Are You Ready for Your Options?
A Primer on How Options Work and When they are Used
Traders and investors use option in many different ways. Some use options to protect existing positions and others trade exclusively in options. Each requires different strategies and techniques. To begin, let’s look at what options are at the most fundamental level.
What is an “Option” Anyways?
Unlike purchasing a share of stock directly where you take immediate ownership of the share you purchase, an option is a contract to purchase that gives you the “right, but not the obligation,” to buy or sell a security at a specific price on or before a certain date.
Like a share of stock, it is a “security” but with more strictly defined terms and properties. First off, when you purchase an option, you have a right, but not an obligation to execute the actual purchase or sale of the underlying stock.
You can let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment, which is the money you used to pay for the option.
Also, because an option is simply a contract to purchase, it “derives its value from the underlying stock and is also called a derivative. There are two fundamental types of options – one covers the buy (the call) and the other (the put) of course covers the selling of the underlying shares.
Calls and Puts
A call option gives you the right to buy shares of the underlying stock at a certain price within a specific period of time. Call options are like being long on a stock and you are fundamentally betting the underlying share will increase in value before your calls expire.
- A put option gives you the right to sell shares of the underlying stock at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Put options are like being short a stock and you are hoping a stock decreases in value before it expires.
One of the biggest differences between buying shared directly and buying call or puts is the “expiration date.” Options have a shelf life and just like produce, their value changes with time.
What are Option “Positions?”
There are fundamentally four positions you may take when participating in the options market, each with own nuances you will want to learn more about. You can take a position as:
- A Buyer of Call Options – This means you “hold” the right to buy at the specified and may execute on the contact at any time. You are called the “holder” of the option because you bought the contract. In this case, you are the “holder of a long position.”
A Seller of Call Options – as the seller of call options, you are also referred to as the “writer” of the option because you in essence drew up the contract in the first place. This time, you are the “writer of the long position option.”
A Buyer of Put Options – as the exact opposite of a long position, when you become a buyer of a put option you are the holder of a short position because you have the right to sell at any time.
- A Seller of Put Options – finally, as a seller of put options you are, of course the writer of the short position since you, at least on paper, initiated the contract.
It is important to note, that as the holder or buyer of options, you are not obligated to execute on the contract. You are only purchasing the right to execute. Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose.
As the writer of the option, however you are obligated to buy or sell. In other words, you are expected to make good on your promise to buy or sell at the agreed upon price at the agreed upon time. This is where things can get a bit hairy. If you are on the wrong side of a position, you may have to buy or sell at a loss simply to fulfill the contract you wrote.
Other Option Terms You Need to Know
- In the Money - You are “in-the-money” when the share price for a call option moves above the strike price and a put option is “in-the-money” when the price moves below the strike price. These amounts are also termed the intrinsic value.
- Listed Options - Options traded on a national options exchange like the Chicago Board Options Exchange (CBOE) are called listed options. They have fixed strike prices and expiration dates and a contract on these boards are for 100 shares of the underlying stock.
- Strike Price - the price you buy an options at is called the strike price and is the price a stock price must go above for call options or below for put options before you can exercise your position. You must execute before the expiration date or the contract is void and your position is worthless.
- Premium - The total cost (the price) of an option is called the premium. This price is set by looking at the stock price, strike price, time remaining until expiration and volatility.
Trading Options for a Living
Trading in options is a great way to get started in the world of trading for a number of reasons:
Leverage – if you are starting out with a limited amount of capital, options allow you to take positions in a stock or company with as little as a few hundred dollars.
Systems – There are predefined systems available where you simply follow the rules of the system and only need to invest a few minutes each day to take and monitor your positions
- Profit However the Market Moves - options are the only financial instrument where you can profit from up, down, or sideways markets.