Stock Market: Introduction to Options Trading

Do you have the base of knowledge you need for the investments you've chosen?
Before you begin trading, you must have the basic knowledge of the types of investments you have opted to trade. The stock market overall has a language that is foreign to those of us who are not familiar with the everyday jargon.
Be sure you have a solid understanding of the instruments that you will be trading and that you take advantage of reading our 'client education' series where you will find topics such as:

* What is an Option?
* Stock Vs Options
* Call Options
* Put Options
* Defining Put Options

The better informed you are as an investor; the more likely you will be to structure your trade plan in the way that is most beneficial to you. If you have specific questions we are here to help you develop your plan and work with you to ensure its success.

An option is a contract to buy or sell a specific financial product officially known as the option's underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange-traded fund (ETF), or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted on. And it has an expiration date. When an option expires, it no longer has value and no longer exists.

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. You make choices - whether to buy or sell and whether to choose a call or a put - based on what you want to achieve as an options investor.

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

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.

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. Suppose you anticipate that the price of Disney may rise to $40.00 per share before December - you could purchase a Call Option with an expiration date of Friday, December 21 (as if 11/09 trade date) at approximately $1.50 per share for a cost of $1500.00 plus commissions and fees associated with the trade which gives you the right to purchase 100 shares of DIS by 12/21/07 at a price of $32.50 per share. 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).

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.