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Options Trading Basics
by Michael Thomsett

Options trading is changing everything. The Internet, expanded trading potential at lower cost, and faster execution of trades have all taken the once-exotic options market into the mainstream.

The modern options market began in 1973 when options trading was available on only 16 listed companies. That year, 1.1 million contracts traded. In the latest full year, over 3.6 billion options contracts were traded.

Besides the ease of access to markets, inexpensive transaction charges, and the Internet, others reason account for the exponential growth in options trading. Once a solely speculative, high-risk venture, today’s options are used by many traders as a method for portfolio management. Options can reduce the risk of holding stock, generate current income, and conform to conservative risk tolerance levels through many safe strategies.

Anyone who has rejected options as high-risk, complex, and technical may want to take a second look at this market. Options have become tools for augmenting portfolio returns while protecting portfolio positions, so the potential for expanding holdings - whether for conservative investors or technical traders - makes options trading a strategy you might want to use.

A problem of jargon

The biggest initial hurdle with options is understanding the special language of this industry. Stock investors are well aware of the basics in their universe: terms like common stock, dividend yield, rate of return, earns per share, P/E ratio … the list goes on, but these are widely understood and applied to judge risk and profitability of a company’s stock. With options, you need to master a completely new language. Even so, you need only a few basic terms and concepts to gain a working understanding of options trading.

An option is a contract granting specific rights to the option buyer. As a right only, the option has no tangible characteristics or value. In comparison, shares of stock have physical, tangible value as well as rights (voting rights and dividends, for example). Every option relates to the right for 100 shares of stock. So a single option enables its holder to control 100 shares. This leverage feature of options opens many possibilities (and risks) for options trading.

There are two kinds of options. A call grants its owner the right, but not the obligation, to buy 100 shares of a specified underlying stock at a fixed price and by or before a specific date. A put grants its owner the right, but not the obligations, to sell 100 shares under the same limitations.

The underlying stock is also fixed. If you own an option, you cannot transfer it from one underlying stock to another. The fixed strike price of the option is the price at which that option can be exercised - a step in which the owner decides to buy (with a call) or sell (with a put) those 100 shares. Because the strike price is fixed, the potential profits from options are derived from price movement of the stock. For example, if you own a call with a 30 strike (meaning you can exercise the call at $30 per share), and the stock price rises to $42 per share, you make a profit of $1,200 upon exercise. The call lets you buy 100 shares at the fixed strike price no matter how high the current market value of the stock has risen.

You can also exercise a put by selling 100 shares of the underlying stock at the fixed strike. For example, if you buy a 55 put, you have the contractual right to sell 100 shares at $55 per share. So if the stock price falls to $30, exercising the put allows you to sell 100 shares 25 points higher than current value, equaling a $2,500 profit.

These rights do not go on forever. The expiration is a date in the future when the option becomes worthless. After expiration, no right exist and the option’s life has ended. You can exercise calls or puts any time you want before expiration, but the last day to make that decision is on the third Friday of expiration month. This can be anywhere from the current month up to 30 months in the future.

Option valuation

The four attributes - call versus put, underlying stock, strike price, and expiration - are collectively called the terms of every contract. They cannot be adjusted or transferred. The value of an option, known as the premium, is going to vary based on three factors. First, the intrinsic value is equal to the number of points current value is above a call’s strike or below a put’s strike. For example, if you are holding a 30 call and the stock price is $32 per share, the premium contains exactly two points of intrinsic value. When the stock price is equal to or lower than the call’s strike, there is no intrinsic value. This is the opposite for a put. If you own a put with a 40 strike and the stock is priced at $37 per share, there are three points of intrinsic value.

The second part of price is called time value. As expiration nears, time value declines and the rate of this time decay accelerates during the last few weeks, ending up at zero on expiration day. The rate of decline in time value looks very similar to the chart showing how a 30-year mortgage is paid off, with about half of principal payments taking place in the last seven years. The curve picks up steam as the end approaches.

The third, and most complex part of option premium is the portion that changes due to uncertainty about changes in both stock and option values in the immediate future. This is called implied volatility of the option. This is where all of the unknowns come into play.

So buying options - going "long" - offers limited risk but potentially unlimited profit. Even so, the percentages are not promising. Due to the effects of time decay and expiration itself, about three out of every four options expires worthless. Complicating this further, you can also sell options. When you go long, the sequence of events is well-known: buy, hold, sell. When you go short, it is the reverse: sell, hold, buy. Shorting options can be high-risk or highly conservative, depending on whether or not you also own 100 shares of the underlying stock.

The range of possible strategies is complex, but offers something to suit every risk level and every purpose, from short-term speculation to insuring long stock positions, from creating current income to freezing stock prices for purchase two years later. The interesting aspect of options is not the exotic terminology, but the flexibility within the range of strategies. This interesting and jargon-rich market deserves a second look.

About the Author

Michael C. Thomsett is author of Getting Started in Options, Trading with Candlesticks and numerous other books on technical analysis, stock trading and options.

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