John this should help in learning the basics. Get used to losing 5 Grand, making 7 Grand, losing 4 Grand, making 5 Grand, etc
OPTIONS
BASIC FACTS
If you are familiar with options, you may skip to the bottom of the page to see some of strategies involved in making money using options.
What is an Option? A stock option is a contract which allows its holder the right, but not the obligation, to buy or sell shares of the underlying stock at a specified price on or before a given date. This right is granted by the seller of the option. The thing to remember is if one buys an option, he/she is not obligated to exercise the option.
There are two types of options, Calls and Puts. Besides options on a given stock, options can also be bought or sold on S&P 100, S&P 500 and Dow Jones Industrial Averages. Options on Nasdaq Averages can also be bought and sold.
There are also two styles of options, American Style and European Style. We will only talk about American Style options here. European options are beyond the scope of these pages. For more information on European style options refer to the Chicago Board of Option Homepage.
Options are traded in blocks of one hundred. Each block is called a Contract. This means that one option contract represents the right to buy or sell 100 shares of the underlying security. Prices (Premiums) are quoted on a per share basis. Thus, a premium of 7/8 represents a premium payment of $87.50 per option contract ($0.875 x 100 shares).
For example, an American-style ABC Corp. May 60 call entitles the buyer to purchase 100 shares of ABC Corp. common stock at $60 per share at any time prior to the option's expiration date in May. Likewise, an American-style ABC Corp. May 60 put entitles the buyer to sell 100 shares of ABC Corp. common stock at $60 per share at any time prior to the option's expiration date in May.
Underlying Security
The specific stock on which an option contract is based is commonly referred to as the underlying security. Options are categorized as derivative securities because their value is derived in part from the value and characteristics of the underlying security.
Strike Price
The strike price, or exercise price, of an option is the specified share price at which the shares of stock can be bought or sold by the holder, or buyer, of the option contract. To exercise your option is to exercise your right to buy (in the case of a call) or sell (in the case of a put) the underlying shares at the specified strike price of the option.
Option Prices
The strike price for an option is initially set at a price which is reasonably close to the current share price of the underlying security. Additional or subsequent strike prices are set at the following intervals: 2.5 points when the strike price to be set is $25 or less; 5-points when the strike price to be set is over $25 through $200; and 10-points when the strike price to be set is over $200. New strike prices are introduced when the price of the underlying security rises to the highest, or falls to the lowest, strike price currently available.
The strike price, should not be confused with the premium, the price at which the contract trades, which fluctuates daily.
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 this 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 stock 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 selling the stock in the stock market. The converse of in-the-money is out-of-the-money. If the strike price equals the current market price, the option is said to be at the-money.
Premium
Option buyers pay a price for the right to buy or sell the underlying security. This price is called the option premium. The premium is paid to the writer, or seller, of the option. In return, the writer of a call option is obligated to deliver the underlying security (in return for the strike price per share) to an option buyer if the call is exercised. Likewise, the writer of a put option is obligated to take delivery of the underlying security (at a cost of the strike price per share) from an option buyer if the put is exercised. Whether or not an option is ever exercised, the writer keeps the premium.
Two factors make up the premium price. One is the price of the underlying security. The other is the time left until expiration of the option. The more time that is left until option expiration, the more expensive the premium. As the expiration date approaches, the option loses its value if it is not at or in the money.
Exercising the Option
If the holder of an option decides to exercise his right to buy (in the case of a call) or to sell (in the case of a put) the underlying shares of stock, the holder must inform his broker of his intention usually 48-hours prior to its expiration date. Different firms may have different cutoff times for accepting exercise instructions from customers, and those cutoff times may be different for different classes of options.
Expiration Date
Options expire on the third Saturday of each month. However, since markets are closed on Saturdays, for all practical purposes, options expire on the third Friday of each month. After the exercise date, if options have not been exercised, they become worthless. That is why options are categorized as investments with expiration dates.
Options: Leverage Power or Suckers Game!
Before you spend a penny on options, you should know that more than 90% of options expire and become worthless. Therefore, be careful, invest only money that you can afford to lose! Do NOT try to out-smart the market. You will lose your money fast. A good strategy is to only allocate 10% of your capital to options. Options are not marginable. You must have cash on deposit with your broker.
Below, we will give several scenarios in which options can help you make money. We will use examples to illustrate our points.
1) Buying Calls
If you know that a stock is going to go up in price, you buy calls. You buy calls to leverage your purchasing power. Pfizer a major drug company's stock is trading at around $100 a share. Most people can not afford to buy 1000 shares of PFE to take advantage of Pfizer's new drug, Viagra. For those people, Call options are a good way to take advantage of the price movement in the stock price. You will only buy calls if you are bullish on the stock. The two figures shown below illustrate the point.
Figure 1: Six month price chart and volume for Pfizer (PFE) from Oct 97 to April 98
Figure 2: Three month price chart and volume (No. of Contracts) for the Pfizer June 95 Call
In the example given above, we illustrate our point by noticing that the underlying stock price went from $80, in February 1998 to $100 in April 1998. At the same time, the June 95 Call on the stock has gone from $2 to $12. A person who had bought the June 95 Call in February for $2 could have turned that option premium to $12. A 6-fold increase of his money. In a sense he has leveraged the stock. Ten Contracts (1,000 shares) would have cost him $2,000. By spending $2,000, he controls 1,000 shares of PFE at $80. That is $80,000 worth of stock. His down side in this example would have been if the stock had dropped in price to below $95. Then he would have lost his entire premium. A total loss of $2,000 plus commission. The June 95 Call gives the buyer the right but not the obligation to buy the stock at $95 a share by June 19. He also has the choice of selling the options to his broker at the market price, say $12 rather than exercising the option. This is how most people make money playing the options, rather than exercising the options. In this case a Profit of over $10,000 would have been realized.
2) Selling Calls
Selling or Writing Calls are interchangeable terms. If you have bought a stock and the stock has appreciated in price, but you are not sure that the stock can keep it's upward movement, then you may want to lock in some of your profit. You may do that by selling or writing calls. You sell Calls if you are bearish on a stock. This is how it works.
Let say that you have bought Pfizer stock (the above example) for $70 and stock is trading at $100 now. You can sell June 95 Calls on PFE and receive $10 per share in premium. You now have reduced your cost of the stock to $60 ($70-$10). In exchange for receiving the $10 premium, you agree to sell your stock for $95 by 3rd Friday in June. You now have locked in some of your profit, regardless of what happens to the stock price, you keep the $10 premium. In turn, your broker requires you to deposit your stock with him since you now have placed a restriction on your stock.
You may have heard the term Naked Calls. Naked Calls refer to writing calls without owning the underlying stock. To do this, you must have a margin account with your broker. Different brokers have different requirements for Writing Naked Calls. The minimum margin account balance in many cases is $50,000 in order to write naked calls. You only do this if you are bearish on a stock. Regardless of what happens to the stock price, you keep the premium. In a sense, this is one way of SHORT selling a stock.
3. Buying Puts
If you think a stock is going to drop in price, you can Short sell the stock. The drawback to this strategy is if the stock temporarily goes up in price, you will get a margin call. You either have to deposit more money in your account so your margin account is in good standing, or in most cases, you buy the stock to cover your position. Another way to play this strategy is to buy Puts. You buy puts when you think the stock is going to drop in price. Technically speaking when you SHORT sell a stock, your loss could be unlimited. When you buy puts however, your maximum loss is the premium that you have paid. You buy Puts if you are bearish on a stock. We will use an example to illustrate the point.
If in Mid-February 1998, one had been bearish on Intel Corp (INTC), he could have sold the stock short at, say, $84. The chart below shows that the stock price went to $96. Most likely, he would have received a margin call from his broker. He would either have had to deposit additional funds in his account, or buy the stock to cover his position. In March 98, the INTC price dropped to $75. His forecast on the INTC price was accurate, but the temporary rise in the stock price forced him to take a loss on the trade. To avoid such a scenario, he could have bought Puts on INTC. Figure 4 shows the price chart for Intel's July 90 Puts.
Figure 3: Six month price and volume chart of Intel Corp. (INTC)
Figure 4: Intel's 90 July Put Six Month Price and Volume Chart (volume in No. of Contracts)
Using the same example, our investor could have purchased Intel's July 90 Put for a premium of $7. His maximum loss would have been his premium. Note that the Put Option price chart follows the stock's price chart but it is an inverse image. When a stock goes up in price, puts drop in price. Conversely, when the stock drops in price, the put price goes up.
4. Selling Puts
If you are bullish on a stock and do not want to buy calls, you can Sell Puts. By selling Puts, you receive a premium, in return you agree to buy the stock at the strike price. In the example above, if one had sold Puts, he would have agreed to buy INTC for $90 a share by July 17. Let's assume that you had sold Intel's $90 puts for $10 each and you had sold 10 contracts. You would have received (1,000 x $10) $10,000 in premium, but you committed yourself to a $90,000 ($90 x 1,000) purchase. Your broker then requires you to deposit sufficient funds to cover the $90,000 transaction. If your option is called in, you agree to purchase the stock at $90 but you also get to keep the premium that you had received. You sell Puts when you are bullish on a stock.
Figure 5 is plot of Pfizer's September 98, $80 put to illustrate how options can be used to increase your profit. Note that as the PFE stock goes up in price, the put loses its value.
Figure 5: Pfizer's September $80 Put Price Chart and Volume (in number of contracts)
5. Options as an Insurance Policy:
I am sure that most of us have bought stocks and as soon as we bought them, had buyer remorse! One way to alleviate that feeling is to buy put options. Say in January 1998, we had bought Pfizer at $80. We could have bought the Pfizer $80 Put at the same time, to protect our investment. In January, the Puts had a premium of $8. By buying the put, we know that even if the stock drops in price, the writer of put is obligated to buy the stock from us at $80. This is just like an insurance policy that gives us piece of mind. Our break even point on the stock is now $88 ($80+$8) rather than $80. There are many ways to use options to hedge an investment. We just introduced the simplest way. For more information about options, please contact the Chicago Board of Option. |
