MajorWager School Level 1: Introduction to Options Trading

What is a Stock?

A stock represents a share in the ownership of a company. When you own a stock, you are a partial owner of that company and may benefit from its profits (dividends) and stock price appreciation.

How Do Stock Prices Move?

Stock prices fluctuate due to supply and demand, which are influenced by factors such as earnings reports, economic conditions, and investor sentiment.

What is a Stock Exchange?

Stock exchanges, such as the New York Stock Exchange (NYSE) and NASDAQ, facilitate the buying and selling of stocks. These exchanges operate as a marketplace for investors to trade shares.

What Causes Stock Prices to Change?

Stock prices change based on:

• Company performance (earnings reports, new product launches, leadership changes)
• Market sentiment (investor optimism or fear)
• Economic factors (interest rates, inflation, job reports)
• Supply and demand dynamics

Definition of an Option Contract

An option is a contract that gives the holder the right, but not the obligation, to buy or sell an asset at a predetermined price before or on a specific date.

Call vs. Put Options

Call Option – Gives the right to buy a stock at a specific price (strike price) before expiration.
Put Option – Gives the right to sell a stock at a specific price before expiration.

Why Use Options Instead of Stocks?

• Leverage – Options allow traders to control a large number of shares for a fraction of the cost.
• Hedging – Investors use options to protect their portfolios from downside risk.
• Speculation – Options provide opportunities for traders to profit from market movements.

Understanding key terms is essential before trading options:

• Strike Price – The predetermined price at which an option can be exercised.
• Expiration Date – The date when an option contract expires.
• Premium – The cost of buying an option.
• In-the-Money (ITM) – When an option has intrinsic value (e.g., a Call Option is ITM if the stock price is above the strike price).
• At-the-Money (ATM) – When the stock price is equal to the strike price.
• Out-of-the-Money (OTM) – When an option has no intrinsic value (e.g., a Call Option is OTM if the stock price is below the strike price).
• Option Chain – A listing of available option contracts for a given stock.

Buying vs. Selling an Option

Buying an Option – The trader pays a premium for the right to buy/sell stock.
Selling an Option – The trader receives a premium but takes on an obligation to fulfill the contract if exercised.

Understanding Time Decay (Theta)

Options lose value as they approach expiration, a concept known as time decay. Traders must be aware that an option’s value decreases over time if the stock price does not move in their favor.

The Concept of Leverage

Options allow traders to control 100 shares per contract. For example, buying a Call Option on a $100 stock might cost only $5 per share instead of $100, allowing traders to take larger positions with less capital.

Example 1: Call Option Trade

• Stock: AAPL ($150 per share)
• Call Option: $155 strike price, expires in 30 days, costs $3 per share

If AAPL rises to $160, the trader can exercise the option to buy at $155, profiting from the difference minus the premium paid.

How the Call Option Price Moves

As AAPL moves toward and above $155, the call option price increases. If AAPL reaches $160, the option now has intrinsic value of $5 ($160 – $155), plus any extrinsic value (time value and volatility impact). If demand for the option rises due to expected volatility, the premium could move from $3 to $6 or more. This allows traders to sell the contract for a profit without ever exercising it.

Example 2: Put Option Trade

• Stock: TSLA ($200 per share)
• Put Option: $190 strike price, expires in 30 days, costs $5 per share

If TSLA drops to $180, the trader can sell at $190, profiting from the difference minus the premium paid.

How the Put Option Price Moves

As TSLA moves below $190, the put option increases in value. If TSLA reaches $180, the option now has intrinsic value of $10 ($190 – $180), plus any extrinsic value. If demand for the put option rises due to increased market fear, the premium could move from $5 to $12 or higher. Traders can then sell the contract for a profit without ever exercising it.

Why Use Options?

• Speculation – Traders anticipate stock movements.
• Hedging – Investors protect portfolios from losses.
• Income Generation – Selling options to collect premiums.

Why Trade Options Without Exercising?

Many traders do not plan to exercise options but instead trade them based on price movement. Factors influencing price include:

• Intrinsic Value – The difference between the stock price and the strike price.
• Extrinsic Value – Factors like time decay, volatility, and demand for the option.
• Delta – Measures how much an option price moves relative to the stock price.
• Gamma – Measures the rate of change of Delta, influencing rapid price moves.

Because options can gain value quickly as stock prices move, traders buy and sell options intraday purely to capture profits from short-term moves in the option premium without ever holding until expiration or exercising the contract.