e-Traders Club

Basic Options Education

What is an option?

Options are derivative securities, meaning that their value is derived from other underlying securities (stocks, futures, etc). While they can be extremely volatile, they also can be extremely versatile, helping traders capitalize on the market and leverage current positions. Options trade in contracts with specific terms. They give buyers the right to buy or sell a particular security at a fixed (strike) price, on or before a specific date. One option usually represents rights on 100 shares of underlying stock, and they typically expire on the third Friday of each month. For example, ABC Oct 30 Call gives the buyer the right to purchase 100 shares of ABC at $30 up until the third Friday in October.

Long Calls

A call option gives the buyer the right to purchase shares of an underlying security. Purchasing calls is a bullish strategy; the buyer expects that the price of the underlying stock is going to increase. Hopefully, as the price of the underlying security increases, so will the value of the option. While the profit potential for a long call is unlimited, potential loss is fixed at the option’s purchase price. If the underlying stock price falls to zero, the option will simply expire worthless.

The strike price of a call, relative to the price of its underlying stock, determines whether it is "in-the-money" or not. If the current stock price is above a call’s strike (plus premium), it is considered in-the-money. The holder can exercise the call and purchase stock shares below current market price. If the stock price is below the call’s strike, the option is “out-of-the-money.” No one will exercise ABC 30 call when ABC is trading at $20, or pay much for the option. Keep in mind that any premium paid for options must also be considered when determining whether a position is profitable or not.

The three main factors that affect the price of a call option are:

1. The underlying security price in relation to the strike price
2. The time remaining until the option contract expires
3. The volatility of the underlying security

Long calls that are already in the money command a higher price than those whose strike is well above current market price. Also, as the calendar date approaches the expiration date of an option (the third Friday of each month), the time value of the contract will decrease. Finally, the more fluctuation there is in a stock’s price, the more likely it is that its options will fluctuate; the less a security fluctuates, the less movement there will be in the price of its calls.

In-the-money option owners have the choice of selling their calls or exercising them. If a call is in the money on expiration day it will be exercised automatically. Selling a long call (selling to close) renders one flat in the position. Owners can also exercise their options and take possession of the stock at their strike price. (Note that funds must be on hand to cover the full purchase amount of the stock.) This strategy might prove beneficial if the owner wishes to hold on to the shares, expecting the stock price to increase. The owner also may have the shares delivered into his/her account and sold immediately. Some traders sell in-the-money call option contracts, and then rollover the profit into another call option contract at a higher strike price. Of course, this trader would still have to feel bullish about the underlying security.

Long Puts

A put option gives the buyer the right to sell shares of an underlying security. Buying puts is a bearish strategy; the buyer expects that the underlying stock’s price is going to drop. As the price of the underlying security decreases, the value of the put will most likely increase. The potential profit on long puts is limited (since the stock can only drop to zero), and the potential loss is fixed at the option’s purchase price.

The strike price of a put, relative to the price of its underlying stock, determines whether it is “in-the-money” or not. If the current stock price is below the put's strike, it is considered in-the-money. If the strike is below current market, the put is “out-of-the-money.“

The three main factors that affect the price of a put option are:

1. The underlying security price in relation to the strike price
2. The time remaining until the option contract expires
3. The volatility of the underlying security

As the underlying security price decreases, the value of the put will increase. If the underlying security price increases, the price of the put option will decrease. As the current calendar date approaches the expiration date, the time value of the option contract will decrease. Finally, the more fluctuation there is in a stock’s price, the more likely it is that its puts will trade at a premium. The less a security fluctuates, the less movement there will be in the price of its puts.

Put holders have the option of selling their puts or exercising them. Selling a long put (selling to close) makes the position flat. Owners can exercise their puts if they are also long the underlying stock. They "put" their shares to the market, receiving payment at the strike price. Traders who are long a security sometimes employ this strategy, utilizing puts as a hedge. If a put is in the money on expiration day, it will be exercised automatically.

Writing Covered Calls

Writing covered calls is the sale of a call while holding shares of the underlying stock. The writer of a covered call is bullish on the long term prospects of the security but bearish on the short term prospects. The covered is also used to generate income on the stock by collecting premiums on the sale of out of the money calls. The call is not considered short since the underlying security serves as collateral, and will be tendered should the option be exercised. If a covered call writer wishes to retain the stock, the calls can be bought back. (Provided this is done prior to exercise.)