Options Trading

Before you enter the world of options trading, it is best that you understand what an option is.

An option is a contract which conveys to its holder the right, but not the obligation, to buy or sell shares of the underlying security at a specified price on or before a given date.

After this given date, the option ceases to exist. 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.

An option contract usually represents 100 shares of the underlying stock.

Strike prices (or exercise prices) are the stated price per share for which the underlying security may be purchased or sold by the option holder upon exercise of the option contract.

The strike price - a fixed specification of an option contract - should not be confused with the premium, the price at which the contract trades, which fluctuates daily. Option strike prices are listed in increments of 2 ½, 5, or 10 points, depending on their price level.

Adjustments to an option contract's size and/or strike price may be made to account for stock splits or mergers.

Generally, at any given time a particular option can be bought with one of four expiration dates plus LEAPS (take note of the expiration months shown above).

Option holders do not enjoy the rights due stockholders - e.g., voting rights, regular cash or special dividends, etc. A call holder must exercise the option and take ownership of underlying shares to be eligible for these rights.

Buyers and sellers in the exchange markets, where all trading is conducted in the competitive manner of an auction market, set option prices.

Imagine somebody owns a piece of property which you really like, but do not have enough spare cash to purchase at short notice. There are various means available to you to raise the money, but they all need time to accomplish. So what can you do to prevent the owner from selling the property to another interested party?

Well, you can get him to offer you an option.

An option is a contract which conveys to its holder the right, but not the obligation, to buy the subject of interest stipulated in the contract.

So basically if the owner offers you an option, he is agreeing to let you hold the exclusive rights to purchase his property for a fixed price for a fixed amount of time. So if you manage to raise the necessary money within the stipulated duration, you would be able to purchase the property at the agreed price by exercising your option.

The owner of course does not offer the option for free. You will have to pay him a fee to secure the option. After all, you are preventing him from selling to other interested buyers for some time and he does bear some opportunity cost. The option fee is determined by factors such as the effective duration of the contract and exercise price.

If you choose not to exercise your option due to whatever reason, you will forfeit the option fee when the option expires.

In the context of the stock market, an option is a contract which conveys to its holder the right, but not the obligation, to buy or sell shares of the underlying security at a specified price on or before a given date. After this given date, the option expires and ceases to exist.

A call option is an option contract that gives the owner the right to buy the underlying security at a specified price for a certain, fixed period of time (until its expiration). For the writer of a call option, the contract represents an obligation to sell the underlying stock if the option is assigned.

A put option is an option contract that gives the owner the right to sell the underlying stock at a specified price (its strike price) for a certain, fixed period of time (until its expiration). For the writer of a put option, the contract represents an obligation to buy the underlying stock from the option owner if the option is assigned.

An option contract usually represents 100 shares of the underlying stock.

Strike Prices (or exercise prices) are the stated price per share for which the underlying security may be purchased or sold by the option holder upon exercise of the option contract.

Generally, at any given time a particular option can be bought with one of four expiration dates besides LEAPS ((Long-term Equity Anticipation Securities also known as long-dated options). Basically, LEAPS means calls and puts with expiration as long as thirty-nine months.

It is important to know that option holders do not enjoy the rights due stockholders - such as voting rights, regular cash or special dividends. This is because option holders own the option and not the actual shares of the company. A call holder must exercise the option and take ownership of the underlying shares to be eligible for these rights.

In conclusion, an option is a contract to secure the rights to purchase something for a stipulated amount within a stipulated timeframe. Options trading is an investment instrument that confers an option holder the right to buy or sell shares from the options seller at a stipulated amount within a stipulated timeframe. For many, options trading is a good leveraging instrument to make money off stocks they cannot afford. For others, options are a good way to protect their investments.

The first thing that you have to do when you are looking to begin trading in stock options is to read everything that you can find on the topic. Stock options are not stocks, and trading in stocks does not qualify you to trade in options by default. If you want to be successful, see what others have to say about the subject and learn as much as you can from as many diverse sources as you can.

This means doing internet research, talking to people who trade in stock options, reading books on the topic, and possibly even buying software that is designed for stock options traders to see what they are using and what they need to know. Next you will want to build up your experience by "trading on paper" for a while.

Go through the motions of making trades without actually doing so and see if you are making "money" or if you are losing out. If you have been losing out on your imaginary deals, you will not do much better in the real market. Get a feel for how things move before you jump in with both feet. Once you feel like you have a good background in information, you can set up an options account.

Contact a broker or discount broker who specializes in stock options, and set up an account with him or her. You will do your trading through your broker, at least at first, so make sure that you are comfortable with the broker, what he or she has to offer, what that broker does not offer, and what their requirements for opening an account are.

Invest a small amount of money to begin with, and focus on safe trades and following recommendations to keep the risks low. Once you have really started to get into things, you can ease your investments and your risks up a little higher in the quest for greater profits, but starting small will help keep you from digging yourself into a hole too early in the game.

Stock option trading can be a fun and profitable adventure, but you should go into it fully prepared and with the knowledge that you could lose money just as easily as you can make it, especially at first. Keep that in mind and study hard, though, and you will soon be trading options like a pro on the market.

If you're trading stocks or bonds, there are a whole range of strategies you can follow, which range from the long term buy and hold, right through to day trading using technical analysis. Options trading is very similar.

Understanding exactly what an option is one of the trickiest things to understand when you're starting out. Here's a 101 to bring you up to speed.

Basically, an option is a contract that gives you the right to buy (a call option) or sell (a put option) a stock or bond at a set price (the strike price) on or prior to a set date (the expiration date). You might need to read that a few times to get the hang of it!

There are different types of options available in the marketplace, with 'American' options able to be exercised anytime between purchase and expiration, and 'European' options only able to be exercised on the expiry date. Although the terms are geographical, nowadays the location where you buy options doesn't automatically mean you've bought one type or the other. As a general rule of them, American-style options are mostly used for stocks and bonds, whereas European-style options are for indexes.

Officially, options expire on the Saturday after the third Friday of the expiry month of the contract.

However as US markets are shut on Saturdays, that makes the Friday the effective expiry day. Talk about confusing!

Now that you have a basic understanding of what an option is and how it works, let's take a look at some basic strategies. I'll just focus on American-style options for stocks.

When you buy or sell an option, you basically have two choices - you can hold it to maturity, or you can choose to exercise it prior to expiry. A large proportion of investors do hold their options until maturity before exercising it to trade the underlying asset. Let's look at an example.

You've purchased a call option for $1, with a strike price of $25. As options contracts are generally for 100 share lots, your purchase (ignoring commissions) would cost you $100, and you'd have the right to purchase $2500 of stock through the option. Now, if the expiry date arrives and the stock is worth $27, it makes sense to go ahead of buy the stock, because you only have to pay $25. That means you've made an immediate profit of $2 per share if you sell them again immediately on the stock market. However you still have to factor in what you paid to buy the option, which was $1 a share. So after your purchase costs are deducted, your overall profit is $1 a share. Well done!

But what happens if the share price doesn't hit $27 - or even $26, which is your breakeven point for this option. Well, if there is still time to expiry and the share price is above $26 but appears to be dropping, it may be a good idea to exercise the option immediately so you can get out of the contract without loss. If the share price is under $26, you might still be able to sell the options for a smaller amount than you paid, for example 20c a share, and recoup some of your losses. If the option is now worthless, you basically just let the contract run in the hope that the price might jump up again, but accept that you've lost your $100. One of the good things about options is that you've only bought the option to purchase or sell - you're not under any obligation to do either upon expiry. So your risk is limited to the amount you spend buying the option in the beginning.

One thing to be aware of is that option prices aren't just influenced by the price movements of the underlying assets - they're also affected by their time to expiry. As the expiry date approaches, option prices tend to drop rapidly. So if you have an option that you don't want to hold until expiry, it may be worth selling out early to avoid being too badly hurt by the price dropping as expiry approaches.

Just are there are terms associated with Stocks Trading, there are specific terms associated with options trading.

But first, you must understand that options is an investment instrument that stems from stocks, and the fundamental principle of its function is to confer a options holder the right to buy or sell shares from the options seller at a stipulated amount within a stipulated time frame. You can equate this to placing a cash guarantee to purchase something within a time frame and preventing the seller from selling that item to any other interested parties.

Now why would you want to do this?

Well, for one, you might need to raise money to purchase that item and do not want the seller to talk to other potential buyers whilst you do your fund raising. For many, options trading is also a good investment instrument to make money off stocks they cannot afford. For others, options are a good way to protect their investments.

Before you learn how trading options can do the above, it is best that you learn all the terms relating to options trading.

CALLS AND PUTS
There are primarily two types of options - Calls and Puts.

A call option gives its buyer (holder) the right to buy 100 shares of the underlying security at the strike price, anytime prior to the options expiration date. The buyer is not obligated to exercise the option, thereby letting the option expire. The seller (writer) of the option has the obligation to sell the shares should the buyer exercise his option.

The opposite of a call option is a put option, which gives its buyer the right to sell 100 shares of the underlying security at the strike price, anytime prior to the options expiration date. The buyer is not obligated to exercise the option, thereby letting the option expire. However, the seller of the option has the obligation to buy the shares should the buyer exercise his option.

STRIKE PRICE

The strike price is the price at which the owner of an option can purchase (call) or sell (put) the underlying stock.

EXPIRATION DATE

The date on which an option and the right to exercise it cease to exist.

EXPIRATION FRIDAY

The last business day prior to the option's expiration date during which purchases and sales of options can be made. For equity options, this is generally the third Friday of the expiration month. Note: If the third Friday of the month is an exchange holiday, the last trading day will be the Thursday immediately preceding the third Friday.

EXERCISING THE OPTION

The buyer of a Call or Put option may choose to buy (in the case of a call) or sell (in the case of a put) the underlying shares of his option anytime, as long as it is within the effective date of the option. If he chooses to do so, this activity will be known as exercising the option.

ASSIGNMENT OF OPTION

When somebody exercises the rights of an option he owns, the Options Clearing Corporation will notify the seller of the option. Upon receiving the notification, the option seller is obligated to buy or sell the underlying stock at the strike price. This is known as the assignment of option.

OPTIONS PREMIUM

The price you pay to procure an option is called the "premium". An option's price is called the "premium".

WRITER

A writer is somebody who sells an option that is not owned through an opening sale transaction. While this position remains open, the writer is subject to fulfilling the obligations of that option contract. He will be obligated to sell stock (in the case of a call) or buy stock (in the case of a put) if that option is assigned. An investor who sells an option is called the writer, regardless of whether the option is covered or uncovered.

COVERED OPTION

An open short option position that is fully offset by a corresponding stock or option position. That is, a covered call could be offset by long stock or a long call, while a covered put could be offset by a long put or a short stock position. This insures that if the owner of the option exercises his rights, the writer of the option will not have a problem fulfilling the delivery requirements. Trading options using this strategy is secured because you can limit your losses.

NAKED OPTION

A short call option position in which the writer does not own an equivalent position in the underlying security represented by his option contracts. This is a more risky options trading strategy because your losses are potentially unlimited, although it can be quite rewarding on the upside too.

UNDERLYING SECURITY

The security an option seller must deliver (in the case of call) or purchase (in the case of a put) upon assignment of an exercise notice by an option contract holder.

EXPIRATION FRIDAY

The Expiration day for options is the Saturday following the third Friday of the month. Therefore, the third Friday of the month is the last trading day for all expiring options. This day is called "Expiration Friday". If the third Friday of the month is an exchange holiday, the last trading day is the Thursday immediately proceeding this exchange holiday. After the option's expiration date, the contract will cease to exist. At that point the owner of the option who does not exercise the contract has no "right" and the seller has no "obligations" as previously conveyed by the contract.

IN, AT, OUT-OF-THE-MONEY
The strike price, or exercise price, of an option determines whether that contract is in-the- money, at-the-money, or out-of-the-money.

If the strike price of a call option is less than the current market price of the underlying security, the call is said to be in-the-money because the holder of this call has the right to buy the stock at a price which is less than the price he would have to pay to buy the stock in the stock market . Likewise, if a put option has a strike price that is greater than the current market price of the underlying security, it is also said to be in-the-money because the holder of this put has the right to sell the stock at a price which is greater than the price he would receive selling the stock in the stock market.

The converse of in-the-money is out-of-the-money.

If the strike price equals the current market price, the option is said to be at-the-money.

Understanding how Call Options work and your choices in various scenarios relating to the fluctuation of the related stock prices are the fundamentals of Options Trading. This article gives an overview of Call Options and how you can make money through purchasing and selling Call Options.

A Call Option gives its buyer (holder) the right to buy 100 shares of the underlying security at a fixed price per share, at any time between the purchase of the call and the stipulated date when the option expires. The buyer has a choice and is not obligated to exercise the option. The seller (writer) of the option however, is obligated to sell the shares should the buyer exercise his option.

A buyer of a Call Option takes the position that the stock will appreciate (rise in value) within the effective date of the option, because that will result in a corresponding increase in value for that call. This means that there will be a higher market value in the call, which can be sold and closed at a profit. If not, he can also choose to exercise his option, which means that he buys the stock at a fixed price lower than the current market value.

On the other hand, the seller of a Call Option takes the position that the stock will depreciate (fall in value) within the effective date of the option, because that will result in a corresponding decrease in value for that call. This means that there will be a lower market value in the call. How this benefits the option seller is through the fact that the option buyer will not be willing to exercise his option as he will be paying a higher price than the fixed price in the contract. It will not make logical sense for him to do so as he would be losing money and he may as well exercise his option if he wants to purchase the underlying stock at all.

In such cases, the option buyer is most likely to either sell his option at a loss or move on or wait it out in the hope that the underlying stock price would rise. However, once his option expires, he loses his premium, which is the initial fee he paid to purchase the Call Option.

For a better understanding, let's further go on to illustrate various scenarios relating to the price of the underlying stock and take a look at the choices for action within each. Remember that this is in relation to Call Options.

Scenario 1 - The Market Value of the Underlying Stock Appreciates

In such a scenario, the value for the related Call Option will also appreciate. The buyer of such an option will have two choices. He can either choose to exercise his option and buy the underlying stock at a below current value price, or he can sell his Call Option for a profit.


Scenario 2 - The Market Value of the Underlying Stock Remains Stagnant

In such a scenario, the price of the underlying stock has not seen a change, or the change is too insignificant to create an opportunity for profit. The option buyer has two choices. The first choice he can make is to sell the Call Option before its expiration date. As the price of an option is determined by the remaining time before its expiration, the option buyer will most certainly see a loss if he sells his option without the underlying stock price seeing an appreciation. The magnitude of the loss will depend on how much time is remaining in the option before expiration. The second choice he can make is to hold on to the Call Option in the hope that the stock's market value will appreciate before expiration.

Scenario 3 - The Market Value of the Underlying Stock Depreciates

In such a scenario, the value for the related Call Option will also depreciate. The buyer of such an option will have three choices. He can sell off his option and accept his losses, sit it out in the hope that the stock value will appreciate, or simply let his option expire if his option is already nearing its expiration date.

Understanding how Put Options work and your choices in various scenarios relating to the fluctuation of the related stock prices are the fundamentals of Options Trading. This article gives an overview of Put Options and how you can make money through purchasing and selling Put Options.

A Put Option gives its buyer (holder) the right to sell 100 shares of the underlying security at a fixed price per share, at any time between the purchase of the call and the stipulated date when the option expires. The buyer has a choice and is not obligated to exercise the option. The seller (writer) of the Put Option has granted this right conferred to the buyer of the option.

A buyer of a Put Option takes the position that the stock value will depreciate (fall in value) within the effective date of the option, because that will result in a corresponding increase in value for that put. This means that there will be a higher market value in the put, which can be sold and closed at a profit. This is because a Put Option works in the complete opposite way from a Call Option. It is also true that an appreciation in the stock value would result in a decrease in the value of the Put Option.

For a better understanding, let's further go on to illustrate various scenarios relating to the price of the underlying stock and take a look at the choices for action within each. Remember that this is in relation to Put Options.

Scenario 1 - The Market Value of the Underlying Stock Appreciates

In such a scenario, the value for the related Put Option will depreciate. The buyer of such an option will have three choices. He can either choose to sell the Put Option at the current price below his purchase price and suffer a loss, hold on to the Put Option in the hope that the stock value falls and the Put Option appreciates or simply let his option expire if his option is already nearing its expiration date.

Scenario 2 - The Market Value of the Underlying Stock Remains Stagnant

In such a scenario, the price of the underlying stock has not seen a change, or the change is too insignificant to create an opportunity for profit. The option buyer has two choices. The first choice he can make is to sell the Put Option before its expiration date. As the price of an option is determined by the remaining time before its expiration, the option buyer will most certainly see a loss if he sells his option without the underlying stock price seeing an depreciation. The magnitude of the loss will depend on how much time is remaining in the option before expiration. The second choice he can make is to hold on to the Put Option in the hope that the stock's market value will depreciate before expiration and his Put Option would appreciate.

Scenario 3 - The Market Value of the Underlying Stock Depreciates

In such a scenario, the value for the related Put Option will appreciate. The buyer of such an option will have three choices. He can sell off his option at the current price which is above his purchase price and make a profit, sit it out and hope for the underlying stock to depreciate some more, or exercise his option and purchase the underlying stock he is entitled to.