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Lesson 1 - Understanding Options

by Uncle Bob Williams

This is not a typical "What are Options" course. We can find plenty of well written and technical explanations about Options and Options strategies at almost every Broker that provides Options Trading.

For standard explanations, we suggest reviewing the current list at:

http://www.UncleBobsMoney.com/links/

We are going to try to show what Options are, and what specific information we need to know to successfully trade the Strategies at Uncle Bob's Money. This is not a watered down version, and we won't be skipping any crucial parts - what we will do is focus on what we need to know.

Stocks vs. Options

Stocks and Options are very different and when we understand the difference, it will remove all of the mystery, mystique and 'danger' from Options.

If we buy a stock, say 100 shares of Acme Company for $50 per share, which works out to be a $5,000 total investment, plus a transaction fee from our Broker:

Uncle Bobs Money: Man holding Acme Stock Certificate in front of Acme Building, Copyright UncleBobsMoney.com


=> We now own part of Acme Company.

=> We may get paid dividends from profits that Acme Company makes, and we may be entitled to vote on certain company actions, and if we have enough stock we may actually control the company.

=> Our investment has a 50% chance of going up or down.

=> The Profit / Loss graph of our investment in Acme Company looks like this.
Proft - Loss graph of a Stock

Since the risk a stock will go up or down is 50/50, and since the value of the stock can go to zero, many people like to buy Mutual Funds. If we buy a Mutual Fund that tracks the S&P 500, our investment risk is still 50/50, but that risk is spread out over 500 companies. The hope is that all 500 companies will do well overall: meaning that they hope the share price overall will go Up and that the risk of all 500 companies going bankrupt is small.

For people who are more advanced Stock Traders, they will also sell a Stock that they don't own, which is called "Selling Short" or just "Short". These Traders are betting that the Stock price will go down, and they will be able to buy the shares they just sold at a lower price. IE: We sell 100 shares the stock at $50 per share (we get paid $5,000), and if the price goes down to say $49 per share, we buy the 100 shares that we sold before but didn't own. (It cost us $4,900 to buy those shares.) And we walk away with a $100 profit.


So, all of that above should be clear for most people who have Stock and Mutual Fund investments.

What the heck is an Option?

An Option is not a Stock, and it doesn't work like a Stock, so when we think about Options, we need to remove our "Stock Thinking" hat, and put on a new hat that is quite similar to an Insurance Policy. Yep, Options are like Insurance.

If you buy an Option on Acme Company stock: (we'll get into the parts of an Option next - but let's first look at the basics, how the Option compares to a Stock. It's OK if you don't understand the Options Terminology that follows, we will explain them shortly.) Let's say that we buy 1 Contract, on a CALL Option at the $53 Strike which has an Expiration 2 months from now, and we pay $1.00 per share for that Option. 1 Option Contract = 100 shares of stock, so the total cost for this Option is $100.


=> We do NOT own part of Acme Company.

=> We will NOT get paid dividends from the profits of Acme Company, we will NOT be entitled to vote on certain company actions, and we will Never have any control over the company no matter how many Options we purchase.

=> Our investment in this Option has a 50% chance of going up or down.

=> The Profit / Loss graph of our investment in the OPTION looks like this.
Proft - Loss graph of a CALL Option

The graph doesn't go to zero because our loss is limited to how much we pay for the Option.
We can see that as the price of the stock goes above $53 per share, our profits start to skyrocket. In fact the profits of our Option will be many, many times greater than the profit of the Stock.
In this case, our total investment is only $100, and that is the maximum we can lose.

The Options trader also has the possibility to buy PUT Options which means we will make money if the price of the stock goes DOWN. The Options trader can buy the $47 PUT Option, and if the price of the stock goes below $47, we can also make massive profits with a very limited loss. We will explain PUTs and CALLs later, so don't worry if any of this is unclear now.

We see that with Options, we can put a small amount of money at risk, and our potential for profits is very, very high. So high it's what Dan Sheridan of Sheridan Mentoring calls "Mafia Money".

But, don't get excited yet.

The CALL Option that we purchased has an Expiration Date, and if the stock doesn't go above $53 before expiration, then our Option will expire worthless and we will lose our $100 investment in that Option. The same is true with the PUT Option, if the stock doesn't go below $47 before expiration, then our Option will expire worthless and we will lose our $100 investment in that Option.

It is possible to trade Options on Indexes, like the S&P 500. So we can leverage the stability of the index on our Options trades. Uncle Bob's Money only trades Options on the Indexes because of their greater stability over individual stocks.

BIG CAVEAT:

If we start looking around for people who have Options Courses, we will come across many who practice what's called "Directional Trading", which is very similar to trading Stocks. What they show is how to use Options to make massive profits IF the market goes a certain direction. Remember, we said above that the probability of a stock going up or down is 50/50. If we buy a stock and it goes up, we can make money. If the stock goes down, we can lose money. What these "Directional Traders" do is very similar to our examples above, they show how to use a fraction of our savings to potentially make massive profits instead of buying stocks. In our example above, the stock trader spent $5,000 to buy 100 shares and ALL of his money is at risk. However the CALL Options Trader invested only $100, and he still has the possibility of massive profits if the Stock goes up, with only the risk of his $100 investment if the stock goes down.

There are more advanced "Directional" techniques, like Back Spreads and many others, which have very cool sounding names, but they all boil down to making a bet on which direction the price of a stock is going to go: UP or DOWN. If the stock price goes the direction you guessed, then you make money, and if not, you lose your investment. There are also Directional Options strategies where you can "Short" Options, and these have the potential to have a higher probability of making a small amount of money, but with a massive potential for loss.

All of these "Directional" techniques sound very enticing, and there are many guys who do an excellent job of selling you on this investment technique.

Options Education is not all the same, beware. Copyright UncleBobsMoney.com

Repeatedly it's been proven statistically that the stock market is truly random. Yet even so, there are no shortages of people trying to come up with trading models that will predict the future. If you have a 'crystal ball' there are plenty of ways to use Options to cash in. You can find free ways to learn those techniques if that is what you are interested in.

Now, it is easy to think: Hey, I don't need to guess which way the market is going. I can buy a CALL Option to make money if the stock goes up, and I can buy a PUT Option if the stock goes down. Either way, I have very limited risk - I risk only the amount I pay for the Options, and I have massive profit potential if the stock moves in my direction.

This is true. However, there is a catch. The catch is that Options are priced based on the probability of the market price hitting your Option Strike Price before the Option's Expiration. Think of it like going to the Casino—the odds are always slightly out of your favor. If you bet long enough, the house will eventually get all of your money. The same is true with Options pricing. If you were to consistently purchase a PUT Option and and CALL Option, you may very well get lucky and have a big hit, but the odds are against you and if you play long enough, you will eventually lose all of the investment money.

There is hope.

However, there are proven strategies that use Options which allow us to put the Odds in OUR favor. It is possible to use Options to generate income no matter which way the market moves.

The Options Strategies we use at Uncle Bob's Money are called "Non-Directional" Options Strategies and they have been used by Options Market Makers and Options Pit Traders since the beginning of Options trading in the 1970's. It is very possible to use a combination of Options positions where we put the Odds of winning IN OUR FAVOR. Some strategies, like the Iron Condor, can have probabilities of success exceeding 90%! We won't ever see those odds in Las Vegas or on any Stock!

We aren't creating any new secret techniques to outsmart the Nobel Prize winners who created the Options Pricing Formulas, but we are able to use specific Options Strategies to sway the Odds of making money in our favor, while minimizing the amount of risk we take.

What Uncle Bob's Money offers is:


=> We show which proven "Non-Directional" Options Trading Strategies will generate income, and how they work.

=> We provide Model Portfolios for the "Couch Potato" Investor who just wants to sit back and watch their money grow.

For More Active Traders:

=> We provide a Trading Calendar that shows the ideal time to enter into each specific Options strategy.

=> We provide a Trading Checklist that constantly evaluates the key trading factors for each trading strategy and it shows when to enter into a Options Trade, and when to exit.

=> We provide a Trade Finder tool that shows the best Options Trades for each strategy. We won't have to do any math or get lost trying to figure out the best possibilities from the Options Chain; the Uncle Bob's Money tools do all the work.

=> We provide a Trade Monitor tool that will constantly monitor your Option Strategy positions and suggest specific points to both maximize profits and minimize potential losses.

=> We provide a Trade Monitor Checklist that will constantly evaluate the key Market conditions and suggest exit points when those conditions hit warning levels.


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