Module 1: Introduction to Options

Options trading is an exciting way for Canadian investors to potentially enhance their investment returns. But what exactly are options?

What are options?

An option is a contract that gives the buyer the right, but not the obligation, to buy (call option) or sell (put option) a specific asset at a predetermined price within a set time frame.

Standard Contract Size: The "100 Shares" Rule

One options contract typically represents 100 shares of the underlying asset. This means:

• If you buy one call option, you're getting the right to purchase 100 shares of the underlying stock at the strike price.
• If you buy one put option, you're getting the right to sell 100 shares of the underlying stock at the strike price.
• The premium (price) quoted for an option is per share, but you pay for 100 shares worth.

Let's look at an example:

Imagine you see a call option for a fictional company called "CanTech Innovations" quoted at $2.50.

This might seem cheap, but remember:

• The actual cost of this option is $2.50 x 100 = $250 per contract.
• If you buy this option, you're getting the right to buy 100 shares of CanTech at the strike price.

This 100-share standard is why options can provide leverage. You can control the same number of shares with options for a fraction of the cost of buying 100 shares outright.

Remember: Always multiply the quoted option price by 100 to get the true cost of the contract!

Understanding this 100-share standard is essential for accurately calculating your potential profits, losses, and the overall risk of your options trades. It's a fundamental concept that will come into play in every options transaction you make.

Why do people trade options?

Let's explore the main reasons why investors, including beginners in Canada, might choose to trade options:

a) Potential for Higher Returns (Leverage)

• With options, you can control a large amount of stock with less money upfront.
• Example: Instead of buying 100 shares of a $50 stock for $5,000, you might buy an option for $200 that gives you control over those 100 shares.
• Benefit: If the stock price goes up, your percentage gain could be much higher than if you had bought the stock directly.

b) Earn Extra Income (Income Generation)

• You can make money by selling options, even if you already own stocks.
• Example: If you own 100 shares of a stock, you can sell someone else the right to buy those shares from you. You get paid for selling this right, even if they never end up buying the shares.
• Benefit: This can provide additional income on top of any dividends your stocks might pay.

c) Protect Your Investments (Risk Management)

• Options can act like an insurance policy for your stocks.
• Example: If you're worried your stock might go down in value, you can buy an option that gives you the right to sell it at a specific price. This limits how much money you could lose.
• Benefit: This can help you sleep better at night, knowing your investments have some protection.

d) Profit from Any Market Direction

• With options, you can make money whether stock prices rise, decrease, or even remain the same.
• Example: If you think a stock price will rise, you can buy a call option. If you think it will go down, you can buy a put option. There are even strategies for when you think the price won't change much.
• Benefit: This flexibility allows you to adapt to different market conditions.

e) Test the Waters with Less Risk (Speculation)

• Options allow you to benefit from a stock's price movement without buying the actual stock.
• Example: If you think a stock might rise but you're unsure, you could buy a call option instead of the stock itself. This way, you risk less money while still potentially benefitting if you're right.
• Benefit: This can be a way to gain experience and confidence in your market predictions with less financial risk.

Remember, while these potential benefits make options trading attractive, it's important to understand that options also come with risks. As a beginner, it's crucial to learn more about how options work before starting to trade them.

Key benefits of options trading

• Limited risk (for buyers): You can't lose more than the premium paid
• Flexibility: Multiple strategies for various market conditions
• Potential for high returns: Leverage can amplify profits

Potential risks for beginners

• Complexity: Options can be challenging to understand at first
• Time sensitivity: Options expire, potentially becoming worthless
• Leverage cuts both ways: It can amplify losses as well as gains

How options differ from stocks

Example

Let's use CanEnergy Ltd., a fictional company from the Energy sector. Imagine CanEnergy is trading at $50.

1. Buying 100 shares would cost $5,000.
2. Buying a call option (right to buy 100 shares) might cost $200.

If CanEnergy rises to $55:

• Stock investment gain: $500 (10% return)
• Option investment gain: Potentially $300 (150% return), minus the premium paid

Exercise

1.Which of the following is NOT a reason people trade options?

1. Leverage
2. Income generation
3. Guaranteed profits
4. Risk management

2. True or False: Options buyers have the obligation to buy or sell the underlying asset.

3. Which of the following is a key difference between stocks and options?

1. Options have an expiration date
2. Stocks pay dividends
3. Options represent ownership in a company
4. Stocks have limited risk

Answers: 1) c, 2) False, 3) a

Remember, while options can offer exciting opportunities, they also come with risks. It's crucial to understand these concepts thoroughly before starting your options trading journey.

Now that you've taken the first step towards expanding your investment toolkit, let's build on that foundation by exploring essential options terminology. Understanding these key terms is crucial for navigating the options market. Ready to enhance your options vocabulary? Let's dive into Module 2!

Disclaimer:

The strategies presented in this article are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

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