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.

Options trading 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 or the American 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.

Conclusions

Options present the trader with a unique method to capitalize on market movements, and there is no one "correct" way to trade options. We'll be going into further detail about potential options strategies and other basic options features, to help get you on your feet and trading options with the confidence you will need to succeed.

Vincent Mao was an Editor at TradingMarkets.com from 2001-2003 and 2004-2005.

You can find more how-to and educational articles to improve your investing and trading each day on TradingMarkets.com.