages is to cut your losses and let your profits run, and writing covered out-of-the-money calls means that you are less likely to see very large gains in individual stocks that you own. After all, in the long run you do stand to see some trades that work better than you hoped, that result in multiples on your original investment.

Still at certain times, such as when the market or an individual stock has had a very fast run up, it can be prudent to write some covered calls on some of your stocks, in the name of securing a return as insurance against potential pullbacks, which obviously tend to occur.

My goal with this site is changing toward getting the basics of options trading explained to laymen, in the hope that a fuller understanding of the wide range of stock option trading strategies will make investors less inclined to recklessly speculate with options. Even investors who are very conservative can make use of options strategies by which they can reduce total portfolio risk by writing options, once they have the details of options trading explained properly to them.