An option is a contract that gives you the right (but does not obligate you) to buy or sell the underlying security at a specified price during a specified period of time. The seller of an option is, in turn, obligated to sell (or buy) the shares to (or from) the buyer of the option at the specified price upon the buyer's request.

Options are currently traded on the following U.S. exchanges: American Stock Exchange LLC (AMEX), the Chicago Board Options Exchange, Inc. (CBOE), the International Securities Exchange (ISE), the Pacific Exchange, Inc. (PCX), and the Philadelphia Stock Exchange, Inc. (PHLX). Like trading in stocks, option trading is regulated by the Securities and Exchange Commission (SEC).

There are two types of options, a put option and a call option. A put option is gives you the right to purchase the underlying security (or commodity) at a specified price while a call option gives you the right to sell the underlying security (or commodity) at a specified price. Both puts and calls have expiration dates. Once these expiration dates expire the contract is worthless.

Options are characterized as 'derivative securities' because they derive part of their value from the underlying security. Stock options trade in 'units' which typically represent one hundred (100) shares of the underlying security, that is that one (1) option will give you the right (but not the obligation) to purchase or sell one hundred (100) shares of that security prior to the expiration date of the contract.

There are several terms that are associated with options some of the common ones are:

Term (more commonly referred to as expiration date): The date on which the option expires

Series: Options which are of the same security, same strike price and same expiration date

Long Position: the holder of the option contract holds a position in the underlying security and the number of options bought exceeds the number sold

Short Position: the holder of the option contract holds a position in the underlying security and the number of options bought is less than the number sold

Exercise: the holder of the option contract 'exercises' their right to buy or sell the underlying security at the price of the option

Strike Price: the price per share that the underlying security may be bought or sold

In-the-Money: the strike price of the call option is less than the market price of the underlying security; the strike price of the put option is greater than the market price of the underlying security

Out-of-the-Money: the strike price of the call option is greater than the market price of the underlying security, the strike price of the put option is less than the market price of the underlying security

Premium: the amount that the person purchasing the option will pay for the option in the competitive marketplace.

Options versus Stocks

Similarities:

* An option (listed options) are similar in nature to stocks
* Options need a buyer to bid on the option and a seller willing to offer the option for sale
* Options can be bought and sold like a stock
* Options are traded just like stocks

Differences:

* Stocks get their value from the value of the company while options get their value from the 'derivatives' (i.e. they get their value from the stock they are derived from)
* When you purchase stock they do not expire; options have an expiration date
* There are a fixed number of shares of a stock that are available for sale while an option has no fixed number available
* Option holders have no rights with the company (voting rights or the right to dividends) while stock holders have such rights

Investor/Seller

An investor who purchases an option has the right to exercise that option (but not the obligation to do so). The seller of the option has the obligation to allow the investor to exercise the option.

An investor in a Call option may exercise the right to purchase the stock at the strike price of the option (but has no obligation to do so).

An investor in a Put option may exercise the right to sell the stock at the price of the option (but has no obligation to do so).

The seller of a Call option has the obligation to allow the investor to purchase the stock at the strike price.

The seller of a Put option has the obligation to allow the investor to sell stock at the strike price.

It is important to note that most often, options are not exercised, rather the investor will chose to take profits by open trade of the option before the expiration date.

Options may be used as an alternative to purchasing stocks (since each option is equal to 100 shares of stock) which allows the investor the ability to profit from market moves with lower risk (i.e. lower investment equals lower risk).

Put options are financial contracts between a buyer and a seller which will allow the buyer (but does not obligate them) to sell an underlying security (or commodity) to the seller at a certain price. Options have expiration dates which limit the time that the buyer is allowed to do this.

The seller of the option is agreeing that regardless of what the price of the underlying security is that they are now obligated to buy the security on behalf of the buyer. For this, the buyer pays a fee (which is known as a premium) to the seller.

There are two (2) basic styles of put options, a European style which allows the buyer to exercise the option for a short period of time just prior to the option expiring, while an American style option allows the buyer to do so at any time prior to the expiration (as soon as the original date of purchase).

The most common put option is for a specific company (for instance IBM), however there are other types of assets which options are available for such as gold, crude oil, grains, and interest rates.

The buyer of a put believes that the price of the underlying asset is going to decrease by the time the option expires, or they are protecting their assets in that position. If they anticipate that the price of the underlying asset may decrease chances are they will purchase a put option to limit their risk which is simply the amount of the premium (fee paid). The writer (seller) of the put collects the premium because he does not believe the underlying asset will decrease.

A financial contract between a buyer and a seller that gives the buyer the right (but does not obligate) to buy a specific quantity of an asset (commodity or stock) from the seller for a certain price is a "Call".  The buyer purchases the Call Option from a seller for a fee (called a Premium) with the expectation of the underlying asset rising in value.  When the asset (the stock or commodity) exceeds the 'strike price' (i.e. the price at which the buyer can purchase the asset) the option is said to be 'in the money'.  There is no obligation for the buyer of the Call Option to hold the underlying asset unless in fact they 'exercise' their rights under the call option.  American "Call Options" (unlike their European counterparts) allow the buyer of the option to purchase the underlying asset at any time up through the expiration of the option.  When a call option is exercised, the commodity or stock that is represented by that option is transferred from the seller of the option to the buyer of the option.

 

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The buyer purchases the Call Option from a seller for a fee (called a Premium) with the expectation of the underlying asset rising in value. There is no obligation for the buyer of the Call Option to hold the underlying asset unless in fact they 'exercise' their rights under the call option. American "Call Options" (unlike their European counterparts) allow the buyer of the option to purchase the underlying asset at any time up through the expiration of the option. When a call option is exercised, the commodity or stock that is represented by that option is transferred from the seller of the option to the buyer of the option.

Purchasing of an option versus the underlying security limits the out of pocket expenses associated with the immediate outright purchase of an asset. When purchasing an option, they are purchased in blocks that allow the holder (the buyer) generally to purchase one hundred (100) shares of the underlying asset at a fixed price.

As an example: On November 9, 2007 shares of Disney (stock symbol DIS) were trading at approximately $32.00 per share. To purchase 100 shares you would have to spend $3200.00 plus commissions and fees associated with the trade. Purchasing an option to buy DIS at 32.50 in December would cost you only 1.50 per share (or 1500 dollars). Should the shares rise to $40.00, you could purchase 100 shares for $3250.00 (plus commissions and fees) and immediately sell those shares for $4,000.00 (less commissions and fees).

To understand the value of purchasing an Equity Option, you must first understand what they are.

Equity is defined as the stock of a company, for instance International Business Machines (IBM). An option is simply a contract that allows you (but does not obligate you) to purchase or sell shares of the equity for a set price during a fixed period of time, at a price that is significantly less than purchasing the actual security.

Some of the benefits of purchasing an Option to purchase (or sell) a stock is that it allows you to prepare to purchase stock at a price lower than current market price, protects your holdings in a stock from declining market prices, and can increase your income against stocks that you currently hold in your portfolio.

Let's assume you currently own 500 shares of IBM that you purchased at $89.00 per share and you believe that the stock will increase to the years' record high of $129.00 per share. You (as the holder of the security) decide that you would like the 'option' of being able to purchase additional shares of IBM at $90.00 per share. You can purchase a 'call option' for $10.80 (cost would be $10.80 X 100 (number of shares that you can purchase)) allowing you to purchase 100 shares at $90.00 per share, rather than purchasing the stock outright at $90.00 per share, limiting your exposure in the event that the stock price declines (rather than increases). The converse side of that is that you can purchase a 'put option' to sell shares at $90.00 per share for approximately $2.10 (cost would be 2.10 X 100 (number of shares that you can sell)) thereby guaranteeing that you can 'exercise' the option to sell those shares should the market decline.

Depending on your market outlook and exposure, you can protect your investment or increase your investment(s) for a fraction of the cost of purchasing the underlying security outright at the current market price.

The Standard and Poor's Index is comprised of a combination of one hundred (100) stocks from a base of New York Stock Exchange (NYSE) traded securities as well as National Association of Securities Dealers (NASDQ) traded securities. The components may change from time to time based on market fluctuations. The Standard & Poor's 100 Index is a capitalization-weighted index of 100 stocks and is considered a broad based index since it is made up of securities from a variety of industries. The price change is done in proportion to the total market value (the share price multiplied by the number of outstanding shares). The price would also vary with changes such as stock rights, substitutions and mergers or acquisitions.

Currently the OEX is comprised of 3M Company, Abbott Labs, AES Corp., Alcoa Inc., Allegheny Technologies Inc., Allstate Corp., Altria Group, Inc., American Electric Power, American Express, American Int'l. Group, Amgen, Anheuser-Busch, Apple Inc., AT&T Inc., Avon Products, Baker Hughes, Bank of America Corp., Bank of New York Mellon Corp. (New), Baxter International Inc., Boeing Company, Bristol-Myers Squibb, Burlington Northern Santa Fe Company, Campbell Soup, Capital One Financial, Caterpillar Inc., CBS Corp., Chevron Corp., CIGNA Corp., Cisco Systems, Citigroup Inc., Clear Channel Communications, Coca Cola Co., Colgate-Palmolive, Comcast Corp., Conoco Phillips, Covidien Ltd., CVS Caremark Corp., Dell Inc., Dow Chemical, Du Pont (E.I.), El Paso Corp., EMC Corp., Entergy Corp., Exelon Corp., Exxon Mobil Corp., FedEx Corporation, Ford Motor, General Dynamics, General Electric, General Motors, Goldman Sachs Group, Google Inc., Halliburton Co., Harrah's Entertainment, Hartford Financial Services Group, Heinz (H.J.), Hewlett-Packard, Home Depot, Honeywell Int'l Inc., Intel Corp., International Business Machines (IBM), International Paper, Johnson & Johnson, JPMorgan Chase & Co., Kraft Foods Inc-A, Lehman Bros., McDonald's Corp., Medtronic Inc., Merck & Co., Merrill Lynch, Microsoft Corp., Morgan Stanley, Norfolk Southern Corp., NYSE Euronext, Oracle Corp., PepsiCo Inc, Pfizer, Inc., Procter & Gamble, Raytheon Co. (New), Regions Financial Corp., Rockwell Automation, Inc., Sara Lee Corp., Schlumberger Ltd., Southern Co., Sprint, Nextel Corp., Target Corp., Texas Instruments, Time Warner Inc., Tyco International (New), U.S. Bancorp, United Parcel Service, United Technologies, Verizon Communications, Wachovia Corp. (New), Wal-Mart Stores, Walt Disney Co., Wells Fargo, Weyerhaeuser Corp., Williams Cos., and Xerox Corp..

While most investors are not in a position to invest significant amounts of cash into these securities individually, an option allows you to create diversity in your portfolio and allows you to invest a smaller amount of money in return for that diversity.

The options are traded "American Style" which means that they may be exercised at any time from the date of purchase up to and including the date of expiration.

The Dow Jones Industrial Average Index (DJX) is considered a 'broad based' index option. The components of the DJIA Index Options are:

3M Co., Alcoa Inc., Altria Group Inc., American Express Co., American International Group Inc., AT&T Inc., Boeing Co., Caterpillar Inc., Citigroup Inc., Coca-Cola Co., E.I. DuPont de Nemours & Co., Exxon Mobil Corp., General Electric Co., General Motors Corp., Hewlett-Packard Co., Home Depot Inc., Honeywell International Inc., Intel Corp., International Business Machines Corp., Johnson & Johnson, JPMorgan Chase & Co., McDonald's Corp., Merck & Co. Inc., Microsoft Corp., Pfizer Inc., Procter & Gamble Co., United Technologies Corp., Verizon Communications Inc., Wal-Mart Stores Inc., and Walt Disney Co.

Investment into the DJX (the Down Jones Industrial Average Index) allows you as the investor to diversify your portfolio without the necessity of investing in a variety of stocks. An investment in just one share of each stock (without the expense of fees and brokerage commissions) would cost you in excess of $1500.00 whereas you could purchase one (1) index option for approximately $130.00 per unit. This allows you to invest a significantly lower dollar amount and still reap the benefits of having a diversified portfolio.

Option trading while it poses significant risk can also be a very rewarding experience. This type of trading allows you the ability to invest much smaller amounts of capital and maximizing your return.

Specific characteristics of the Dow Jones Industrial average options are that they are traded European Style (i.e. they can only be exercised on the expiration). These typs of options typically expire the Saturday following the third Friday of the expiration month. Trading ordinarily ceases on the business day (generally a Thursday) before the day on which the exercise value is calculated. These options are cash settled and when purchasing, if the expiration has less than nine (9) months until expiration it must be paid in full. Currently they have no position or exercise limits.

Dow Jones Long Term Equity AnticiPation Securities TM (LEAPS) are longer dated options which expire three years from the date of the initial listing.

Stock indexes combine several stock prices and create one single item. Some indexes are based on broad, diverse markets, while others measure a specific sector of the market (such as computer companies for example). The number of stocks that make up the average is not what determines if it is broad based or narrow based, but the variety of the underlying securities.

Capitalization of Indexes

Capitalization Weighted:

An index may be set up so that the capitalization is biased towards the securities that have a larger price. This method of calculation is known as 'capitalization-weighted'. The formula for used is the market price for each stock multiplied by the number of outstanding shares. Typically this allows for greater impact on the value of the index.

Equal Dollar Weighted

This method of calculation gives equal weight to all components of the index. It is calculated by establishing the total market value for each security and then determining the number of shares. Then the combined market value is divided by the current market value.

Simple Average

This method of calculation is done by simply adding up the prices of all the securities in the index and diving by the number of securities. No weight is given to outstanding shares.

Accuracy and Adjustments

From time to time a single security might be dropped from an index due to business events. These might include mergers and liquidations, or perhaps because the stock is no longer considered to be the same as the other types of stocks that make up the index. Sometimes securities are also added to an index.

Adjustments are sometimes made because of this type of substitution of underlying securities or because a new stock is issued. Such changes are left up to the discretion of the publisher of the index and usually will not cause an adjustment in the term of the outstanding options.

From time to time an adjustment panel will make adjustments to the securities which make up the index, or the method of calculation.

Typically as long as the securities in the index are being traded, the prices of the securities are being promptly reported and the market prices reflect price movements, then the index will be accurate. Any fluctuations in this will cause inaccuracies.