Option Trading: A Tutorial for Beginners

In options trading literature and investment magazines, you'll find hundreds of investing strategies that are complex and, naturally, confusing (at least for those who are not familiar with this potentially lucrative investment activity). For those just beginning, however, it's important to first understand the basics of options trading and making money on the stock market.

Starting With the Basics

At the most basic level, option trading is about predicting whether the value of a company's stock will go up or down. Depending on whether you purchase a put or a call, you will either stand to make money, lose money, or break even.

This can be more clearly explained by looking at an example - Matt purchases the option to buy (a call) 100 shares in Company X. He can purchase these shares for $250 (the strike price), and he has six months to exercise the option. Over the next six months, the stock's value increases by 500%. The value of the stock is higher than the strike price, so Matt stands to make a lot of money by selling these options.

In the world of option trading, this is called being in the money. If, on the other hand, the value of the stock decreased to $10, the value is now significantly below the strike price, so chances are good nobody will want to purchase the option. This is known as being out of the money. If a stock's price remains the same as the strike price, this is classified as being at the money.

Understanding How Puts Work

Although how one makes money on calls is easily explained and understood, puts can be a little harder to comprehend because the investor stands to profit if the stock loses value. Using a similar example as the one above, Matt purchases the right to sell (a put) 100 shares in company X. He can sell them for $250. Over the next month, the value of the company's stock drops to zero. This is great news for Matt!

Why? Because those who own shares in the company will be quite eager to purchase Matt's options, because they can sell their now worthless stock for $250. Matt is in the money. If the price of the stock rises, however, those who have ownership in the company will not want the right to sell their shares for less than they are worth. Matt is out of the money. If the strike price and the stock value are equal, Matt is at the money.

There are many more strategies for option trading, but becoming familiar with the basic ways that profits are made on the stock exchanges is an important starting point before more complex strategies are explored.