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.