An option is a choice. If you buy a call or put option, you can choose to either buy or sell a stock at a specific price for a pre-determined period of time. The price is known as the strike price. The life of an options contract is determined by the expiration date. After the option expires, it no longer exists. Each contract can be defined by its underlying security, the strike price of the option, and the expiration date. Options can be used to speculate or to hedge. The industry is growing and options volumes continue to set records. Yet, many investors still don't know how to get started or are still wondering, "What's an option?" Here are a few questions and answers designed to help makes sense of the options product.
What's the difference between a put and a call? Both are options contracts or agreements between two parties. If I buy anIntel (INTC) - Get Intel Corporation (INTC) Report January 20 call option at $0.90 per contract, I have purchased the right to buy 100 shares at $20.00 each. I can exercise my contract and buy the stock through the third Friday of January (before the options expire on Saturday, January 22). The stock is at $20.68 and so if Intel shares rally 6.4% to $22.00, I can exercise my call and buy the stock at $20, sell it in the market for $20.00, and make $2.00 per share profit (minus the $0.90 paid for the calls). An Intel January 20 put, on the other hand, gives me the right to sell 100 shares at $20.00 through the January 22 options expiration.
Who sells options? Anybody can sell an options contract, provided their brokerage firm allows them too. In fact, for every options buyer, there's a seller. In fact, some traders prefer to sell options rather than buy them because of time decay. Since options contracts expire on specific days, the contracts lose value over time. The seller or "writer" of an options contract is taking on the obligation to buy (for puts) or sell (for calls) the stock during the life of an options contract. For example, if I sell an Intel January 20 put at $0.90, I'm on the hook to buy the stock at $20.00 no matter what happens. If the stock falls to $10.00, I would be asked to buy it at $20.00. If so, I have been assigned on the contract and there is nothing I can do. When a call writer is assigned, they are asked to sell the underlying stock - 100 shares for every call option.
If an options contract is an agreement between two parties, what if I can't find someone to take the other side of the trade? Don't worry about it. If there is a quote for an options contract, the market maker fulfills the role of executing the trade. You enter the order with your broker and that's all you really need to worry about.
How do I find options quotes? Your brokerage firm can provide options quotes, but many other web sites offer them as well. The easiest way to view options prices is with an options chain. For example, the options chain below shows INTC quotes. It's from thestreet.com OptionsProfits service and includes puts and calls that expire in January 2011. If, for example, you want to buy INTC 21 calls ahead of the chipmaker's earnings Thursday, you would pay $0.35 per contract or $35.00 plus commissions.
Is it true that most options expire worthless?
An options contract will expire worthless if it is at-the-money
ATM or out-of-the-money
OTM. An ATM option has a strike price equal to the strike price. An OTM call has a strike price above the current stock price. A put is out-of-the-money if the strike price is below the stock price. Intel was trading at $20.68 at the time. So, all of the call options with strike prices greater than $21.00 are OTM. The puts with strike prices less than $20.00 are out-of-the-money.
Should I exercise my option or let it expire? If the option is in-the-money at expiration, it will be automatically exercised based on Options Clearing Corporation rules. If the contract is OTM at expiration, it will expire worthless. However, an options contract can be offset or closed out at any time prior to expiration through an offsetting transaction. For example, if I sell to open a new position in 10 INTC January 20 calls. I can close that position at any time by buying-to-close 10 January 20 calls. Or, I can close a portion - like five or 10 contracts. Contrary to popular belief, most options contracts are offset through closing trades and not held into the expiration.
What's the best option to buy right now? Like with most investments, buying options and creating options strategies is a matter of balancing risks and rewards. As a general rule, the higher the risk, the greater the potential reward. For example, if I buy the aforementioned INTC January 21 calls at $0.35 and the stock rallies to $21.70 through the January expiration, or 4.9% above current levels, the calls will be worth $0.70 ($21.70 minus the contract). It is $0.70 in-the-money and, since you paid $0.35, you've doubled your money on a 4.9% move in the stock. On the other hand, if those calls are held through the expiration and INTC is trading at $21.00, or less, those calls expire worthless and 100% of the premium paid is lost. As a general rule, the option that goes from out-of-the-money to in-the-money offers a lot of bang for the buck. It's kind of like riding the fast race horse at the Kentucky derby. The risks are high as well.
How much should I pay for an option? There are several determinants for options prices. For example, the strike price relative to the stock price, the amount of time left until expiration, and the volatility of the underlying stock. A very volatile stock will have higher premiums than a low volatility stock because there is a greater probability that puts and calls will end up in-the-money ITM at expiration when a stock is making big moves! (Here's another recent article that covers the determinants of options prices.)
I want to trade call options on INTC how do I get started? The first steps are education, a game plan, and an options broker that allows customers to trade options. Once you understand the product and have decided what strategies you want to add to your trading plan, you open an account, submit an options approval and then fund an account. The brokerage firm might place restrictions on the type of trading activity allowed based on your experience and net worth. For example, most brokers won't allow straight put and call selling when the investor has no previous trading experience. Covered calls (long stock), protective puts (long stock, long puts) and collars (long stock, short calls and long puts) are good starting points for options newbies.
Where can I find options trading ideas and information? There are many free web sites available to investors interested in learning about options. For example, the Chicago Board Options Exchange has a massive amount of options data and information. The Options Industry Council is an excellent source of free options education. Finally, TheStreet's OptionsProfits , which you are reading today, is a premium service that offers subscribers research, trading ideas, and market updates from more than a dozen experienced options traders and educators.
See you Wednesday!
At the time of publication, Fred Ruffy held no positions in the stocks or issues mentioned.
Frederic Ruffy is an experienced trader and provides daily commentary and analysis of the options market. He is co-founder of the web site, WhatsTrading.com. His work has also appeared in Futures Magazine, Technical Analysis of Stocks & Commodities, Stock Futures and Options, and Sentiment.
In addition to writing market commentary and trading-related books and articles, Fred has also worked as an instructor, educating investors on advanced topics like measuring volatility, the benefits of sector rotation and the risks and potential profits from trading around earnings. An active trader himself, with over 15 years securities industry experience, his market observations and analysis of the options market are featured regularly in the financial press including Barron's, Reuters, The Wall Street Journal, and Bloomberg.
OptionsProfits For actionable options trade ideas from a team of experts, visit TheStreet's OptionsProfits now.
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