What is an option?
An option is a contract that gives the buyer to right to either buy or sell (depending on the type of option purchased) 100 shares of a specific security for a specific price within a specific time frame.
What types of options are there?
There are two types of options. Calls and Puts. Calls give the buyer of the option the right to purchase the stock at the strike price before the option expires.
Puts give the buyer of the option the right to sell the stock at the strike price before the option expires.
Remember 1 option contract is for 100 shares of a stock.
Lets look at some option quotes:
Lets look at the options available on XOM:
XOM: Options for EXXON MOBIL CP - Yahoo! Finance
By default it pulls up the Mar 2007 options. These are all the options on XOM that expire in Mar of 2007. In the US all options expire on the 3rd Friday of the month of expiration. To see April or Jul options just click the appropriate link.
You will notice there are two sections one called "Call Options" and one called "Put Options". Look at the "Call Options".
The first column is called "Strike". This is the Strike price for the particular option. The strike price is the agreed upon price that the buyer of the option can buy or sell the stock for depending on whether he purchases a call or a put.
The next column is the symbol. Each option has its own specific symbol. The first part of the sybol is the stock symbol. The last two letters actually tell whether it is a call or a put, the month it expires, and what the strike price is. I'm not going into how to figure that out now because it would take too long.
The rest of the columns should look familiar to anyone that has looked at stock quotes before. Last, change, bid, ask, vol. The only difference with options is that everything must be multiplied by 100 because 1 option contract is good for 100 shares of stock. So if the price is .20 then you must multiply it by 100 to figure how much it really costs. To buy 1 option that is .20 it will cost .20 x 100 = $20.
The last colum is Open Interest. This is how many of the option contracts are open that have not expired or been executed.
When would you buy/sell an option?
Well as I mentioned their are two types of options...calls and puts. Each can be bought or sold. So there are four posibilities.
If you think a stock will go up in value you can
Buy a Call
or
Sell a Put
If you think a stock will go down in value you can
Sell a Call
or
Buy a Put
Buy a Call - When you buy a call you are buying the option of purchasing a security for a specific price within a specific time frame. Lets use XOM as an example. Today XOM is trading for about $71/sh.
If you think XOM is going up in price you can buy a call. I will buy 1 contract of XOM with a strike price of $75 and an expiration date of April 07 for $1. This will cost me $100 + commisions. Lets assume XOM goes to $80/sh before the option expires. I can exercise my option and purchase 100 shares of XOM for $75/sh and immediately sell them for $80/sh. How much money did I make? I paid $100 for the option. I purchased 100 shares at 75/sh and sold 100 shares for $80/sh. That trade made me $500. So $500 - $100 = a $400 profit. I turned my $100 into $500 for a 500% increase!!!! WOW!!!
But remember if XOM never went about $75/sh and I let my option expire then I would have lost 100% of my money
The upside potential is unlimited and the downside potential is the ammount of money you spent to buy the option.
Sell a Call - Lets use the same example example as above. If I would have sold the option I would have recieved $100. If it expired worthless then I just made $100 for not doing too much.
However if it was excercised for $75/sh when it was trading at $80/sh then if I don't own any XOM stock I have to go buy 100sh @ $80/sh and turn around and sell them for $75/sh for a $500 loss. But since I already recieved $100 for selling it the loss is really $400. I still don't like it!
The upside potential is the ammount of money you recieve from selling the option and the downside potential is unlimited.
Puts are the exact opposite of Calls
Buy a Put - Is the right to sell a stock for a specific price. If a stock is trading @ $20/sh and you think it will go down in value you can buy a put at $15/sh. If the stock goes to $10/sh you can exercise your option and buy the stock on the market for $10/sh and sell it for $15/sh.
The upside potential is the strike price x 100 and the downside potential is the ammount you paid for the option.
Sell a Put - If you think a stock is going up in value you can sell a put on it. Lets say a stock is trading @ $20/sh and you think it will go to $25/sh. You can sell a put with a strike price of $15/sh. If the stock price goes to $25 then the option will expire worthless and you made the ammount of money that you sold it for. If the stock price goes to $10/sh then you have to buy the stock for $15/sh loosing $5/sh.
The upside potential is the ammount you recieve for selling the option. The downside potential is the strike price x 100.
The important thing to remember about options is it uses leverage. If things go your way you will make more money than if you bought the stock outright. If things do not go your way you will loose more money than if you bought the stock outright.
Have fun! Go Play!