Option Basics

[jkruer01]

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!

[jimrice57]

What a great beginning to explaining options and there are many ways to learn for free. For example check out the following site:

CBOE - Learning Center

Here you can register for free and get many of the webinar's that in the archive and learn the different strategies for free. Education in any investing group is paramount to making money. However I do want to warn you that there are many people who will attempt to train you in option trading and you could spend quite a bit of money and not learn how to make money with options.

The Options Industry Council is another site with lots of free information:

888Options.com - Your Destination for Options Education - Check them out as well.

There are many ways to use the basic calls and puts but the biggest issue it managing your risk and not losing much money. As with any new investing training - paper trade before you try.

Good Luck and keep learning.

[dnystwn]

I've been toying with the idea of doing a covered call.

It involves going long on a certain stock and selling a call with a higher strike price than the current price.

For example, buying YHOO at 26.00 and selling call with strike price of 30.00 for 1.00

If YHOO goes up above 30.00, I could be forced to sell the stock that I own for 30.00 no matter what the new price would be. So I would lose an opportunity to make more money.

If YHOO stays around 25 or goes up to 30.00, the option will expire worthless, so I'll make the 1.00 premium (times 100 for each contract)

The only down side is I won't be able to set a stop order while doing this. Otherwise, this sound like a good strategy to make a little extra money (lower your cost basis).

Thoughts?

[jkruer01]

Covered Calls are a very basic and somewhat safe option strategy.

There are only 2 downfalls to doing covered calls. 1)You limit your upside potential. So if Yahoo goes from 26 to 50 you only get the gain from 26 to 30.

2)You still have the potential to lose money if the stock goes down in value. This is no different from just purchasing the stock out right but it still needs to be mentioned. If Yahoo goes from 26 to 20 and you received $1 for the call you still lost $5/share.

Other than that I think it is a good strategy. If you write a covered call on a stock you own every month it could add 1% to 3% per month to your returns without increasing your risk of just owning the stock outright.

Hope that helps!
Jeremy

[rharmelink]

Originally Posted by jkruer01

Covered Calls are a very basic and somewhat safe option strategy.

A covered call and selling a naked put have about the same profit/loss curve. In essence, you are giving up gains if the stock moves up, but still exposing yourself to downside risk. To pocket some premium on selling the option.

My biggest complaint about a covered call strategy is that you MUST be profitable on both strategies (buying stocks, selling calls) in order to improve your profit over doing one or the other alone. If you're making 1% to 3% per month selling calls, why do you need to own the stock? Stick with selling calls!

Would you be willing to sell naked calls? If not, you are afraid of the losses they may incur. Those losses are the same potential gains you would have had on stocks you bought. Why aren't you afraid of losing those potential gains?

[joshuat]

Because if you are writing naked calls, you are forced to buy the stock at whatever the current market price is. This can be many multiples of what you got for selling the call. The end result is that your net worth is less than when you started. Whereas with the covered call you are giving up profits. Covered calls are a risk mitigation technique.

Example:

Buy 100 XYZ @ 40. Sell calls at 60 for $2. Net cost: 40000-200 - 38000.
Stock goes to 80.

Call gets executed at 60, so you end up making $20002.

Alternatively, suppose you just wrote 1 call, without buying the stock.
Stock goes to 80, call gets executed at 60, you end up at -$18 (-20 + 2)

There's a huge difference between being up 20K vs down 18.

[Leeb06]

Randy I agree with you for the most part. If you are buying stock for a short term trade then selling calls would greatly decrease your upside without providing you with much downside protection. However, if you own a stock and have already determined a sell level for that stock then selling a call could provide you with additional income as you wait for level to be reached. This is especially true in a sideways, rangebound market.

When selling a call you need to be aware of the implied volatility level you are selling. If the level is to low you probably would be better off just being long the stock. However selling an option whose volatility is higher then its historic average can provide income at a premium price.

Originally Posted by rharmelink

A covered call and selling a naked put have about the same profit/loss curve. In essence, you are giving up gains if the stock moves up, but still exposing yourself to downside risk. To pocket some premium on selling the option.

My biggest complaint about a covered call strategy is that you MUST be profitable on both strategies (buying stocks, selling calls) in order to improve your profit over doing one or the other alone. If you're making 1% to 3% per month selling calls, why do you need to own the stock? Stick with selling calls!

Would you be willing to sell naked calls? If not, you are afraid of the losses they may incur. Those losses are the same potential gains you would have had on stocks you bought. Why aren't you afraid of losing those potential gains?

[ApexAZ]

Originally Posted by jkruer01

Covered Calls are a very basic and somewhat safe option strategy.

There are only 2 downfalls to doing covered calls. 1)You limit your upside potential. So if Yahoo goes from 26 to 50 you only get the gain from 26 to 30.

2)You still have the potential to lose money if the stock goes down in value. This is no different from just purchasing the stock out right but it still needs to be mentioned. If Yahoo goes from 26 to 20 and you received $1 for the call you still lost $5/share.

Other than that I think it is a good strategy. If you write a covered call on a stock you own every month it could add 1% to 3% per month to your returns without increasing your risk of just owning the stock outright.

Hope that helps!
Jeremy

You don't completely limit your upside potential because even if you get assigned when it hits the strike price and you're forced to sell, no one is preventing you from buying more if you feel comfortable with it going up more :)

When it comes to the stock dropping, you can still limit your losses by covering. You just need to buy the contracts back (but at a lower price most likely if the share price dropped).

[Straddle]

The Black & Scholes formula is an easy tool to determine the intrinsic value of options.

[pintodave]

Hey Guys and Gals,

I havent been on here in a long time so I thought I'd see what was going on and I saw the new options page.

If you guys want some great educational material, here are a few sites:

CBOE.com - check out their video archives and look for the Dan Sheridan video's. The site can be a pain to navigate, but it is all free stuff and awsome material. Actually I am going to Dan's class this Thurs in Chicago!

If anyone has problems accessing the videos I'll start a new post with detailed directions.

Optionpundit.net - There is a lot of good free info here also. There is also a pay service as well, but you can still access the message board and check out some articles.

Dan Sheridan and optionpundit.net focus on "income options strategies" or also known as "market neutral" which are pretty darn cool. It is not "daytrading" but it is short term.

Thought I'd throw this out there. I am by no means an expert but I can answer some basic questions or atleast tell you where to find an answer :)

David