Option Basics

In today's ever-changing markets, you want to ensure that your investments will work for you no matter what scenario the markets may bring. When trading only stocks or futures, this can sometimes be a difficult task to accomplish. However, option trading offers many solutions to such problems. Options are financial instruments that can provide you, the individual investor, with tremendous profit potential, limited risk, and the flexibility you need to take advantage of almost any investment situation you might encounter. Whether your market outlook is bullish, bearish, choppy, or quiet, option trading can significantly increase your trading opportunities for profit.

Definition

There are two types of option contracts: calls and puts.

A call option is a contract which conveys to its holder the right, but not the obligation, to buy a fixed number of shares or future contracts of the underlying security at a specified price, on or before a specific date.

A put option works exactly the same way as a call except that it gives the holder the right to sell a fixed number of shares or contracts of the underlying asset.  So if you think the market is going up, you would look at buying calls, and if they think the market will decline, you would look at buying puts.

As an option trader, you can play the role of either the buyer or the seller of the option contract, and in many strategies the position will be made up of both contracts that you are buying and contracts you are selling.

As the seller of an option, you are taking on an obligation to deliver the stock or future to the buyer of the option at the specified price upon the buyer's request. For taking this obligation, you are paid a premium that you collect at the time the option is sold.

 

 
 


Option Terms

As stated earlier, an option is the right to buy or sell a particular underlying security at a specific price, and that right is only good for a certain period of time. The specific items in that definition of an option are as follows:

Type

 Type describes whether we are talking about a call option or a put option. If we are talking about stock options, then a call option gives its owner the right to buy stock, while a put option gives him the right to sell stock. While it is possible to use options in many ways, if we are merely talking about buying options, then a call option purchase is bullish—we want the underlying stock to increase in price—and a put option purchase is bearish—we want the stock to decline.

Underlying Security

Underlying security is what specifically can be bought or sold by the option holder. In the case of stock options, it's the actual stock that can be bought or sold (IBM, for example).

Strike Price

The strike price is the price at which the underlying security can be bought (call option) or sold (put option). Listed options have some standardization as far as striking prices are concerned. For example, stock and index options have striking prices spaced 5 points apart.

Expiration Date

The expiration date is the date by which the option must either be liquidated (i.e., sold in the open market) or exercised (converted into the physical instrument that underlies the option contract-stock, index, or futures). Again, expiration dates were standardized with the listing of options on exchanges. For stock options and most index options, this date is the Saturday following the third Friday of the expiration month (which by default, makes the third Friday of the month the last trading day).


 
 


These four terms combine to uniquely describe any option contract. It is common to describe the option by stating these terms in this order:

Underlying, expiration date, strike, and type

For example, an option described as an IBM July 50 call completely describes the fact that this option gives you the right to buy IBM at a price of 50, up until the expiration date in July.  

Why Trade Options

Options give you options. You're not just limited to buying, selling short or staying out of the market. With options, you can tailor your position to your own situation and market outlook.

Following are some examples that illustrate the wide array of possibilities option trading offers:

  • Prepare to buy a stock at a lower price when you think the market will go up by purchasing a call option to buy the stock at its current price. Here, for only the option's premium, you can profit from an increase in the stock price, saving the unused capital for other investment opportunities.

  • Leverage your gains by controlling more stock or futures contracts with your initial investment. When the market moves favorably, you benefit by getting a greater return on your investment.

  • Protect your investments from a market decline by purchasing an option to sell your stock or futures contract at the current market value. This limits your risk to only the cost of the put option.

  • Make money above and beyond what your current investments arc bringing in by selling covered calls. The money you receive from selling the calls will also provide some protection from a price decline in the underlying investment.

  • Profit from a big market move — even if you're not sure which way it will be — by purchasing a straddle, which consists of buying a put and a call.

  • Make money if the market goes nowhere by purchasing a butterfly spread or writing astraddle. You benefit by profiting from the time decay factor of the options.

Profit Graphs

Some traders prefer to see columns of numbers and others—myself included—prefer to look at graphs or charts. A "profit graph" is a graph of the potential profits and losses from a position. With options, it is possible to describe most of the major strategies by the shape of their profit graphs. A simple example should be sufficient to demonstrate the concept.

Example: Suppose that XYZ common stock is trading at 50, and the XYZ July 50 call is selling for 3, or $300. The profit table shown below details the potential profits and losses at various XYZ prices at July expiration. The same information is shown in the profit graph. Figure 2.1, which shows that this position has a limited loss on the downside and can make theoretically unlimited profits on the upside.

*There is an unlimited risk of loss associated with selling options. The Volatility Capture strategy involves the selling of naked put options or put option credit spreads. There is considerable risk in such transactions if the underlying should fall by a large amount in a short period of time. The premium from the written options will most likely not be able to completely compensate for that risk. Risk management strategies in the form of long volatility derivatives are employed, but there is no guarantee that the risk protection will actually work. In other words, the ownership of volatility is designed to protect the naked puts in the case of a sharp, sudden drop in the stock market. However, there is no guarantee that volatility will, in fact, increase when the stock market drops.

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