Options
are a powerful tool that all investors need to become familiar with.
Before
you get started trading options, we'd urge you to forget the stories
you may have heard about how risky they are, and how some investors
have gone bankrupt using them. The truth is that options are designed
to help investors limit and manage risk. Over the course of this multi-part
series on options we will show you how to not only make money using
options, but more importantly, how to save money as well.
THE TWO MAIN
USES OF OPTIONS
Investors
use options for two primary reasons -- to speculate and to hedge their
risk. All of us are familiar with the speculation side of investing.
Every time you buy a stock you are essentially speculating on the direction
the stock will move. Wall Street has coined the phrase "investing"
so that buying stock does not sound so risky, but the truth is that
we are always uncertain about which direction any equity investment
is going to go. You might say that you are positive that IBM is heading
higher as you buy the stock, and indeed more often than not you may
even be right. However, if you were absolutely positive that IBM was
going to head sharply higher, then you would invest everything you had
into buying the stock. All rational investors realize that there is
no "sure thing" when it comes to investing, as every investment
incurs at least some risk. This risk is what the investor is compensated
for when he or she purchases an asset. When you purchase options as
a means to speculate on future stock price movements, you are limiting
your downside risk, yet your upside earnings potential is unlimited
(we'll explain this in more detail later).
Aside
from speculation, investors also use options for hedging purposes. A
hedge is not just a little green bush in your front yard, it is a way
to protect your portfolio from disaster. Hedging is like buying insurance
-- you buy it as a means of protection against unforeseen events, but
you hope you never have to use it. The fact that you hold insurance
helps you sleep better at night. Consider this -- almost everyone buys
homeowner's insurance, right? But why exactly do they do this? Since
the odds of having your house destroyed are relatively small, this may
seem like a foolish investment to make. After all, most of us will never
have a fire, flood or any other hazard that would cause us to cash in
on our insurance. However, we all continue to pay our insurance premiums
every year. Why do we go on paying these hefty fees year after year
instead spending the money on something we would perhaps enjoy more?
The answer to this question is obvious -- our homes are very valuable
to us and we would be devastated by their loss. Because of this fear
of loss, most of us will happily pay someone else every year to bear
this risk for us, no matter how remote the chances of loss might be.
If you employ certain options strategies as a means to hedge your portfolio,
you are essentially doing the same thing -- paying someone to protect
you from unforeseen risks. (We'll teach you how to do exactly that over
the course of this multi-part options trading series.)
OPTIONS CHARACTERISTICS
Options
are derivative instruments, meaning that their prices are derived from
the price of another security. More specifically, options prices are
derived from the price of an underlying stock. This will all become
very clear shortly.
Another
important thing to understand is that every option represents a contract
between a buyer and seller. The seller (writer) has the obligation to
either buy or sell stock (depending on what type of option he or she
sold -- either a call option or a put option) to the buyer at a specified
price by a specified date. Meanwhile, the buyer of an options contract
has the right, but not the obligation, to complete the transaction by
a specified date. When an option expires, if it is not in the buyer's
best interest to exercise the option, then he or she is not obligated
to do anything. The buyer has purchased the option to carry out a certain
transaction in the future -- hence the name.
Here
are a few terms you must first become familiar with before trading options:
Option
Buyer (Option Holder) -- Party that purchases and holds the options
contract.
Option Seller -- Party that writes, or creates, the options contract.
Strike Price -- The price at which the option seller agrees to buy or
sell a certain stock in the future.
Expiration Month -- The month in which the option will expire.
Expiration Date -- This is always the third Friday of the month in which
the option is scheduled to expire.
Option Contract -- Each options contract represents an interest in 100
shares of a certain underlying stock.
Put Option -- This type of option gives the option holder the right,
but not the obligation, to sell 100 shares of a particular underlying
stock at a specified price (the strike price) on a specified date (the
expiration date). For example, let's say you were to purchase a put
option on shares of Microsoft (MSFT) with a strike price of $50 and
an expiration date of March 19th. This option would give you the right
to sell 100 shares of Microsoft at a price of $50 on March 19th (the
right to do this, of course, will only be valuable if Microsoft is trading
below $50 per share at that point in time).
Call Option -- This type of option gives the option holder the right,
but not the obligation, to purchase 100 shares of a particular underlying
stock at a specified strike price on the option's expiration date. For
example, let's say you were to purchase a call option on shares of Intel
(INTC) with a strike price of $40 and an expiration date of April 16th.
This option would give you the right to purchase 100 shares of Intel
at a price of $40 on April 16th (the right to do this, of course, will
only be valuable if Intel is trading above $40 per share at that point
in time).
"In-The-Money" Option -- An option that, if it were exercised
today, would be worth more than $0. In the case of a call option, the
option is only considered to be "in-the-money" when the price
of the underlying stock is greater than the option's strike price. So,
in the case of our Intel example above, the call option will be "in-the-money"
when shares of Intel are trading above $40. Meanwhile, in the case of
a put option, the option is only considered to be "in-the-money"
when the price of the underlying stock is less than the option's strike
price. So, in the case of our Microsoft example, the put option will
be "in-the-money" only when shares of Microsoft are trading
below $50 per share.
"Out-Of-The-Money" Option -- An option that, if it were exercised
today, would not be worth a single cent. In the case of a call option,
the option is considered to be "out-of-the-money" when the
price of the underlying stock is less than the option's strike price.
So, in the case of our Intel example above, the call option will be
" out-of-the-money " when Intel is trading below $40 per share.
After all, if Intel is trading for less than $40 (let's say it is at
$35), then the right to purchase Intel at a price of $40 per share is
completely worthless (if you can buy the stock in the open market for
$35, then you certainly wouldn't want to buy it for $40). Options traders
use the term "out-of-the-money" to describe this type of situation.
The analysis is similar when it comes to put options. In the case of
a put option, the option is considered to be "out-of-the-money"
when the price of the underlying stock is greater than the option's
strike price. So, in the case of our Microsoft example, the put option
will be "out-of-the-money" when shares of Microsoft are trading
above $50 per share.
"At-The-Money" Option -- An option is considered to be "at-the-money"
when its strike price is exactly equivalent to the price of the underlying
stock.
EXAMPLE: CALL
OPTION CONTRACT
As a
quick example, let's say IBM stock is currently trading at $100 per
share. Now let's say an investor purchases one call option contract
on IBM at a price of $2.00 per contract. Note: Because each options
contract represents an interest in 100 underlying shares of stock, the
actual cost of this option will be $200 (100 shares x $2.00 = $200).
Here's
what will happen to the value of this call option under a variety of
different scenarios:
When the option expires
IBM is trading at $105.
Remember:
The call option gives the buyer the right to purchase shares of IBM
at $100 per share. In this scenario, the buyer could use the option
to purchase those shares at $100, then immediately sell those same shares
in the open market for $105. Because of this, the option will sell for
$5.00 on the expiration date (since each option represents an interest
in 100 underlying shares, this will amount to a total sale price of
$500). Since the investor purchased this option for $200, the net profit
to the buyer from this trade will be $300.
