Option Basics
If you are new to options trading, this section will define what options are and explain the most basic
concepts. The material in this section is pretty basic. Please bear with it. You need to understand basic
concepts and terminology before you get into the more advanced topics. All of the other topics on this site
are much more interesting (and profitable).
But first, let's get you up to speed on the basics. There are two kinds of options -- calls and puts:
Call Option ... When you buy a call option, it gives you the right to buy a given asset at a fixed price
(known as the strike price) anytime before a specified expiration date. The option writer (the person who
created the option which you purchased), has the legal obligation to sell the asset to you at the strike price,
if you exercise the option before the expiration date.
Put Option ... A put option is just the opposite. When you buy a put option, it gives you the right to
sell a given asset at the strike price anytime before the expiration date. The option writer, has the legal
obligation to buy the asset from you at the strike price, if you exercise the option before it expires.
Underlying ... The asset is usually referred to as the Underlying (underlying asset). Options are
available for the following types of underlyings:
Stocks . over 1900 stocks for which options are available in the U.S.A.
Stock Indexes . SPX (S&P 500), OEX (S&P 100), computer software index, biotech index,
gold/silver index, oil index, and around 50 others.
Futures (Commodities, Indexes, Currencies) . Gold, silver, soybeans, wheat, crude oil,
treasury bonds, eurodollars, foreign currencies, S&P 500 index, and many others.
Others . Cash foreign currencies and interest rates.
Examples of Options:
IBM July 110 Call option... The option buyer has the right to buy 100 shares of IBM stock at
the strike price of $110 per share anytime before the option expires in July. If the option buyer
decides to exercise the option, the option writer has the legal obligation to deliver (sell) 100 shares
of IBM stock under those terms.
Soybeans August 850 Put option... The option buyer has the right to sell one August Soybeans
futures contract at the strike price of 850 cents per bushel anytime before the option expires in
August. If the option buyer exercises the option, the option writer has the legal obligation to buy the
futures contract under those terms.
Why do people buy options?
Two reasons, limited risk and leverage. When you buy an option your risk is limited to the price you pay
for the option. And from a leverage standpoint, it allows you to control an expensive asset for a fraction of
what it would cost you to purchase the asset outright.
So, if you think that the price of a stock will increase, you can buy a call option instead of buying the stock,
or if you feel the price will decrease, you can buy a put option instead of selling the stock short.
For example, buying 100 shares of a stock at $90 per share would cost you $9000 (or $4500 on 50%
margin). On the other hand, you could buy a call option on that stock for say $400 and effectively control
those 100 shares until the option expires.
Now before you start buying options, a word of caution...
Most people who trade options lose money.
Why? Because they buy options and that's all they do. They don't take advantage of other option strategies.
You should be aware that eighty percent of all options expire worthless. And to make matters worse, the
general public buys options without paying attention to the fair value of the option and the implied
volatility . As a result, they buy overpriced options and often wind up losing
money even when they were correct about the price direction!
Exchange Listed Options ... Options are traded on organized exchanges. This makes it
possible for you buy and sell options the same way that you would buy or sell stocks, futures, etc. You need
to open an account with a stock brokerage firm to trade stock & index options. Trading futures options
requires that you open an account with a commodity futures broker.
Exchange listed options have standardized strike prices and expiration dates.
Strike Price ... This is the fixed price at which the option can be exercised. It is also known as the
exercise price. Options are available for lots of different strike prices for stocks and futures
contracts. Your broker will give you a strike price table.
Expiration Date ... This is the date on which the option expires. For stock options and index
options, this is always the Saturday following the third Friday of the expiration month. For example,
July 1996 stock & index options will expire on Saturday July 20, 1996. Futures options have their
own expiration dates. Again, your broker will give you a list.
American Style versus European Style ... American style options can be exercised
anytime before the expiration date. European style options can only be exercised upon expiration (right
before they expire). Most options that trade on exchanges in the United States are American style. One
noted exception, however, is the very popular SPX (S&P 500 index option) which trades on the Chicago
Board Options Exchange (CBOE) and is a European style option.
Option Writer ... An option writer is any person who writes (creates) an option. When you sell an
option that you don't already own, you have just created a new option, and this makes you an option writer.
In-the-Money ... Call options that have a strike price which is below the current market price of
the underlying asset are said to be in-the-money. And likewise, put options that have a strike price which is
above the current market price of the underlying asset are in-the- money. For example, when IBM stock is
trading at 114, an IBM 110 call option (110 strike price), would be 4 dollars in-the-money. An IBM 120
put option would be 6 dollars in-the-money.
Out-of-the-Money ... This is the opposite of in-the-money. Call options that have a strike price
which is above the current market price of the underlying asset are out-of-the-money. Put options that have
a strike price which is below the current market price of the underlying asset are out-of-the-money.
Continuing with the same example above, when IBM is trading at 114, an IBM 120 call option would be 6
dollars out-of-the-money and an IBM 110 put option would be 4 dollars out-of-the-money.
At-the-Money ... When an option's strike price is the same as the current market price, the option
is at-the-money. Actually, whichever strike price is closest to the market price, is considered to be
at-the-money. So if the stock's price is 114, the 115 call option and the 115 put option would both be
considered to be at-the-money (even though, the call option is technically 1 dollar out-of-the-money and the
put option is 1 dollar in-the- money).
Option Premium ... This is the price of the option.
Each stock option covers 100 shares of stock. For example, when you see a stock option's price
(premium) quoted at 4.50 it means that one option costs $4.50 per share times 100 shares, for a total
cost of $450. So for stock options, just multiply the quoted premium by 100 to get the total cost.
All other options (options on futures contracts, index options, etc.) each have their own specified
quantities. For example, each soybean futures contract covers 5,000 bushels of soybeans and the
price is stated in cents per bushel. So, if an option on a soybean futures contract has a premium of
11.50, it means the cost of one option is 11.50 cents per bushel times 5,000 bushels, for a total cost
of $575.00. Your broker will give you a copy of the contract specifications for all exchange listed
options.
An option's premium consists of two components:
Intrinsic Value . is the amount that the option is in-the-money. It is the amount that you would
receive if you were to exercise the option right now (see "exercising an option" below).
Time Value . is the additional amount that people are willing to pay over and above the intrinsic
value. The sum of intrinsic value plus time value equals the option premium. So, if an option's
premium is 5.25 and its intrinsic value is 3.00, the time value is 2.25.
Exercising An Option ... Owning an option gives you the right to exercise it.
Call Options . When you exercise a call option, you buy the underlying asset at the strike price
and you can then sell it at the current market price. For instance, suppose you own an IBM 110 call
option and IBM is trading at 114. Exercising the call option, you would buy 100 shares of IBM
stock at the strike price of $110 per share. You could then sell the stock at the current market price
of $114 per share. Your profit would be $4.00 per share, which was the intrinsic value of the
option.
Put Options . With a put option it is a little different. First, you buy the underlying asset at the
market price. Then, you exercise the put option, selling the asset at the strike price. Let's say you
own an IBM 120 put option and IBM is trading at 114. First you would buy 100 shares of IBM at
the market price of $114 per share, then you would exercise your put option, selling the stock at the
strike price of $120 per share. Your profit would be $6.00 per share (again, the intrinsic value of
the option).
Note that when you exercise an option, you only receive the intrinsic value. If the option still has time
value, you would be throwing that away. For this reason, you normally don't exercise options that still have
time value remaining.
In fact, only two percent of all options are ever exercised. Normally, when you buy an option, you will sell
it before it expires (and take your profit or loss), or just let it expire worthless.
Delta ... This is the rate of change in an option's price relative to a one unit change in the price of the
underlying asset. For example, if a call option on a stock has a delta of 0.50 and the price of the stock
increases by one dollar, the option's price should increase by 50 cents ($1.00 times 0.50). The
characteristics of an option's delta, and how to use it, is covered in much more detail in our Delta Neutral
section.
Gamma ... This is the rate of change of the delta. Let's continue with the example above where a call
option on a stock has a delta of 0.50. If the call option has a gamma of 0.03 (for instance), it means that the
delta will increase from 0.50 up to 0.53 when the price of the stock increases by one dollar. It also means
the stock's delta will decrease from 0.50 down to 0.47, if the price of the stock decreases by one dollar.
Time Decay ... The time value of an option's premium erodes as the option approaches the
expiration date. Time decay accelerates and becomes most noticeable during the last month before
expiration.
Theta ... This is a measure of the rate of time decay. It is the amount that an option's premium will lose
per day due to time decay. It is usually stated in dollars per day.
Vega ... This is a measure of much an option's premium will increase or decrease due to a change in
volatility. There are two separate sections on this site which explain the concept of volatility (because it is
so important).
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