Options Trading in Plain English

October 9, 2024

Options Trading in Plain English

BY Keith Kaplan
CEO, TradeSmith

I just read this email in the TradeSmith Daily feedback inbox:

Dear Keith,

You obviously love options and I have read several of your explanations of how they work. Yet I still do not feel that I understand them enough to have the confidence to trade.

Can I suggest that you ask a colleague who does not trade options to write the next explanation. Someone who will not use the jargon and someone who does not think that A + B automatically equals C.

I see the potential value in trading options but won't do anything I don't understand and I am afraid that I do not understand your explanations of them.

I suspect you would not understand my explanation of how to dig a tunnel which I think is very straightforward!

Best wishes,

David

First off, this is a great piece of feedback, David. Thank you for taking the time to write in.

I’d like to respond in a few ways… give you my best “plain English” explanation of options… and, later in this email, offer you an options trade idea that you can test out on your own.

I strongly encourage you to test this idea out, because there’s no better way to understand options than by trying them out.

Of course, I don’t want you to lose money, either. So, I’ll show you how you can test out trading options in a completely safe, risk-free way.

Understand, you won't make any money with this method (because you won’t have any at risk). But you will be able to pass a major hurdle of learning this unique trading tool.

But let me start by saying this.

You’d have to accept the fact that options trading is a little complex. Trading them is not as easy as buying and selling stocks.

That’s because options contracts don’t just mirror the stock price. They are a form of leverage, which raise both your potential for making money and your risk for losing it. Options can multiply your money relatively quickly – and that’s good! That’s one of many reasons why I love trading them.

There are tradeoffs for that profit potential, though. One is the complexity. And the other is that leverage cuts both ways – you can lose money quickly, too.

You mentioned digging a tunnel, David, and that’s actually a perfect metaphor here. If I’m a railroad company and I know that going through a mountain will be better than going around it in the long run, the benefit of digging a hole through the mountain is clear.

But, of course, there are risks and complexities to digging a tunnel through a mountain. The tunnel could collapse, the cost could prove too expensive, and the job could wind up taking too long.

Risk and reward are present here, just like they are in options trading and, really, everything we do. But the best way to mitigate risk is knowledge.

You sound like you know a lot about building tunnels. I don’t. So, I would not trust myself to design a tunnel until I learned all the things you know about it.

That’s exactly what we’re doing here with options trading.

But as for asking someone to write that does not trade options, I would never seek to learn how to dig a tunnel from someone who’s never done it. That sounds like a good way to build a bad tunnel.

Regardless, we’re going to keep things super simple today. Instead of getting into all that stuff about delta and gamma and moneyness…

Let’s just look at the base mechanisms for what an options trade is.

A Brief, Straightforward Explanation of Options

There are really just two things you need to know about options right now:

Options are contracts which give you the right to buy or sell a stock at a certain price by a certain date.
There are two types, call and put options. Call options give you the right to buy stocks, and put options give you the right to sell stocks.

Let’s say a stock is trading at $10 per share. You think it’s going to go up. So, you buy a call option that gives you the right to buy the stock at $10. (There’s our “certain price”; let’s set aside the “certain date” for a moment.)

Turns out you were right and the stock climbs to $11. So, now – because of the $10 “strike” price of your option – you have the ability to buy the stock for $1 cheaper than the market price. And that ability (the call option) becomes more valuable because you can do that.

If the stock goes to $12, you can buy the stock at a $2 discount to the market value and the option gets more valuable. At $15, it becomes very valuable. And so on.

Put options are for the opposite scenario. The stock is at $10, you think it’s going down, and so a put option that gives you the right to sell the stock at $10 becomes more valuable as the stock falls.

That is the fundamental mechanic at play for options. You own options so you can buy or sell stocks at a more favorable price than where they’re trading. Or you can sell the contract itself and profit on that. An options contract might double in price when the stock itself only climbed, say, 5% or 10%.

Now, let’s talk about expiration dates.

All options expire at a certain date. So, as time ticks down and the option hasn’t moved in your favor, the likelihood of a payout becomes lower and the value of the options contract decreases. This is the added layer of complexity where it helps to understand delta, gamma, and all those other factors… but it’s not completely necessary. (We’ve actually solved a big part of this complexity headache here at TradeSmith, with our Probability of Profit (POP) indicator. But that’s a topic for another day.)

In any event, I hope this explanation was helpful. With this framework, I encourage you to go back and read through my recent pieces about options education here in TradeSmith Daily. Here are some links to them:

But also, I’d like you to try something else…

The No-Stakes Education Program

Go over to Google and find a “paper trading account.” Lots of places offer them – just go with someone reputable.

When you sign up for this account, you get some large amount of fake money to practice trading with. You’ll still get live market data, too.

Once you’re all set up, look for a trade idea. Any will do, and it doesn’t even have to be right (remember, fake money). It just matters that you place a trade.

Maybe you think the S&P 500 will go up by the end of the year. That’s a pretty solid bet considering the strong seasonal tailwind stocks have from November through December.

So, just as an example of something to trade in your paper trading account, you could look at the SPDR S&P 500 ETF (SPY) options chain. There you might buy the SPY $572 call option expiring on January 17, 2025.

As I write, that would cost you $20.48… times 100. Each options contract controls 100 shares of stock, but the options chain quotes you a price per share, so the real cost will always be 100 times more. $2,048, in this case. (There’s that complexity and leverage again.)

That’s a good amount of money. But remember, you’re using a paper trading account just for practice. So, don’t sweat it.

Place the trade, then… wait. See how the S&P 500 trades over a couple of weeks. See how the value of the option changes in response. If it goes up, consider selling it for a simulated profit.

All the deep, nitty-gritty stuff can wait.

What matters is that you do it and learn from the experience.

It’s like a lot of things in life. You’ll never learn to ride a bike by reading a book about it. You have to get on, push the pedal, and find your balance. You might fall and scrape a knee, but you get back up and do it again. The risk is low, but not non-existent.

Digging a tunnel is a different story. You wouldn’t want to just start digging into a mountain without any knowledge. The stakes are much greater.

Trading is such a wonderful thing to learn because you can do it in a zero-stakes environment. When you’re paper trading, you can afford to have absolutely everything go wrong… and never see the financial equivalent of scraping your knee – or collapsing a tunnel on your head.

And there’s one last thing I’d like to address before I let you go.

Plainly, not everyone needs to be an options trader. Plenty of investors are happy to buy stocks and sit on them. Some even trade stocks without touching options. Some want to trade leveraged futures on soybean oil. And some want to pay a financial advisor to do it all for them (underperform the market, and rob them blind while they’re at it).

My point is, if you don’t think options trading is for you, that’s perfectly okay. You don’t need options to make money in the market. But it can help.

I’d still like you or anyone else reading this who wants to learn options trading to give this a fair shake. But don’t think it’s a necessity, either.

We’ll be back to the nitty-gritty stuff next week. Read along if you can, but it’s just as important that you practice.

All the best,