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Option Basics

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1Option Basics Empty Option Basics Mon Dec 05, 2016 4:23 pm



Options are also known as derivatives because the option contract derives its price and value from the underlying asset on which it is based. The value of an option fluctuates as the price of the underlying asset rises or falls in price.

An option is the right, but not the obligation, to buy or sell a stock or index for a specified price on or before a specific date. A call option is the right to buy a stock/index, while a put option is the right to sell a stock/index. The investor who purchases an option, whether it is a put or call, is the option “buyer”. Conversely, the investor who sells the put or call “to open” is the option “seller” or “writer”.

Options are contracts in which the terms of the contract are standardized and give the buyer the right, but not the obligation, to buy or sell a particular stock/index at a fixed price (the strike price) for a specific period of time (until expiration). All option contracts traded on U.S. securities exchanges are issued, guaranteed and cleared by the Options Clearing Corporation (OCC). OCC is a registered clearing corporation with the SEC and has received ‘AAA’ credit rating from Standard & Poor’s Corporation. The ‘AAA’ credit rating corresponds to OCC’s ability to fulfill its obligations as counter-party for options trades.

The options markets provide a mechanism where many different types of investors canachieve their specific investment goals. An options investor may be looking for long term or short term profits, or they may be looking to hedge an existing stock or index position. Whatever your objectives may be, you need a thorough understanding of the markets you will be trading.

Options Share the Following General Characteristics:

  •  Options give you the right but not the obligation to buy or sell an underlying security or index
  •  If you buy an option, you are not obligated to buy the underlying security. You simply have the right to exercise the option.
  •  Options are in force for a specified period of time after which they expire and you lose the right to buy or sell the underlying security
  •  When options are purchased the buyer incurs a debit
  •  Options are available in various strike prices representing the price of the underlying security
  •  The cost of an option is referred to as the option premium
  •  There are two kinds of options: calls and puts. Calls give you the right to buy the underlying security and puts give you the right to sell the underlying security
  •  Most options are never exercised and are closed out before option expiration

Buying Options
Any investor can buy options if they have the required account established with their broker. Buying options limits the investor’s risk to the amount of capital invested in the option purchase. Therefore the only requirement is that the investor has enough funds in their account to purchase the options. Since the purchase of an option contract results in a long position, a cash debit is subtracted from the buyer’s account.

Underlying Security
The underlying security in options trading is defined as the financial instrument on which an option contract is based or derived. It is a stock or Exchange Traded Fund (ETF) that you have the right to purchase or sell. The symbol used for the underlying security in options trading is usually the symbol used by the exchange on which the underlying security is traded. For example, GE is used for General Electric and SPY is used for the S&P 500 Index ETF.

Strike Price
The strike price is the actual price at which the option holder may buy or sell the underlying security as defined in the option contract. For example, a GE Mar 20-Strike call gives the buyer of the option the right to buy 100 shares of General Electric at $20 per share between now and the monthly option expiration which is usually the third Friday of the month.

Expiration Date
The expiration date is the actual date that an option contract becomes void. Monthly options normally expire on the third Friday of each month. Be aware that at expiration options that are not closed prior to expiration and are in-the-money will be exercised automatically.

Option Type
There are two types of options - call options and put options.

  • A call option profits when the price of the underlying security moves higher.
  • A put option profits when the price of the underlying security moves lower.

How to Read Option Symbols
An option symbol is comprised of several components that define the underlying stock or ETF and information about the specific option contract. An option symbol consists of the stock or ETF trading symbol, year of expiration, month of expiration, expiration date, option type (call or put) and strike-price.

There are many financial websites available today that will give you option quotes. Use Yahoo Finance or the Chicago Board Options Exchange website at [You must be registered and logged in to see this link.] to obtain option quotes.

The symbol for the General Electric Jan 2018 25-Strike call option is GE180119C00025000. Let’s look at the components of this option symbol.

GE, 18, 01, 19, C, 00025000

  • GE is the trading symbol for General Electric
  • 18 is the expiration year 2018
  • 01 is the expiration month of January
  • 19 is the expiration date which is Friday January 19th in this example
  • C designates a call option (put options are designated with a “P”)
  • 00025000 designates a 25-Strike price

Stock Option Point Values
Normally, 1 stock option contract covers 100 hundred shares of the underlying stock. Therefore an option with a 3.5 point premium would cost $350 (100 shares x $3.5).

Exercise is the term used when the buyer of an option uses their right to purchase or sell the underlying security at the terms of the option contract. Your broker handles the entire option exercise transaction, and the resulting stock position is transferred into your account.

Advantages of Options Versus Stocks/Mutual Funds
When you purchase options you commit a limited amount of capital and thus have less total dollars at risk in the market compared to stocks and mutual funds. The surplus dollars can be placed in safe investments like a money market fund. Instead of buying stocks consider “leasing” them with options especially when your market expectations are likely to change more frequently with today’s volatile markets.

If you set aside a small portion of your portfolio for options to benefit from the frequent market swings it can create big profit opportunities for traders positioned to capitalize on market swings. Options offer profit potential not only when the market rallies, but also when it declines. With stocks and most mutual funds you can only benefit from bullish markets. If you are bearish on the stock market cash is usually your only alternative. With options you can profit from both bullish and bearish markets.

A Lower Risk Alternative to ‘Going Short’
Put options are normally a better choice than selling short a stock or ETF. Option purchases normally do not require a margin account, whereas short selling a stock does require a margin account. In addition, a short stock position has virtually unlimited loss potential if a stock continues to rally in price. Conversely, the maximum loss for a put option purchase is limited to the purchase price of the option.

Options offer greater leverage than stocks or mutual funds. A 10% move in a stock can easily translate into a 50 to 100% move in the related option. Purchasing options offers profit leverage if you are correct in your market view but also offers limited risk if your market view is incorrect.

Risk Management
The first step toward intelligent risk management is to trade options only with that portion of your capital that can be comfortably devoted to speculation. This will permit you to trade rationally and to sleep soundly which is not possible if your ‘Safe Money’ is at risk. Never trade options with money needed to pay living expenses. Restrict your options trading to funds that can be lost without undue financial hardship.

Once you determine the amount of your available trading capital, try to allocate no more than 10% to any one trade. This should help mitigate losses when losing trades occur. This rule holds regardless of how successful you have been in the past and regardless of how attractive the next trade appears. There will always be losing trades. By compounding your capital after a few profitable trades, you are exposing yourself to potentially painful losses once that losing trade comes along.

Risk and Diversification
Option positions should be diversified. A major advantage of option purchases is ‘truncated risk’, whereby your loss is limited to your initial investment yet your profit is virtually unlimited. Diversification will allow you to use truncated risk to its maximum advantage. While some of your positions will inevitably be unprofitable, each profitable trade can offset several unprofitable trades. Option positions should be established among 5 or more underlying stocks and indexes in unrelated industries. This gives you diversification, which can help mitigate sector weakness.

In order to trade options, your broker must first approve your account for option trading. There are various levels of option trading and each level has financial requirements that differ from broker to broker:

  • Level 1 Covered call writing
  • Level 2 Call and put purchases and covered put writing
  • Level 3 Spreads
  • Level 4 Uncovered call and put writing (requires margin)
  • Level 5 Index option writing (requires margin)

Be sure to ask your broker about their requirements for the level of options you plan to trade.

Order Types
Listed below are definitions for a variety of popular orders that may be helpful.

Market Order
A market order is simply an order without restrictions or limits that guarantees execution but not price. Because it lacks restrictions, it takes precedence over all other types of orders. A market order to buy is executed at the best offering price available, which is normally the “ask” price. A market order to sell is executed at the best bid price available which is normally the “bid” price.

Limit Order
A limit order is an order in which an investor has placed a restriction or limit on the acceptable purchase or selling price. There are two types of limit orders: a buy limit order and sell limit order. A buy limit order sets the maximum amount an investor is willing to pay to purchase a security or option contract. A sell limit order sets the minimum price that an investor is willing to accept to sell their security or option contract.

Day Orders
Day orders are only valid for one trading day. If you place the order during market hours, then it will expire at the end of the trading day if it is not executed. If you place a day order after the market close then it will be valid for the next trading day.

Good Until Canceled Orders (GTC)
Normally each brokerage firm will establish time periods for which GTC orders are valid. Once a GTC order is placed, it will remain open until the option expires, the order itself expires, the order is filled, or the order is cancelled.

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