Understanding
Stock Options Trading
and Technical Analysis Basics

What are Options?

For beginners, starting stock options can be very daunting, with all the new terms and concepts. This guide will hopefully shed some light on options for you with its simpler explanations.

Options are another form of security that you can invest and trade in the stock market. Like futures, they are considered derivatives of - or based on - normal stocks. In the United States, options are traded via Options Exchanges, the first and biggest of which is the Chicago Board Options Exchange (CBOE). For more information on what Options Exchanges do, their history and their current initiatives, visit the CBOE website at http://www.cboe.com/.

Summary:

Options are securities derived from - or based on - normal stocks. They are traded on Options Exchanges.

Buying an option gives you the right, but not the requirement or obligation, to buy an underlying stock at a specified price at a later specified date. For example, you can buy an option to buy shares in Microsoft in say 2 months' time at a predefined price.

The most widely used method of explaining this is via the housing industry. Imagine that you just found your dream home, but can't afford the $100,000 you need to buy it today. You then contact the owner, and the both of you agree to a contract where you get the right to buy the house in 6 months' time at say $110,000 (taking into account the rising cost of housing). However, since you could possibly run away without buying the house, leaving the owner waiting 6 months for nothing, you agree to pay him a token "downpayment" or premium, of $5,000 for the right to buy his house.

So, fast-forward 6 months. No matter what the new market value of the house is, you have the right to buy the house at $110,000. 2 things can happen: the market value of the house could have skyrocketed to $200,000. In this case, you still get to buy it at $110,000, keeping the rest as profit (or savings, depending on how you look at it). On the other hand, if the price of the house drops to $80,000, you can decide not to buy it, since you have the right, but not the obligation, to buy it. So all you've lost is the initial $5,000 premium you spent to lock in the contract.

Summary:

When you buy an option, you get the right, but not the obligation, to buy the related stock at a future date, but at a price you specify now. If the stock's market value rises above your agreed-upon price, you profit. If the stock's value crashes, all you've lost is your premium.