Part 2: Options Basics: What Are Options?

In part 2, we are going to learn, "What are Options?" by using  information from the  Investopedia Staff.  

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.

Still confused? The idea behind an option is present in many everyday situations. Say, for example, that you discover a house that you'd love to purchase. Unfortunately, you won't have the cash to buy it for another three months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of $200,000. The owner agrees, but for this option, you pay a price of $3,000.

Now, consider two theoretical situations that might arise:

1. It's discovered that the house is actually the true birthplace of Elvis! As a result, the market value of the house skyrockets to $1 million. Because the owner sold you the option, he is obligated to sell you the house for $200,000. In the end, you stand to make a profit of $797,000 ($1 million - $200,000 - $3,000).

2. While touring the house, you discover not only that the walls are chock-full of asbestos, but also that the ghost of Henry VII haunts the master bedroom; furthermore, a family of super-intelligent rats have built a fortress in the basement. Though you originally thought you had found the house of your dreams, you now consider it worthless. On the upside, because you bought an option, you are under no obligation to go through with the sale. Of course, you still lose the $3,000 price of the option.

This example demonstrates two very important points. First, when you buy an option, you have a right but not an obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment, which is the money you used to pay for the option. Second, an option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives, which means an option derives its value from something else. In our example, the house is the underlying asset. Most of the time, the underlying asset is a stock or an index.

Calls and Puts

The two types of options are calls and puts:

1. A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.
2. A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

Participants in the Options Market

There are four types of participants in options markets depending on the position they take:

1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts

People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions.

Here is the important distinction between buyers and sellers:

• Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose.
• 
  
• Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell.

Don't worry if this seems confusing - it is. For this reason we are going to look at options from the point of view of the buyer. Selling options is more complicated and can be even riskier. At this point, it is sufficient to understand that there are two sides of an options contract.

Tour of the Chicago Board Options Exchange (CBOE)

The Lingo

To trade options, you'll have to know the terminology associated with the options market.

The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur before the expiration date.

An option that is traded on a national options exchange such as the Chicago Board Options Exchange (CBOE) is known as a listed option. These have fixed strike prices and expiration dates. Each listed option represents 100 shares of company stock (known as a contract).

For call options, the option is said to be in-the-money if the share price is above the strike price. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value.

The total cost (the price) of an option is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value) and volatility. Because of all these factors, determining the premium of an option is complicated and beyond the scope of this tutorial.

OK, let's take a test:

1. The two types of options are ___________ and __________.

2. _________ are similar to having a long position on a stock.

3. _________ are very similar to having a short position on a stock.

 List four types of participants in options markets depending on the position they take;

4. __________

5. __________

6. __________

7. __________

People who buy options are called 8. _________ and those who sell options are called 9. ____________.

For call options, the option is said to be 10. ____________ if the share price is above the strike price. 

All the answers are in this blog that you just read. It is easy to look up the answers. 

If you got 0 or 1 wrong, you may want to look into the options trade if the risk is what you would like to take. 

If you got 2 wrong, study up on this investment instrument. 

If you got 3 wrong, look into using an Options Trader.

If you have 4 or more wrong, consider staying away from Options. 

Trading Commodities to make some fast money!

Darnell L Williams

I wake up at 4:00 AM EST to check the prices of commodities especially the price of oil. I make a living off of oil. I use the many products from oil, from fueling my car and lubricating it to using all the different plastics made from oil.  So oil is a big part of my life and I suspect it is a big part of your life as well.  

Oil is a commodity that is traded on a Commodity market like other commodities such as Gold and Silver. Corn and Black Eyed Peas are commodities.  Bacon and chicken are commodities.  

We are going to find out what are commodities and how are they traded?   

 Click on the link below or on the picture.

https://www.youtube.com/watch?v=nGZn_pGT_PM

 What is a Commodity?

The InvestorGuide Staff Writers and Editors explain commodities this way!

A commodity is a product, which is of uniform quality and traded across various markets. There are generally two types of commodities, 'hard commodities' and 'soft commodities'. Hard commodities include crude oil, iron ore, gold, and silver and have a long shelf life. Agricultural products such as soybean, rice or wheat, are considered 'soft commodities' since they have a limited shelf life. These commodities have to be similar and interchangeable or 'fungible'. For example, soybean from one country or market should be of the same quality wise as soybean from another, or gold in one country should be of the same purity as gold from another.

Consumer products like televisions or computers vary from manufacturer to manufacturer and hence cannot be traded as commodities. But now, electricity, bonds, and currencies are also traded as commodities across the globe.

These commodities are traded across markets situated in different corners of the world through commodity exchanges such as the New York Mercantile Exchange, the Chicago Board of Trade, the London Metal Exchange, etc. These exchanges consist of traders who are classified as hedgers or speculators. Hedgers are actual manufacturers or farmers who want to sell their commodities at a guaranteed price, so that they are insulated against any price fall or fluctuations in the market.

Speculators are traders who enter into the market solely to make a large profit. If the speculator has information that natural disasters are destroying wheat in a particular country, he will try and purchase wheat as soon as possible, since he would expect the price of wheat to rise in the coming days. Speculating requires a keen business sense and an in-depth understanding of the market or the losses incurred could be significant.

Traders do their trading in any of the above commodity exchanges in the following ways. Spot Trading occurs when the deals are done on the spot regarding price or delivery, or if the delivery takes place in a minimum amount of time after the trade is finalized. Trading is also done by way of 'Futures Contracts' where the price of the commodity is decided immediately, but the delivery is made after a certain period of time. 'Futures Contracts' benefit either the buyer or seller since the price, which is agreed upon could change marginally or drastically by the time the delivery is actually made. These contracts can give buyers and sellers a way to 'foresee' the market in the future, since the rates have already been set. These markets are quite open and transparent, but to prevent fraud and misuse, the government has set up 'The Commodity Futures Trading Commission' or the CFTC, which keeps a close watch on the trading market.

The delivery date and the method of payment must be agreed upon before the contract is executed. Since commodities are physically and actually present, the chances of bankruptcy are nil, but profit and losses on a large scale are possible because of the sheer volume involved in trading. You too can directly invest in the Commodities market, but if you do not have experience, then it is better to go through a commodities broker. His vast knowledge and contacts will help you save time and money.

The commodities market is based on the simple principle of supply and demand. Since there is a lot of demand from emerging economies such as India and China, some commodities such as crude oil and steel are in very high demand. Hence trading in these items is also very high.

Commodities are in short, similar items grown or produced in different countries and traded in different markets around the world.

Warning;

I worked at Westinghouse Electric at the Telecomputer Center when in my early 20s. I met a man that took $3,000 and traded commodities for 6 months and made $33,000. He was hooked. The next year, he lost $33,000 plus his family savings, a home equity loan, and he borrowed money from his family. I don't have to tell you that his marriage was on the rocks!  

Let's see what you learned.

1. A commodity is a product, which is of uniform quality and traded across various markets. (True or False)

2. 'hard commodities' and 'soft commodities' as well as people are the three major Commodity Types traded. (True or False)

3. Hard commodities have a long shelf life. (true or False)

4. . Agricultural products have a long shelf life. (true or False)

5. Consumer products like televisions or computers vary from manufacturer to manufacturer and is traded as Hard Commodities.

6. Electricity, bonds, and currencies are traded as commodities around the world.

7. __________ are traders who enter into the market solely to make a large profit.

8.  ______ Trading occurs when the deals are done on the spot regarding price or delivery, or if the delivery takes place in a minimum amount of time after the trade is finalized.

9. Trading is also done by way of ________________ where the price of the commodity is decided immediately, but the delivery is made after a certain period of time.

10. The commodities market is based on the simple principle of _________________.

The Answers

1. True

2. False

3. True

4. True

5.  False

6.  True

7.  Speculators

8. Spot

9. 'Futures Contracts'

10. supply and demand

 Results

If you got 10 or 9 right, you are ready for the next step, seeing a Commodities Broker.

If you got 8 or 7 right, read up on the subject and see a Commodities Broker.

If you got 6 right, I don't think that is for you.

You can short your securities and make money

I laugh every time I get  an email from the public when the stock market goes down or crashes. These people think that they are upsetting me saying things like, "How is that stock market treating you?" Just that sentence tells me that the writer knows nothing about the market or what I am doing in the market.  My market strategy has change a lot since the early  1970s and so has the market.

 

At that time, the options market was not open like it is to the public today. Back them, companies sold warrants in the market place and I could buy the warrants or short them as I pleased.  When a warrant was about 2 to 3 years before expiration, I would short them. Then buy them back 3 month before expiration. "I called it free money."  But now hardly any company sells warrants that I can borrow. The options market took its place.  Oh, you don't know what I am talking about? Let's take a class on short selling!

 

We will use the information from Michael Griffis and Lita Epstein, book  "Trading For Dummies, 3rd Edition." You can buy it at any book store.

   

Selling stocks short is common in the trading world. When you sell a stock short, you sell something you don’t have first and buy it later with a goal of profiting from a falling stock price. To sell a stock short, you borrow shares of a stock from your broker to sell them in the open market. Your broker gets those shares from its own inventory, or from other clients.

 

The proceeds of that sale go into your account. To close that position, you must buy the shares on the open market and return them to the broker. If the price you pay for the stock, or the buy-to-cover price, is less than your selling price, you’ve earned a profit on the short sale. Conversely, if the buy-to-cover price is higher, you’ve suffered a loss.

 

Say you borrow 100 shares and sell the shares short for $100 per share. When the price drops to $80 per share, you buy the shares back and return them to your broker. You sold the stock for $100 per share and bought it back for $80, netting a profit of $20 per share. It’s the same if you purchase the stock for $80 and sell it later for $100.

 

Conversely, say you borrow 100 shares of Company Y and sell them for $100 per share. The stock price rises to $120 per share, and you decide to cover your loss. You buy back the shares and pay $120 per share, but you sold them for $100 per share. You have lost $20 per share on this trade.

 

Some of the quirks that are unique to selling stocks short include:

 

·         Paying dividends to the lender.

If the stocks pay a dividend during the time a short seller holds a position, short sellers pay the dividends on the ex-dividend date to the people who loaned them the stocks. Short sellers need to keep the ex-dividend date in mind whenever shorting stocks.

 

·         Being forced to close a position.

Whenever the original owner sells the stocks you borrowed, your broker can call away the shorted shares, which means your broker can force you to return the borrowed shares by buying them on the open market at the current price. This happens rarely and occurs only when no shares are available for shorting.

 

·         Mandating the execution of short sales from only a margin account.

Short sales must be executed in a margin account because your broker loans you the stock to sell short and charges you interest on any margin balance in the account.

 

·         Paying margin maintenance requirements.

Your broker can force you to close a short position if you’re unable to satisfy maintenance margin requirements.

 

·         Having no or only minimal access to selling some stocks short.

Lightly traded stocks may be unavailable for selling short, and when they can be sold short, they may be more likely to be called away (which happens when the original owner sells the stock you borrowed and your broker is unable to borrow additional shares).

 

·         Restricting short sales on certain stocks.

You can’t short a stock that’s less than $5 per share, and you can’t short initial public offerings (IPOs), usually for 30 days following the IPO. And, as became evident during the credit crisis, regulators can prohibit short selling on whole categories of stocks.

 

·         Limiting short selling to only stocks on an uptick.

This uptick rule was eliminated in July 2007, but a modified version was implemented again in 2010. The essence of the old rule was that you couldn’t sell a stock short in a falling market. Short sellers could not easily pile into a falling stock. The 2010 rule does not apply to all securities.

Today it’s only triggered when a security’s price decreases by 10 percent or more from the previous day’s closing price. The rule then stays in effect until the close of the next day. However, many people consider this new version of the rule to be ineffective.

 

One unusual aspect of shorting is that it creates future buying pressure. Every shorted sale must be covered, and that means that every share of stock that’s been shorted must be repurchased. Future buying pressure can cause the price of a heavily shorted stock to jump dramatically if all the short sellers simultaneously clamor to get out of their positions as the price rises, a situation called a short squeeze.

 

You can find out how many others are shorting the stock by looking at short-interest statistics published in Barron’s and Investor’s Business Daily near the end of each month. From those statistics, you get some idea whether your short position is likely to be squeezed.

 

Now let's test what you have learned here!

 

1. If a stock closed on Tuesday, July 14 and you want to short that stock the next day. That means that, the short sell is only triggered when a security’s price decreases by 10 percent or more from the previous day’s closing price.  (True or False)

 

2. If the stocks pay a dividend during the time a short seller holds a position, the dividend is not paid. (True or False)

 

3.  Short sales must be executed in a __________ account. A) Cash; B) Margin; C) 401K: D) 521.  

 

4. Your broker can force you to return the borrowed shares by buying them on the open market at the current price. That means that you may take a loss or a profit. (True or False)

 

5. All stocks can be shorted. (True or False)

 

6. Your broker can force you to close a short position if you’re unable to satisfy maintenance margin requirements. (True or False)

 

7. You have not borrowed any money in a short sell so your broker cannot force you to satisfy maintenance margin requirements since you have no margin requirements. (True or False)

 

8. You can’t short a stock that’s less than $5 per share. (True or False)

 

9. You can’t short initial public offerings (IPOs), for at least 30 days following the IPO. (True or False)

 

10. Short Sellers must understand that a loss when short selling is unlimited.  (True or False)

 

 

Answers

1. True

2.  False

3.  B) Margin

4. True

5.  False

6. True

7.  False

8.  True

9. True

10.  True

 

If you got one or none wrong, you got an "A". You are ready to start short selling.

If you got two wrong, you got a "B".  You can start some limited shorting.

If you got three wrong, you better use short with the help of a broker.

If you got four wrong, read up on the subject before you short stocks.

If you got more than 4 wrong, stock with buying stocks and bonds.