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Understanding Options

 

What are options?

In this article I want to describe the basics of options: what they are and how one can trade them.

Options trading is extremely popular and provides much greater possible returns that does trading in the underlying stocks. But it also carries more risk.

So it is extremely important to understand how options work as financial instruments and be clear on what your potential risk and rewards are in trading them.

Options are contracts on some underlying trading instrument - shares of stock, bonds, a commodity, even a mortgage loan!

Stock options are the ones most people are familiar with and are the most traded by individual investors.

But regardless of what the option is on, there are common features. One of the most basic is the contract feature specifying what the option owner has actually contracted for.

There are two types of Option Contracts: CALLs and PUTs.

CALLs

A 'call' confers on the (option) contract holder the right to buy an asset at a stated price on or before a specified expiration date. An option to buy, but not an obligation. That's why it's called an option!

The owner also has the option to let his contract expire. But then he loses everything he invested in buying that contract.

Essentially, when buying a Call option, you are betting that underlying asset will increase in price before the expiration date. And, not only rise, but rise enough to make a profit.

But whether you make a profit is determined by the price you paid for the option, and the increase in price of the underlying asset.

Clearly the price must rise enough to cover the difference between the market price and the price at which you can buy the security (the strike price of the option contract). And, since the option itself has a cost, the price has to rise enough to cover that additional amount. That cost is called 'the premium'.

The cost of the option fluctuates with the supply and demand for that contract on the open market. Several factors determine the premium, including the price of the underlying asset, the strike price of the option, the time remaining on the option, and others.

The time remaining is particularly important. Naturally as the option contract nears its expiry date the price of the underlying asset (the stock for example) is less likely to change dramatically from its current price. Therefore the result of excersizing the option is known with more certainty and the cost of the option reflects that outcome. For example, if a Call option is nearing its expiry date and the value of the underlying asset is lower than the strike price of the option the option is practically worthless, and so its cost will be very low.

Suppose it's June 1, for example, and Intel (INTC) has a market price of $27. Call options for Sept 30 are selling for $3 with a strike price of $30. You buy one contract for 100 shares.

So, if you held until expiration you either lose $300 ($3 x 100, the initial price of the contract not including commission), or buy the underlying stock at $30. If the current market price were $35 you've made $200. ($35 - ($30+$3) = $2 per share x 100 shares, ignoring commissions.)

When the market price of a share is above the strike price, the option holder is 'in the money'. If the market price is lower, he's 'out of the money'.

PUTs

A 'put', by contrast, gives the option buyer the option to sell an asset at a certain price by a stated date. The option, not the obligation.

Puts are similar to 'shorting stock', in this sense. Put buyers are betting the stock price will fall before the option expires.

In this case the market price must fall below the strike price in order to garner a profit from exercising the option. (Ignoring the cost of the put, for simplicity.) Under those circumstances, the option holder is 'in the money'.

For example, take the same situation as above but let the option be a put. If the market price falls to, say $25, your profit would be:

First, $3 x 100 = $300 = Cost of put, excluding commissions.

Then, buy 100 shares at $25 per share = $2,500 to repay broker 'loan' (since shorting stock involves borrowing shares you don't own, then repaying later).

Finally, sell 100 shares at Strike price = $30, 100 x $30 = $3,000

Therefore, your profit = ($3000 - $2500) - ($300) = $200.

(Actually, the broker takes care of all the underlying mechanics. The investor merely orders the trades at a given time and date.)

Whether investing in calls or puts, wise investors do the needed homework. Options trading is risky and somewhat more complicated than simple stock trading.

Study the history, volatility, and other factors of both the option contract and the underlying asset. Blindly throwing darts at a board is the best strategy for losing money.

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