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Options: The Basics


Why trade options?

Pretty much every investor is familiar with the saying, “Buy low and sell high.” The problem is, that strategy only works in bull markets. If you’d like to expand your repertoire of trading strategies and potentially profit from other market trends, options can come in handy.

With options, it’s possible to profit whether stocks are going up, down, or sideways. You can use options to cut your losses, protect your gains, and control large chunks of stock with a relatively small cash outlay.

Options are a versatile financial instrument. At the same time, though, options can be complicated and risky. Not only might you lose your entire investment, some strategies may expose you to theoretically unlimited losses. So it’s important that you understand some options basics and strategies most appropriate for beginners before diving in.

This article will give you a brief overview of core options concepts, define some key terminology, and provide suggestions for further reading and options education when you’re done. Covering the basics now will make everything a lot easier to understand as you delve deeper into the fascinating world of options.

Don’t worry if some of these definitions aren’t entirely clear to you at first. That’s completely normal. Just keep on learning and referring back to this article as you become more familiar with options. Everything will become apparent over time.

What is an option?

Options are contracts giving the owner the right to buy or sell an asset at a fixed price (called the “strike price”) for a specific period of time. That period of time could be as short as a day or as long as a couple of years, depending on the option.

The seller of the option contract is obligated to take the opposite side of the trade if and when the owner exercises the right to buy or sell the underlying asset.

Here’s an example of a standard quote on an option.

Know your options buzzwords

Options trading can be a little jargon-y, so it pays to get your definitions straight. Here are some of the more common terms you’ll run into in the options world.

“Calls” and “Puts”

There are only two different varieties of standard options: Call options (“calls” for short) and put options (“puts”). Understanding the difference between the two is absolutely crucial to getting started.

For each call contract you buy, you have the right (but not the obligation) to purchase 100 shares of a specific security at a specific price within a specific time frame. A good way to remember this is: You have the right to “call” stock away from somebody.

For each put contract you buy, you have the right (but not the obligation) to sell 100 shares of a specific security at a specific price within a specific time frame. A good way to remember this is: You have the right to “put” stock to somebody.

As with stock trades, when buying or selling options, commissions also apply. Their cost should be factored into your decision process. At TradeKing, we charge $4.95 per stock or options trade, plus an additional 65 cents per options contract.

Long versus Short

These two terms are in pretty heavy rotation among options traders, so let’s clear these up next.

In the financial world, “long” doesn’t refer to things like distance or the amount of time you hang onto a security. It simply implies ownership of something. If you’ve bought a stock, or if you bought a put or call, you are long that security in your account.

You can also be “short” in your account, meaning you’ve sold an option or a stock without actually owning it. That’s a funny-but-true fact about options: you can sell something you don’t actually own. But when you do, you may be obligated to do something at a later date. What that “something” is depends on the specific options strategy you’re using. Suffice it to say when you’re short an option, you usually don’t want to be obligated to do anything at all, but there are exceptions.

Strike price

That’s the pre-agreed price per share at which stock may be bought or sold under the terms of an option contract. Some traders call this the “exercise” price.

In-the-money (ITM)

The definition of in-the-money refers to the relationship between the strike price and the current stock price. Its meaning is different for calls and puts.

A call option is “in-the-money” if it is cheaper to buy the stock for the strike price than it is to buy the stock in the open market. In other words, the stock price is above the strike price. For example, if a call has a strike price of 50 and the stock is trading at $55, that option is in-the-money because the contract owner has the right to obtain the stock for less than its current market value.

Put options are in-the-money if it is more lucrative to sell the stock at the strike price than it is to sell the stock in the open market. For puts, the stock price must be below the strike price to be in-the-money. For instance, if a put has a strike price of 50 and the stock is trading at $45, the put option is in-the-money because the contract owner has the right to sell the stock for more than its current market value.

At-the-money (ATM)

An option is at-the-money when the stock price is equal to the strike price. (Since the two values are rarely exactly equal, the strike price closest to the stock price is typically called the “ATM strike”.)

Out-of-the-money (OTM)

This term also refers to the relationship between the strike price and the current stock price. As you might have guessed, it varies for calls and puts. An option is considered to be out-of-the-money if exercising the rights associated with the option contract has no obvious benefit for the contract owner.

For call options, it means the stock's market price is below the strike price. For example, if a call has a strike price of 50 and the stock price is $45, the option is out-of-the-money. Think of it this way: It would be more expensive for the contract owner to buy the stock for the strike price instead of purchasing the shares in the open market. So there’s no benefit to exercising for the call option owner.

For put options, it means the stock's market price is above the strike price. If a put has a strike price of 50 and the stock is trading at $55, the put option is out-of-the-money. Remember, a put represents the right to sell stock. So if selling the stock at the strike price generates less money than selling the shares in the open market, the option is OTM.

Intrinsic value versus time value

Intrinsic value refers to the amount an option is in-the-money. In addition to any intrinsic value, the price of nearly all option contracts includes some amount of time value. This is simply the part of an option’s price that is based on its time to expiration. The time until the option expires has value because it means the stock still has a chance to make a move.

If you subtract the intrinsic value from an option’s price, you’re left with time value. Because out-of-the-money options have no intrinsic value, their price is entirely made up of time value.

Exercise

When the owner of an option invokes the right embedded in the option contract, it’s called “exercising” the option. In layman’s terms, it means the option owner buys or sells the underlying stock at the strike price, and requires the option seller to take the other side of the trade.

Assignment

When an option owner exercises the option, an option seller (or “writer”) is assigned and must make good on his or her obligation. That means he or she is required to buy or sell the underlying stock at the strike price.

Understanding volatility

In the options world, there are two types of volatility: historical and implied.

Historical volatility refers to how much the stock price fluctuated (high price to low price each day) over a one-year period. Since it’s “historical”, this figure obviously refers to past price data. If the number of data points is not stated (for example, 30-day) then it's assumed that historical volatility is an annualized number.

Implied volatility (IV) is what the marketplace is “implying” the volatility of the stock will be in the future, without regard for direction. Like historical volatility, this is an annualized number. However, implied volatility is determined using an options pricing model. So although the marketplace may use implied volatility to anticipate how volatile a stock may be in the future, there is no guarantee that this forecast will be correct.

If there’s an earnings announcement or a court decision coming up, traders will alter trading patterns on certain options. That drives the price of the options up or down, independent of the stock price movement. The implied volatility is derived from the cost of those options. Think of it this way: if there were no options traded on the stock, there would be no way to calculate the implied volatility.

Implied volatility can help you gauge how much the marketplace thinks the stock price might swing in the future. That makes it an important element in option pricing. Usually, the higher implied volatility is, the higher option prices will be because higher IV indicates the likelihood of a larger price swing.

Speaking a little greek

You might’ve heard options traders peppering their speech with the names of various Greek letters. It’s no secret fraternity code; these letters simply refer to common measures of how options prices are expected to change in the marketplace.

Just like implied volatility, the options Greeks are determined by using an option pricing model. Although the Greeks collectively indicate how the marketplace expects an option’s price to change, the Greek values are theoretical in nature. There is no guarantee that these forecasts will be correct.

The most common Greeks are “delta”, “theta” and “vega.” Although you may also hear “gamma” or “rho” mentioned from time to time, we won’t get into them here. We’ll just go over the more important terms.

Delta

Beginning options traders sometimes assume that when a stock moves $1, the cost of all options based on it will also move $1. That’s pretty silly when you think about it. The option usually costs much less than the stock. Why should you reap the same benefits as if you owned the stock? Besides, not all options are created equal. How much the option price changes compared to a move in the stock price depends on the option’s strike price relative to the actual price of the stock.

So the question is, how much will the price of an option move if the stock moves $1? “Delta” provides the answer: it’s the amount an option will move based on a dollar change in the underlying stock. If the delta for an option is .50, in theory, if the stock moves $1 the option should move approximately 50 cents. If delta is .25, the option should move 25 cents for every dollar the stock moves. And if the delta is .75, how much should the option price change if the stock price changes $1?

That’s right. 75 cents.

Typically, the delta for an at-the-money option will be about .50, reflecting a roughly 50 percent chance the option will finish in-the-money. In-the-money options have a delta higher than .50. The further in-the-money an option is, the higher the delta will be.

Out-of-the-money options have a delta below .50. The further out-of-the-money an option is, the lower its delta will be. Since call options represent the ability to buy the stock, the delta of calls will be a positive number (.50). Put options, on the other hand, have deltas with negative numbers (-.50). This is because they reflect the right to sell stock.

Theta

Theta is the measure of “time decay.” In other words, it’s the amount an option’s price will change (at least in theory) for a one-day change in the time to expiration. For example, if the theta for an option contract is $.07, then in theory, the time value of an option should decrease by 7 cents for each day that passes. Theta is enemy number one for the option buyer, since it measures how quickly the owner’s option is eroding in value with each passing day. On the flipside, theta is usually the option seller’s best friend, because when you sell an option, you want it to decrease in value as quickly as possible.

Vega

Vega is a slightly trickier concept. It’s the amount an option’s price will change in theory for a corresponding one-point change in the implied volatility of the option contract. Remember, as implied volatility increases, it indicates a potential for wider movement in the stock price. Therefore, option prices will increase as implied volatility increases, and option prices will decrease as implied volatility decreases.

If the vega for an option contract is .10, then in theory that means if the implied volatility of the option moves one percentage point up or down the value of the option will move accordingly by 10 cents.

Keep in mind: vega doesn’t have any effect on the intrinsic value of options; it only affects the “time value” of the option’s price. Here’s an odd fact for you: Vega is not actually a Greek letter. But since it starts with a ‘V’ and measures changes in volatility, this made-up name stuck.

Taking the next step

As you can see, this article hasn’t given you any of the specific instructions of option trading. That’s because it’s very important to understand the vernacular of the options marketplace before you get into the nuts and bolts of making specific trades. We hope you’ll keep this article handy as you delve deeper into the subject of option trading. You’re sure to find it handy as you build your knowledge and understanding of the options market.






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