When my son David turned 10 years old, I gave him a special birthday gift: the Swiss Army Knife that I used when I was a kid.
We sat on the back deck and looked at each part that folded out of the tool.
A sharp knife for whittling… a serrated edge for sawing… a magnifying glass to start a fire… a set of tweezers… some miniature scissors… and a few others.
I remember telling him how this tool could be used for a lot of good things. But it’s also dangerous if used improperly.
Since he was 10 years old and becoming a more mature young man, I told him that I trusted him to always use this tool responsibly — not for anything dangerous.
I’m remembering David’s pocket knife today as we kick off a series on trading options contracts.
Just like a Swiss Army Knife, options contracts are amazingly versatile tools for growing and protecting your wealth.
And just like David’s knife, these tools also have some sharp edges that can be dangerous if used improperly.
So over the next few days, I want to carefully walk you through how these tools work so that you can decide whether they make sense for your retirement.
Let’s jump right in!
Related: Probability and Payoff: The Key to Every Investment
Starting With the Basics of Options Contracts
Options contracts have a reputation for being difficult to understand.
And while some options strategies investors use can take a bit more effort to figure out, each options contract is pretty simple.
Just like the name implies, an options contract gives investors the option to buy or sell a stock.
That’s pretty basic, right?
An options contract gives the holder the right (but not the obligation) to buy or sell stock according to the terms of the contract.
U.S. options contracts are very standardized and trade on exchanges just like stocks.
So once you understand the basics of these contracts, it’s very easy to buy or sell these options contracts — just like you would buy or sell shares of stock.
I’ll spend some time today explaining how a typical options contract is structured.
Then later this week, I’ll talk more about how to buy and sell these contracts. I’ll also discuss what risks and opportunities these contracts give you.
And I’m excited to share some of my favorite strategies for using options at the end of the week!
Options Contracts Give You the Right — But Not the Obligation
The first thing to understand is that when you buy an options contract, you have the right to buy or sell shares of stock. But you don’t have the obligation to buy or sell.
You might be more familiar with this concept thinking about real estate.
Many times buyers enter an options contract for a new home giving them the right to buy once they’ve done their due diligence.
If the buyer does an inspection and finds that there are problems with the home, they might choose not to exercise their right to buy.
But if the appraisal shows that the house is worth far more than the agreed-upon price, the buyer still has the right to go through with the transaction.
That’s exactly the way an option contract works.
When you buy a contract, you’re purchasing the right to buy or sell 100 shares of the stock according to the terms of that contract (or agreement).
It’s important to note that each contract represents 100 shares. So keep that in mind when determining how many contracts to trade.
Understanding the Difference Between Calls and Puts
Options contracts are divided into two primary categories: call contracts and put contracts.
A call contract gives the owner the right to buy shares of stock at a specified price. You can think of this right as being able to call the stock to your account.
A put contract gives the owner the right to sell shares of stock at a specified price. So for these contracts, you can think of putting the stock into someone else’s account.
When you place an options trade, it’s important to pay attention to whether you’re trading a call or a put contract.
Because these contracts typically trade in opposite directions from each other.
Options Are Available for Most Actively Traded Stocks
In our efficient U.S. markets, there are typically dozens (and sometimes hundreds) of options contracts for every stock.
This leaves us plenty of choices for which stocks we want to use these tools with and the specifications for the contracts that we will choose.
Sometimes, new options traders get a bit overwhelmed when they see how many different options contracts are available to trade for each stock.
But once you see how they’re organized and understand the different pieces of each contract, you’ll catch on very quickly.
So let’s take a look at how different options contracts are structured for each actively traded stock on the market.
The Target Price for Your Options Contract
Each options contract designates a price that you’re agreeing to pay (or receive) for shares of stock. This price is called the strike price.
Let’s take a look at an example…
You might decide that you want to buy a call option for shares of Apple Inc. (AAPL). Remember, a call option gives you the right to buy shares of AAPL at the strike price.
As I write this, shares of AAPL are trading just below $130 per share.
You might consider buying an AAPL $135 call contract. That contract would give you the right to buy 100 shares of AAPL at $135.
The beauty of this option is that if AAPL trades sharply higher, let’s say to $175, you can still buy shares at $135.
That would be a valuable right to have!
But if AAPL continues to trade where it is today, you don’t have any obligation to buy at $135. You could simply choose not to exercise your right to buy if AAPL is below the $135 strike price.
Options Have a Limited Shelf Life
It’s important to know that each options contract you trade will have a specified expiration date. Each stock has a series of options contracts for an assortment of dates in the future.
Options contracts typically expire when the market closes on Friday afternoon. And most stocks use weekly expiration dates covering the next four to six weeks.
There are also monthly contracts, which historically get the most use. These contracts typically expire when the markets close on the third Friday of the month.
Depending on which stock you’re considering, there may be monthly options available for six months, a year, or even several years away.
So in our example above, you might choose to buy an AAPL $135 call contract that expires in three weeks.
That contract would give you the right to buy shares of AAPL any time between now and when the market closes on the third Friday from today.
Be sure you pay attention to the expiration dates on the contracts you hold in your account.
That way you know to expect your contract to expire or be exercised when the date is approaching. (Exercising a contract is simply going ahead and either buying or selling shares of the stock according to the terms of the contract.)
Buying and Selling Options Contracts on an Exchange
Now that you understand the basics of what an options contract is, let’s talk about buying and selling these contracts in your account.
The options we’ll talk about trade on an exchange just like shares of stock.
You can buy them at a price that someone else is willing to sell them for. And if you have a contract in your account, you can sell that contract to another investor.
So even though an options contract is a standardized contract to buy or sell shares of stock, many options traders never actually trade stocks in their accounts.
Instead, they buy and sell the options contracts themselves. Let’s consider the AAPL $135 call contract that we talked about earlier.
If you own this contract, you actually have two different ways to profit from a surge in AAPL.
First, if AAPL trades up to $175, you could exercise your right to buy.
In this case, your broker would purchase 100 shares of AAPL at $135 in your account. From there, you could sell those shares in the market for $175, booking a $40 profit per share.
Not bad!
But an easier way to close out your position for a profit would be to sell your call contract.
Since AAPL is trading at $175 — a full $40 above the contract’s agreed-upon strike price — you should be able to sell your contract for at least $40.
That’s the way most options traders lock in profits.
Instead of following the terms of the contract, they simply sell the contract on an exchange just like you would sell shares of stock.
Hopefully, today’s introduction gives you a good overview of what option contracts are.
For some of our Rich Retirement Letter members, this may be a review of information they already knew.
For others, this is a brand new concept. And that’s perfectly fine!
Learning new things can be a bit of a stretch at first. (I remember my brain being a bit overwhelmed when I first started learning about options contracts.)
But once you start to understand the basics, it’s exciting to see how these contracts can help you grow your wealth in ways that normal stock trading simply can’t.
I’ll be back to you tomorrow to talk about how to start using these special tools in your investment account.
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