Overview

Options, are they the key to triple-digit returns? Or are they really just for suckers? By now, I’m sure most of you have received advertisements in your snail mail or even your e-mail boxes regarding how you can make a fortune buying options. So if you are currently just trading stocks, but have always wanted to get into options, I urge you to learn about them before you get started. My purpose here is to give you a solid foundation on the basics of options. In this lesson, you will learn just what they are, the two types of options, the pricing of options, and basic trading strategies. Lastly, if you’re hungry for more advanced information, I’ll point you to some excellent trading lessons written by Market Wizard Tony Saliba.

Options in one form or another are nothing new. They’ve been around for hundreds and perhaps thousands of years. Traders and investors can use options for hedging and speculative purposes. Options are known in the financial markets as “derivatives.” That basically means that their value is tied to or derived from the value of their underlying instrument. For example, the value of an option to buy Microsoft stock will be based on the price of Microsoft stock.

In the financial markets, there are options on individual stocks, various market indices, and futures contracts. In this lesson, we will focus on stock options, but most of the concepts are applicable to other types of options. So just what are options? Options are contracts between a buyer and a seller that gives the buyer the right to buy or sell something at a predetermined price on or before a specific date.

Let’s look at an example. Say that I want to buy a house and you want to sell your house. You're asking $300K for your house. I (the buyer) really like the deal, but need to check elsewhere before I commit to buying your home for $300K. So let’s say that you decide to sell me an option that gives me the right to purchase your home at a stated price of $299K. And for selling me that right, I will pay you $1,000. Also in this contract, you state that this option will only be good for three months. If during the three-month period, I (the buyer) do not notify you (the seller) that I intend to exercise or use my option to buy your house at the stated price of $299K, the option expires worthless and ceases to exist.

In this case, I would have forfeited the $1,000 that I paid to you for the option. Meanwhile, you, the option seller, gets to keep the $1,000. Now let’s say that two months later, home prices in your neighborhood suddenly rose in anticipation of the building of a mega-shopping mall. In this case, your house is now worth $320K. Remember that I still have the right to buy your house at $299K. I can now either exercise my option or I can just sell it. I could exercise my option and purchase your house at the stated price of $299K and immediately sell it for $320K, thus netting a $20,000 profit ($320K - $299K - $1K). Or I can sell my option to someone else for at least $21K.

Advantages

Option trading has been increasing in popularity over the last few years as options provide traders with several advantages:

1. Leverage – Higher returns and lower cash outlay. Stock trading is expensive. In order to buy 100 shares of XYZ stock at $100 per share, you’ll need $10,000. Although this might not seem like a huge amount of money to some people, $10,000 might be a big sum for new traders. If XYZ moved up five points, you would make 5% on your money. With options, you can control or participate in the movement of a stock for a lot less money and earn a higher rate of return. If instead of buying the stock, you purchased an XYZ January 100 call, which gives you the right to buy 100 shares of XYZ stock at $100 on or before the January expiration date, you would have made over 250%!!! Now that’s leverage!
2. Flexibility/versatility – With stock, traders can be either bullish or bearish. With options, traders can be bullish, bearish or neutral. Options can be used by themselves or in conjunction with stock. Options can also be used in combination with other options to create many different risk/reward scenarios.
3. Predetermined risks – For option buyers, the most you can ever lose is the amount paid for the option. You know in advance how much you can lose.

Types of Options

There are only two types of options, calls and puts. Call options give buyers the right, but not the obligation, to purchase the underlying instrument at a specific price (strike price) on or before a specific date (expiration date). Put options give the buyers the right, but not the obligation, to sell the underlying instrument at the strike price on or before the expiration date. Just remember that buyers of options have all the rights and sellers have all the obligations. So on the flipside, call sellers have the obligation to sell the underlying instrument at the strike price to the call buyer if the call buyer chooses to exercise or use the option. Put sellers have the obligation to purchase the underlying instrument at the strike price if the put buyer chooses to exercise.

Back in the old days, there were no organized options markets. Options were traded over-the-counter. Each option contract was tailored to meet each party’s exact specifications. This made it difficult and cumbersome to find someone who wanted to take the other side of your trade. These days, most options are traded on an organized securities exchange such as the Chicago Board Options Exchange, American Stock Exchange or the Pacific Stock Exchange. The terms of option contracts are now standardized, which means that the terms of each contract is set or fixed. Option contracts have standardized contract sizes, strike prices and expiration dates. For stocks, each option contract covers 100 shares of stock. So if you bought a call option, you bought the right to purchase 100 shares of stock. Much like insurance policies, option prices are referred to as “premiums.”

You will often see option premiums being quoted as “10 1/2." This does not mean that you can buy an option for $10.50. Since each option contract is for 100 shares of stock, you need to multiply the 10 1/2 by 100 to come up with the actual price of $1,050.00. In stocks, the number of shares available for trading is known as the “float." In options, it’s known as “open interest.” The exercise price or strike price of options is the price at which the underlying instrument will be delivered if the holder/buyer of the option chooses to exercise. Strike prices are set at two-and-a-half-dollar intervals for stocks trading at $25 and under. For stocks between $25 and $200, strike prices are set at $5 intervals. Stocks trading over $200 have strike prices set at $10 intervals. Certain stocks trading between $20 - $450 also have strike prices set at two-and-a-half dollar intervals. The expiration date of an option is the date that the option expires or ceases to exist. All listed stock options expire the third Friday of the month. Options also have maturities from one to nine months. There are also long-term options called Leaps. Leaps have maturities of up to three years.

Pricing

Options can be classified as being in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM). A call option is in-the-money if the strike price is less than the current market price. For example, if XYZ is trading at $50 and you purchase an XYZ February 40 Call, your option is in-the-money. The buyer of an in-the-money call would be able to purchase stock for less than the current market price. Since in-the-money calls allow the buyer to purchase stock at less than market price, they command the premium. ITM options have a tendency to move almost point-for-point with the stock. Many traders use ITM options as a stock substitute.

A call option is at-the-money if the strike price equals or is very near the current market price of the stock. For example, if XYZ is trading at $50 and you purchase an XYZ February 50 call, your option is at-the-money. The cost of an at-the-money call is lower than that of an in-the-money call, but higher than an out-of-the-money call. Lastly, a call option is out-of-the-money if the strike price is greater than the current market price. For example, if XYZ is trading at $50 and you purchase an XYZ February 60 call, your option is out-of-the-money. out-of-the-money calls have the lowest premiums, but they give you the most bang for the buck. So if you think a stock will make a quick and large move up, buy OTM calls.

For put options, puts are in-the-money if the strike price is greater than the current market price. For example, if XYZ is trading at $50 and you purchase an XYZ February 60 put, your put is in-the-money. Since in-the-money puts allow you to sell at a price that is greater than the current market price, they have the highest premiums. A put option would be at-the-money if the strike price were equal to the current market price. For example, if XYZ is trading at $50, and you purchase an XYZ February 50 put, then your put is at-the-money. At-the-money puts have lower premiums than in-the-money puts and higher premiums than out-of-the-money puts. Finally, a put option is out-of-the-money if the strike price is less than the current market price. For example, if XYZ is trading at $50 and you purchase an XYZ February 40 put, your put option is out-of-the-money. Buy OTM puts when you think that a stock will have a quick and large move down.

ITM options have a tendency to move almost point-for-point with the underlying stock. The prices of ITM options are very sensitive to the movements of the underlying stock. The option’s delta is a statistical measure of the option’s sensitivity to changes in the underlying stock price. Option deltas are actually a statistical probability that range from zero to one for call options and zero to negative one for put options. For example, if Cisco stock is up a dollar today and the January 35 call is up fifty cents, then the call’s delta is .50. Delta could be expressed in decimal or percentage form. Delta could be roughly calculated as:

Change In Option Price / Change In Stock Price = Option Delta.

An option’s value consists of two components, intrinsic value and time value. Intrinsic value is the amount of the option that is in-the-money. For example, if XYZ is currently trading at $50 and you hold a February 40 call, then your call has an intrinsic value of $10. If you hold a February 60 call, then your call would have an intrinsic value of $0. The other component of an option is time value. Time value is the difference between the option’s current price and its intrinsic value. For example, if the February 40 call is currently trading at 10 1/2, then time value is calculated as

10 1/2 Option Price
-10 Intrinsic Value
= 1/2 Time Value

Due to the length and complexity of the actual option-pricing formula, we will not go over the actual calculation in this lesson. However, we will discuss the six factors that determine the value of an option and are the actual inputs to the Black-Scholes option pricing formula. The six factors that affect option prices are:

1. Price of the underlying instrument – This is the most important factor. The higher the price of the underlying instrument, the higher the price of the option. The lower the price of the underlying instrument, the lower the price of the option. If all things remain constant, as the price of the underlying increases, call prices increase and put prices decrease. And as the price of the underlying decreases, put prices increase and call prices decrease.
2. Strike Price – It is the strike price that determines whether an option is ITM, ATM or OTM. The strike price also determines whether an option has intrinsic value. Remember that when you buy OTM options, all you’re buying is time.
3. Time – the more time till expiration, the more time you have for an option to move in your favor. So, more time will cost you more money. A three-month option will cost more than a one-month option. It’s important to know that an option is a wasting asset. With each passing day, an option will lose some of its time value; this is known as “time decay.” Time decay will accelerate in the last weeks and days of an option’s life.
4. Interest Rates – Interest rates have a minor effect on option prices. Despite this, it’s still important to know that as interest rates increase, call prices increase and put prices decrease. To understand this dynamic, think of call buying as a cheap alternative to buying stock. The call buyer in turn will save the difference between the amount spent on the call and the amount that would have been spent on the stock. The higher the interest rate, the more money you would earn by investing the money you saved by buying the call. So, if interest rates were increasing, traders would buy calls and drive prices up.
5. Dividends – as dividends increase, call prices decrease and put prices increase. This is because as a company increases their dividends, the stock will drop by that amount on the ex-dividend date. So if dividends increase, the stock will drop by a bigger amount and lower stock prices equals lower call prices and higher put prices.
6. Volatility – volatility is a measure of price fluctuation. Volatility does not have a bias in direction. More volatility means more ups and downs. An increase in volatility means a greater likelihood that the option will become profitable. So as volatility increases, both call and put prices increase.

Basic Trading Strategies

Options are among the most versatile of financial instruments. They can be used for speculation or hedging. Conservative or aggressive, there’s a strategy for you. Options can be used alone, in conjunction with stocks you already own, or even with other options. When trading options, you need to understand and be aware of the risk and reward characteristics and breakeven points of each option strategy. We will be examining the profit and loss scenarios at option expiration. Keep in mind that it is possible to close the position before expiration. To close your position, simply reverse what you did. If you bought, then sell. If you sold, then buy back. The basic option strategies we’ll be looking at are:

1. Long Call – Buying call options.
2. Long Put – Buying put options.
3. Short Call – Selling call options.
4. Short Put – Selling put options.
5. Covered Call/Covered Write – Selling call options on stocks you own.

Long Call

The long call or call buying strategy is among the most basic, yet most profitable option strategies. It simply involves the purchase of call options. The long call strategy offers the trader unlimited profit potential and limited downside risk. The long call is the most bullish of option strategies as there generally is a high amount of leverage involved. So if you think that a stock is going up, buy calls. For instance, let’s say that you like EMC Corporation (EMC | Quote | Chart | News | PowerRating). It’s currently at $65, and you think that it’s going to move up. You could buy one February 65 call at 7 or $700. The amount of the premium, or $700, is the most that you can lose. It doesn’t matter if the stock goes to zero; the most you can ever lose in buying calls is the amount of the premium paid. At expiration, in order to profit from this transaction, EMC must be above your breakeven price of 72. To find the breakeven price, simply add the strike price of the option to the premium of the option. The breakeven point for long calls is calculated as:

Strike Price + Option Premium = Breakeven Price For Long Calls

In this case, our breakeven price is calculated as 65 + 7 = 72. This is the price that EMC must be above at expiration for us to profit from this transaction. At expiration, there are three possible scenarios. First, the stock price could be above the strike price. For instance, say EMC is at 75, which is 10 points above our strike price of 65. Our option would be 10 points in-the-money and should be worth at least 10. This is great for us since we bought the option at 7 and we could now sell it for 10. As an alternative to selling our call, we could exercise our option to purchase 100 shares of EMC at $65 and then turn around and sell it at 75. Most traders opt to sell their option instead of exercising it. Our profit in either case would be 42.8% while the stock moved only 15.4%.

Second, the stock price could be equal to the strike price. At expiration, let’s say that EMC was at 65; at this price you probably would not exercise your option to buy the stock for 65 while it’s already trading on the open market for 65. Recall that we paid 7 for the option. If we did use our option to buy 100 shares of EMC at 65, we would really be paying 72 (65 + 7) per share for the stock.

Lastly, the stock price could be below the strike price. Let’s say at expiration, instead of moving up, EMC drops to 55. In this case, no one in their right mind would exercise their option to buy EMC at 65 while it’s trading at 55. In this case, our option would be worthless, and we would lose $700, or 100% of our money.

Long Put

The long put or put buying is a bearish strategy that traders use to profit from a down move in a stock. Put buying also has limited risk and a large, but limited reward. The reward is limited because a stock can only go down to zero. Put buying is the most bearish of option strategies. If you think a stock is going down, buy puts. For example, if you think that Cisco Systems (CSCO | Quote | Chart | News | PowerRating) is going to move down, you could buy a put on Cisco. If Cisco is currently trading at 36, and you decide to buy a Cisco February 40 put for $6 or $600, then you bought the right to sell 100 shares of Cisco stock at 40 per share. The breakeven point for the long put is calculated as:

Strike Price – Put Price = Breakeven For Puts

Our breakeven point in this case would be 34 (40-6=34). We would not profit from this transaction until the stock goes lower than 34. Again there are three possible scenarios at expiration. First, the stock could be above the strike price. In this case, let’s say Cisco is at 50; your put with a strike price of 40 would be ten points out-of-the-money. Since no one would exercise their option to sell Cisco at 40, your option would be worthless and you would lose $600 or 100%.

Second, the stock could equal the strike price. Let’s say that at expiration, Cisco is trading at 40. The put option would also be worthless because no one would buy it to sell the stock at 40 while it’s already trading at 40. You would not exercise your option because then you would be essentially selling at 34.

Lastly, the stock could be below the strike price. If at expiration, Cisco were at $30, your put option would be worth at least $10. In this case you would make $400 or a 66% return.

Short Call

Now let’s take a look at the short call or call selling. The short call strategy involves selling call options on stock that you don’t own. Remember that the buyer of the call has the right to buy so that means that you have the obligation to sell. Call selling is a neutral strategy, in which you don’t want the stock to move much either way. The reward is limited to the premium received, but your risk is unlimited. The stock could shoot up significantly, thus forcing you to buy the stock at a high price so that you can meet your obligation to sell it at a lower price.

Let’s look at an example. Say that you think Dell Computer (DELL | Quote | Chart | News | PowerRating) is likely to stay neutral. With the stock at 21, you could sell a February 25 call for 1, or $100. That $100 is your maximum profit. To calculate the breakeven point for a call sell, add the strike price of the option to the price of the premium received. The breakeven would be calculated as:

Strike Price + Premium = Breakeven For Call Sell

Our breakeven price in this case would be 25 + 1 = 26. If the stock goes to 26, you would lose the $100 profit. Once again, there are three possible scenarios at expiration. First, the stock price could be above the strike price. If the stock rallies to 30, you would have been “called out” or forced to sell the stock at 25, but since you don’t own the stock, you would have to buy it on the open market at 30 and sell it at 25. Since you lose $500 in the stock transaction, but got paid $100 for selling the call, you would end up losing $400.

Second, the stock price could be the same as the strike price. If the stock ended up at 25, it is most likely that the holder/buyer of the option would not exercise the option. Therefore, you would keep the $100.

Lastly, the stock could be below the strike price. Let's say that the stock ended up at 18, in which case you would keep the premium because no one is going to exercise their call option to buy the stock at 25 while it’s trading at 18. Selling options on stock that you don’t already own is known as “going naked.” Selling naked options is a very dangerous strategy. If the stock takes off to 50, you would have to deliver or sell the stock to the call buyer at 25 and face a $2500 loss. Of course, you could always buy back the option that you sold, thus canceling your obligation to sell the stock.

Short Put

The short put or put selling strategy is a bullish strategy. Remember that the put buyer has the right to sell the stock, so the put seller has the obligation to buy the stock at the strike price, if the put buyer chooses to exercise. Put selling has a limited reward and a large, but limited risk; the stock can only go to zero. In this strategy, you want the stock to keep moving up so that the put buyer would not exercise their option, and therefore, you get to keep the premium. The breakeven point for put selling is calculated by subtracting the put premium from the strike price. For example:

Strike Price – Put Premium = Breakeven For Put Sell

Let’s say that you’re bullish on Cisco Systems (CSCO). With the stock at 35, you decide to sell a February 40 put for 5 or $500. The $500 is your maximum profit. Breakeven is calculated to be 35 (40-5). At the breakeven price of 35, the put buyer would exercise the option, and we would be forced to buy the shares at 40, but since we received 5 for selling the put, we are really buying the stock at 35, which is also the current market price. So in this case, we would essentially be at breakeven. At expiration, there are three likely scenarios. First, the stock could be above the strike price. At expiration, with Cisco at 50, put buyers would not exercise their option to sell Cisco at 40 while it’s trading at 50. The February 40 put would be worthless, and we would keep the premium.

Second, the stock could equal the strike price. In this case, the put buyer would most likely not exercise the option and we would also keep the premium. Lastly, the stock could be under the strike price. Let’s say that at expiration, Cisco is at 30, the put buyer would definitely exercise their option to sell the stock at 40. We would be obligated to buy 100 shares of Cisco at 40 while it’s trading at 30. Since we were paid 5, or $500, for selling the put, we would really be buying Cisco at 35 while it’s trading at 30, therefore we’re faced with a $500 loss. From 1997 to 1999, Dell Computer Corporation sold puts on their own stock and made over $97 million in the process. Though now with their stock price sitting at a three-year low, their put selling activities could cost the company a potential $3.4 billion in loses (Business Week, 1/15/01).

Covered Call

Our final strategy, the covered call or covered write, is essentially the same as the short call, except that in this case, we own the underlying stock. In this strategy, we sell call options on stock that we already own. What happens is that we are putting a cap on how high the stock can move. We are also receiving a little protection on our downside risk. Covered call writing is a popular strategy used to generate extra income from stocks in narrow-range markets. Our breakeven on this strategy would be calculated as:

Stock Price (purchase price of stock) – Call Price = Breakeven For Covered Call

32 - 3 = 29

For instance, say we bought 100 shares of Sun Microsystems at 32 and sold a February 35 call for 3 or $300. Our breakeven point would be at 29 (32-3). At expiration, there are three possible scenarios. First, the stock price could be trading above the strike price. If Sun was trading at 45 at expiration, we would not be able to sell our shares at 45 since we sold a February 35 call against our stock. We would therefore be called out of our shares at 35, but since we received 3 for the option, we are really selling our stock at 38. In this case, we missed out on any further upside potential past our strike price.

Second, the stock price could equal the strike price. In this case, if at expiration Sun is at 35, the call buyer would not exercise the call, and therefore, we keep the premium. Lastly, the stock price could be below the strike price. If at expiration, Sun is at 25, no one would use their option to buy the stock at 35, the option would expire worthless and we get to keep the premium. Keep in mind that we bought the stock at 32, so we are down 7 points, but since we sold a call for 3, we are really down 4 points. The covered call in this case gave us a little downside protection. The covered call or covered write is a very popular strategy among conservative traders and it is usually the first option strategy that traders utilize.

Conclusion/Recap