Options Basics

We want to start off by saying that many retail traders underestimate the challenge of making money with options. Saying this first off will hopefully instill in all who read this the desire to learn and understand the basics of options trading. After all, our mission is to help you profit and have success, not have to learn the hard way.

Trading stocks is reasonably easy in comparison to trading options. If you think a stock is going up, buy it. If you think a stock is going down, sell it. If you want to take on more risk you can even sell it short. What if you think a stock is going nowhere? Well, sell it or avoid it in the first place. The stock price is what it is and that is what you will pay. With options trading, it's not so simple. Many factors influence the value of an option contract and that is what makes options more difficult if you do not understand how they work.

• What makes options more versatile?
• Get paid to enter long stock positions
• Insure your positions or even your entire portfolio
• Generate more income in your account
• Profit from dropping prices with limited risk
• Increase your leverage without margin rates

Options are the most versatile instrument available and understanding how they work will help you be successful.

What is an Option?

Simply put, option buyers have rights and option sellers have obligations. Option buyers have the right, but not the obligation, to buy (call) or sell (put) the underlying stock (or futures contract) at a specified price until the 3rd Friday of their expiration month. There are two kinds of options: calls and puts. Call options give you the right to buy the underlying asset. Put options give you the right to sell the underlying asset. Each contract controls 100 shares in a stock or exchange traded fund.

	Holder (Buyer)	Writer (Seller)
Call Option	Right to Buy	Obligation to Sell
Put Option	Right to Sell	Obligation to Buy

The price at which an underlying stock can be purchased or sold if the option is exercised is called the strike price. Options are available in several strike prices above and below the current price of the underlying asset. Stocks priced below $25 per share usually have strike prices at 2 1/2 dollar intervals. Stocks priced over $25 usually have strike prices at $5 dollar intervals.

Option Price and Value

Premium

In exchange for the right to buy ("call") or sell ("put") an underlying security on or before the expiration date, the purchaser of an option pays a premium. The price of the contract is known as the debit, and it is the purchaser's maximum risk. On the other side of the trade, the seller of the option receives the premium as a credit to his/her brokerage account, but is obligated to buy (in the case of a short put) or sell (in the instance of a short call) the underlying shares if the purchaser exercises the contract. Brokerages hold cash from the premium as a guarantee against short positions.

In the Money (ITM), At the Money (ATM), Out of the Money (OTM)

The strike price, or exercise price, of an option determines whether that contract is in the money, at the money, or out of the money. If the strike price of a call option is less than the current market price of the underlying security, the call is said to be in the money because the holder of the call has the right to buy the stock at a price which is less than the price he would have to pay to buy the stock in the market. Likewise, if a put option has a strike price that is greater than the current market price of the underlying security, it is also said to be in the money because the holder of this put has the right to sell the stock at a price which is greater than the price he would receive in the market. The converse of in the money is, not surprisingly, out of the money. If the strike price equals the current market price, the option is said to be at the money.

	Call	Put
In the Money (ITM)	Strike Price < Stock Price	Strike Price > Stock Price
At the Money (ATM)	Strike Price = Stock Price	Strike Price = Stock Price
Out of the Money (OTM)	Strike Price > Stock Price	Strike Price < Stock Price

Intrinsic Value and Time Value

The premium of an option has two main components: intrinsic value and time value. Intrinsic value describes the amount the stock price is above the strike price (for calls), or below the strike price (for puts). Therefore the amount by which an option is in the money is intrinsic value. It is also the value of the contract at expiration.

Time value is defined as any premium in excess of intrinsic value. Time value is also known as the amount an investor is willing to pay for an option above its intrinsic value, in the hope that at some time prior to expiration its value will increase because of a favorable change in the price of the underlying security. The longer the amount of time for market conditions to work to an investor's benefit, the greater the time value.

Calls	Puts
Intrinsic Value = Stock Price - Strike Price	Intrinsic Value = Stock Price - Strike Price
Time Value = Option Price - Intrinsic Value	Time Value = Option Price - Intrinsic Value

Changes in the underlying security price can increase or decrease the value of an option. These price changes have opposite effects on calls and puts. For instance, as the value of the underlying security rises, a call will generally increase and the value of a put will generally decrease in price. A decrease in the underlying security's value will generally have the opposite effect.

Time until expiration, as discussed above, affects the time value component of an option's premium. Generally, as expiration approaches, the levels of an option's time value, for both puts and calls, decreases or "erodes." This effect is most noticeable with at-the-money options.

The effect of volatility is the most subjective and perhaps the most difficult factor to quantify, but it can have a significant impact on the time value portion of an option's premium. Volatility is simply a measure of risk (uncertainty), or variability of price of an option's underlying security. Higher volatility estimates reflect greater expected fluctuations (in either direction) in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike, and is most noticeable with at-the-money options. However, the value of time decays as expiration nears: time decay increases dramatically in the last 30 days as expiration approaches.

Let's consider an example to clarify using Apple (AAPL). If AAPL were trading at $300 when you bought a 290 strike call option for $20, then $10 of the option's value would be intrinsic value.

The other $10 would be time value. A 300 call purchased when AAPL is trading for 300 is at the money, but is all time value, and no intrinsic value.

If the stock were at 300 when you bought a 310 call, the option is again all time value, since it has to rise $10 to be in the money.

	Strike Price
AAPL	290 call = $20	300 call = $12	210 = $6
Stock Price = $300	In the Money	At the Money	Out of the Money
	$10 intrinsic	$0 intrinsic	$0 intrinsic
	$10 time value	$12 time value	$6 time value

Buying Calls

If you want leverage, buying calls give you leverage over 100 shares of an underlying stock (or ETF) at the strike price until expiration. Long calls are used to profit from upward moves in the underlying stock.

Using AAPL as an example, the AAPL October 300 call option gives you the right to buy 100 shares of AAPL for $300 per share up until the expiration date in October. Buying this call would bring the expectation that the price of the option will rise, usually through the rise in the price of the stock.

Let's say you decided to purchase the AAPL 300 call for $12 when the stock was trading for $300. If AAPL goes up to $324 before expiration, then your call is worth at least $24. This gives you a 100 percent on the call option on a 8 percent return on the stock. That is the leverage of buying options.

The other side of the coin notes that if the stock does not move up then the option will lose all of its value by expiration. This results from the decay of the value of the option's premium, known as time decay. That is the risk of buying calls. Since they are expiring assets, they have time value that diminishes over time. But regardless of how far the stock falls, your risk is limited to the cost of the call (the premium).

Exiting Long Calls

Many do not understand that when a call has been purchased, the position can be closed in three ways:

• Sell the call - once the option has been bought, it can be sold any anytime. This is the most common way of exiting a long position, call or put.
• Letting it expire - If a call gets to expiration, it will expire worthless if it is out-of-the-money. If the stock price is above the strike price by $.01 or more, it will be automatically exercised and shares will be delivered to your brokerage account. Long calls are almost always sold before expiring, since at that point they will have lost all time value.
• Exercising your call - Utilizing the "right to buy" that is inherent in the call contract is known as "exercising" the option. This results in your brokerage delivering shares of the stock to you at the strike price. Options are rarely bought with the intention of exercising the underlying right.

Buying Puts

Buying puts is similar to buying calls but you get to profit from the downside. Put options give the buyer the right, but not the obligation, to sell an underlying asset at the strike price until market close on the 3rd Friday of the expiration month. Just like call options, put options come in various strike prices depending on the current market price of the underlying instrument with a variety of expiration dates. Expiration dates can vary from one month out to more than a year (LEAPS options). However, unlike call options, you might consider going long a put option if you expect market prices to fall (bearish). In contrast, if you are bullish (expect the market to rise), you might consider selling a put option (more on that later).

Let's consider another example, this time with a put option. What if you were concerned about the downside, so you purchased the AAPL 300 put option for $12 when AAPL stock was trading for $300. If AAPL goes down to $276 before expiration, then your put is worth at least $24. This gives you a 100 percent return on the put option with a 8 percent loss on the stock.

Buying puts on a stock you own can provide insurance on that position. Index puts can also be used to insure your entire portfolio. Buying puts is very much like buying insurance: you pick the deductible and the premiums.

Exiting Long Puts

• Sell the put - once the option has been bought, it can be sold any anytime. This is the most common way of exiting a long position, call or put.
• Letting it expire - If a put gets to expiration, it will expire worthless if it is out-of-the-money. If the stock price is above the strike price by $.01 or more, it will be automatically exercised and shares will be delivered to your brokerage account. Long puts are almost always sold before expiring, since at that point they will have lost all time value.
• Exercising your call - Utilizing the "right to buy" that is inherent in the put contract is known as "exercising" the option. This results in your brokerage delivering shares of the stock to you at the strike price. Options are rarely bought with the intention of exercising the underlying right.

Rules for Buying

There are some critical rules to follow when buying calls or puts. One, the expiration should give the option enough time to perform without being overexposed to time decay. Remember, options have expiration dates, and a large part of their value lies in time value. The time value will deteriorate dramatically as the expiration approaches, especially the last 30-45 days of an options life.

Two, options should be bought when time value - which is influenced heavily by implied volatility, or the expected price swings of the underlying - is expected to stay flat or to rise. If there is a rise in implied volatility, then there will be a rise in the premium paid for an option. This rise in the premium produces profits for long options, even if the stock price may not move. Conversely, and this is very important, if you buy options when implied volatility and premiums are high, such as before earnings, then the stock can move in the direction that you want and you can still lose money, because with the news out, the implied volatility will fall.

Finally, you generally do want to let an option expire. Why? You will receive zero-premium. Management of your option purchases are critical so take profits when options double, and move on when an option loses half of its entry value.

Selling Calls or Puts

Now this is where the covered call strategy comes into play if you sell calls or if you want to get paid to buy stock you can sell a put, or simply put, generate income. Let us explain. When option premiums are high (which means implied volatility is high), this is where selling an option can come into play. Selling a call is a neutral to bearish strategy. You want the market price to be below the strike of the call you sold, so that it expires worthless. In other words, you expect the underlying stock to fall or stay flat.

Selling a put is a neutral to bullish strategy. You want the market to be above the strike of the put you sold, so that it expires worthless. Or, you expect the underlying stock to rise or stay flat.

The key to remember with selling an option is you have obligations, but option buyers have rights. By selling calls or puts, you are obligating yourself to selling the stock at the strike price when you are assigned. Assignment is the other side of an option being exercised. If a call buyer decides to exercise the long call, that exercise is put out randomly to a seller -any seller - of that call, and the individual is obligated to sell stock to the call buyer.

Selling puts obligates you to buy the stock when assigned. This strategy brings income into your account, income you keep if the stock is above the strike price at expiration. Traders sell puts if they think the stock is going to stay flat or go up slightly, but only if they are willing to buy the stock if assigned. For this reason, selling puts can be an excellent way to initiate long stock positions, and get paid to do so.

Selling a Call Example

Let's say you sold the APPL 300 call option for $12 when AAPL was trading for $300. If AAPL is anywhere below $300 at expiration, then you keep your $12 credit. If the stock goes up to $312, however, you will be assigned at expiration, but will break even since you already pocketed $12 from the sale of the call. As the stock price continues upward, your losses increase. Because of this unlimited risk as the stock price rises, selling a call is rarely done in isolation. This is where the covered call strategy lies, selling a call against stock that you own so that it is not done in isolation. This is considered a conservative strategy.

Selling a Put Example

Let's say you sold the AAPL 300 put option for $12 when AAPL was trading for $300. If AAPL is anywhere above $300 at expiration, then you keep your credit of $12. If the stock is below 300, you will be assigned, and you will purchase the stock at the strike price. But the trade is profitable until $288, since you pocketed the $12 credit. This strategy can also say that if you have to purchase the stock, you will be doing so at a great price.

Exiting Short Positions

When an option has been sold, the position can be closed in one of three ways:

• Buying back the option - After an option is sold, it can be bought back at any time. This is done when there is a risk of assignment that the option seller wants to avoid. For instance, if you sold a call, the stock went up through your strike, and you do not want to be assigned and forced to sell the stock, you could buy back the option to close the position.
• Letting it expire -If the option gets all the way to expiration, it will expire, worthless if it is out of the money. Typically, this is what you want to have happen with options that you have sold. If it is in the money by $.01, it will be automatically exercised and you will be assigned, automatically selling stock if you were short a call or buying stock if you were short a put.
• Assignment - American-style options (all equity and ETF options) can be exercised at any time before expiration. So you could be assigned at any time after you have sold an option. Most traders view this as a negative, but it is not necessarily so. If you are using cash-secured puts to acquire stock, then assignment means you have achieved your objective at a below-market price.

Rules for Selling

Selling an option is a good strategy when implied volatility/premiums are high and expected to fall. A higher implied volatility will bring you more premium income. However, selling options are risky, and implied volatility can always go higher.

It is also best to sell option when time decay is greatest, the last 30-45 days before expiration. This will give us the greatest chance of having the option expire worthless because time decay is on our side.

Option Terminology

Calls - An option contract which gives the holder the right, but not the obligation, to buy a specified amount of an underlying security at a specified price within a specified time in exchange for a paying a premium.

Puts - An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. The put option buyer hopes the price of the shares will drop by a specific date while the put option seller (or writer) hopes that the price of the shares will rise, remain stable, or drop by an amount less than their profit on the premium by the specified date.

Strike Price - A price at which the stock or commodity underlying a call or put option can be purchased (call) or sold (put) over the specified period.

Exercise - Implementing an option's right to buy or sell the underlying security.

In the Money (ITM) - A call (put) option whose strike price is below (above) the stock price.

At the Money (ATM) - An option whose strike price is roughly equal to the stock price.

Out of the Money (OTM) - A call (put) option whose strike price is above (below) the stock price.

Intrinsic value - The amount that an option is in the money.

Time Value - The price of an option less the intrinsic value.

Options Chains

For any option contract, option chains provide the most recent prices and other important factors. Option chains show specific data for a given underlying stocks' different strike prices and expiration months. Here is an example of an option chain for AAPL:

• This is an option chain for Apple, in this example we are looking at an Apple (AAPL) Feb 2011
• Down the middle are the strike prices. Calls are on the left, puts on the right
• Contracts shaded in gray are in the money, and contracts that are white are out of the money
• Each strike will list the following:
  • The price of the last trade ("Last")
  • The price at which there are willing buyers (the "Bid")
  • The price at which a contract is offered for sale (the "Ask" or "Offer")
  • The volume of the day's trading ("Vol")
  • The contract's "open interest" ("Open Int"), which tells us how many active contracts there are for a given month and strike.

Summary of Option Basics

• Option buyers pay a premium for the right, but not the obligation, to act.
• Option sellers (writers) have an obligation (only if they are assigned).
• Options are used for speculation, income generation, or even hedging a position
• The four basic positions: buying calls, buying puts, selling calls, selling puts
• Option premiums are made up of intrinsic value and time value
• Time value is largely a function of implied volatility
• Buy when implied volatility is low and expected to stay flat or rise
• Option chains are used for important trading information




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