Options Education

The Basics of Options

Before you actually start investing with and trading options you need to understand the basic terminology (the language of options) and more about what makes them tick. For example, the factors that affect the prices or premiums, and how that relates to the price of the underlying stock.

Definition

An option is the right, not the obligation, to buy or sell a stock at a specific price on or before a specific date.

Two Types of Options

Call	Put
The right to buy	The right to sell
The obligation to sell	The obligation to buy

Contracts

A Call option gives the buyer or holder the right to purchase the underlying asset and gives the writer or seller the obligation to sell a set number of shares of the underlying stock at a specified price (strike price) on or before the date the contract expires (expiration date).

A Put option gives the buyer or holder of the contract the right to sell the underlying asset and give the writer or seller of the contract the obligation to buy a set number of shares of the underlying asset at a specified price (strike price) on or before the date contract expires (expiration date).

An option contract usually controls 100 shares of stock. However, if there has been a recent split in the stock this may not be the case. The buyer of the contract will pay a premium, while the writer or seller of a contract will collect a premium.

Option Contract

Strike Price

The price at which you have the right to buy or sell according to the contract.

Expiration Date

The third Friday of the month.

Premium

The Cost of the option

Example

Let's take a look at an example of how all of these factors go together. You are interested in building a golf course and have found a 1,000-acre plot of land in a potentially high growth area. However, it will take time to obtain the necessary financing and land-use permits in order to begin building. You want to secure the land while you put everything into place, but you don't want to lay out a hefty price to purchase the land outright just in case you can't ultimately build the course there.

Strike Price

• You go to the property owner and strike a deal that allows you to purchase the property for 2 million dollars.
• He agrees and you now have the right to purchase the property at the agreed upon price.

Your solution is to go to the landowner and create a contract that will give you the right to buy the land, but not the obligation. The contract will control all 1,000 acres. The price that you agree to is called the strike price. If you are not successful in obtaining the right to build a golf course, you can simply walk away from the deal and lose only the amount that it cost you to purchase the contract.

The contract is written with an expiration clause so as to protect the landowner from being obligated to sell his property for an unreasonable amount of time. It also will decrease the cost of the contract to you, because you will only be tying up the land for a short pre-determined period.

Expiration Date

• The expiration date offers some protection to the property owner by invalidating the contract after 6 months.
• Gives the buyer only a limited time to decide whether to ultimately purchase the land or not.

The landowner will expect to collect a premium for being obligated to sell you the property. The amount of money he expects will be determined by how long he will be under obligation and what the expectations are for the property to move up or down in value. The more time the land will be tied up, the more money he will expect. Likewise, the more likely the land is to increase in value during the duration of the contract, the more money he will expect.

Premium

• The landowner will collect a premium for being obligated to sell us the land for the agreed upon price.
• His price is based on how much the property might move in value during that period and how long he will have the obligation.
• The premium is $20,000.

Of course, your reasons for entering into this type of deal are fairly clear, but why would the property owner be interested in such an arrangement? For one thing, he gets to keep the premium paid for the contract no matter what happens, allowing him to make a little upfront money on a property he may or may not wind up even selling. In addition, the agreed upon sale price (strike) is likely to be much higher than he could obtain if he sold the property without the land-use approvals that you're working to obtain.

This example is very similar to what happens with a call option in the stock market. Stock options are contracts that have strike prices, expirations, and premiums. Rights are transferred and the parties to the contract take obligations.

Strike Price

This is the price per share at which you will have the right to buy or sell the underlying stock. For example, if you see May 30 calls, this means you have the right to buy stock at $30 per share. If you have written or sold a contract, the strike price will be the price at which you will be obligated to buy or sell. Strike prices are determined by the exchanges and are stated in even increments.

Strike Price Increments

Stock Price	Strike Increment	Starting At
$5.00 to $25.00	$2.50	$5.00
$25.00 to $200.00	$5.00	$25.00
$200.00 to $60,000.00	$10.00	$200.00

Expiration Date

Every option contract has a month in which it expires. For standard options, the dates can range from one to nine months, and contracts expire on the Saturday following the third Friday of the month. However, since you can't trade on Saturday, the third Friday of the month is considered the option expiration date.

Options are identified in part by their expiration dates. If you see a quote for May 30 calls, the May refers to the expiration month and the actual date will be the third Saturday in May. The option no longer trades at the close of the markets on the third Friday of May, and officially expires the next day. If the markets happen to be closed on that Friday, the last trading day will be on the preceding Thursday.

Option Premium

The premium is the amount the buyer pays to purchase the option; in other words, it is the option's price. The premium also represents the amount the seller of the option will collect for assuming on the obligation of the contract. When looking at an option, you will see a bid and ask price, just like you would with a stock.

Note that options in the U.S. are generally for 100 shares of stock. The premium, or price, is quoted for one share. If you see a May 30 call at $4, the price for one contract is 100 shares multiplied by $4, or $400. (1 x 100 x $4 = $400)

Three factors affecting premium

• Time
• The underlying asset price relative to the strike price
• The volatility of the underlying asset

The value of an option is highly dependent on the amount of time left before the option expires. Options are considered wasting assets because they have a limited lifetime and their value decreases as their expiration dates approach. Time value is the portion of the premium that is dedicated to time remaining until a contract expires.

When buying time, the purchaser of an option is buying the possibility that an option's value will increase before the expiration date. As the option approaches expiration, its time value decreases toward zero. In the last two weeks, the weeks just before expiration, their decline in value accelerates. This works in our favor when we are the contract sellers. At expiration, the option's value will be zero unless the option finishes In-the-Money.

In-the-Money, Out-of-the-Money, and At-the-Money

In-the-Money (ITM), Out-of-the-Money (OTM), and At-the-Money (ATM) are three terms used to describe the relationship between an option's strike price and the current price of the underlying stock.

A call option is considered to be In-the-Money (ITM) when the stock is trading higher than the option's strike price, Out-of-the-Money (OTM) when it is trading for less than the option's strike price, and At-the-Money (ATM) when it is trading at exactly or very close to the option's strike price.

For example, the OEX Mar 390 Call would be In-the-Money if OEX was trading for more than $390, Out-of-the-Money if OEX was trading for less than $390, and At-the-Money if OEX was trading for exactly $390. If an option is In-the-Money, it has intrinsic value (value if it were to be exercised).

Intrinsic Value

Intrinsic value is the difference between the stock price and the ITM strike price. In other words, it is the ITM portion of an option's price. For example, if a stock is trading at $37.50 and the strike price on the option is $35, the intrinsic value in the option is $2.50.

Intrinsic value can never be a negative number, but the option does not need to be ITM to have some time value (this is called extrinsic value). Interest rates and stock dividends, if applicable, can also play a small role in the premium.

The General Rule of the Option Pricing

In-the-Money options are more expensive, but their value also increases more quickly as the price of the stock goes up.

Out-of-the-Money options are less expensive, but their values increases more slowly as the price of the stock goes up.

Delta

Delta is one of the "Greeks", a collection of analytical tools used by options traders to measure risk (more in-depth discussion of the individual Greeks is available in Level 2). Delta is the term used to describe the relationship between option price movement and the movement in the price of the underlying stock. Delta is the amount of change in an option's price if the underlying stock price moves by 1 point.

For example, if the stock price on the left increases from $390.44 to $391.44, then the price of the 385 Call (Delta .5463) will increase from $5.50 to $6.04. Delta is positive for call options and negative for put options.

It is important to note that delta is not a fixed value. As an option moves further In-the-Money (ITM), its delta increases. Similarly, the further Out-of-the-Money (OTM) the option becomes, the further the delta decreases.

Why is this important? It will give us insight into why we would want to buy an In-the-Money or At-the-Money option, rather than an Out-of-the-Money option. It is also a concept that, along with the other Greeks, is put to greater use in more advanced options trading strategies.

Volatility

One of the most important aspects in determining the value of an option is the behavior of the underlying stock. Given the many different opinions among investors about how a stock might behave going forward, it stands to reason that individual option traders may also disagree about the value of any given option. This difference of opinion can affect the price of the underlying security dramatically.

This brings us to the important concept of volatility. Volatility is the measure of stock price movement, or how much a stock price moves up and down – the greater the up-and-down movement of the stock, the greater the odds that the option will be In-the-Money during its lifespan. Higher volatility – and the greater chance of being In-The-Money – increases the price of the option.

Volatility of the underlying stock is a key factor in determining the value of an option. As the volatility of a stock increases, an option's premium will likewise usually increase. The difficulty of predicting the behavior of a volatile stock allows the option seller to command a higher price for the additional risk assumed.

There are two types of volatility – historical and implied. Historical volatility is a measure of price movement based on how the security has behaved in the past. Implied volatility is a measurement of price movement as implied by the current market price. It is basically determined by running the model backwards. If our model stated that an options price should be $4 but it was trading at $5, we would plug in 5 for the price and solve for volatility. This number would be the market's opinion of what the future volatility of the underlying issue might be.

Putting it all together

Time and volatility are closely related. Together, they are generally referred to simply as Time Value.

An option can have no intrinsic value and still have worth. However, when nearly the entire value of the option is based on time, risk increases significantly.

• Option price = Intrinsic value + Time value + Volatility + Dividend
• $5.70 = $2.50 + $1.50 + $1.60 + $.10

As you can see, only part of an option's price is made up of intrinsic value.

• Option price = Time value + Volatility + Dividend
• $3.20 = $1.50 + $1.60 + $.10

Now that you know the basics what makes up an option, let's move on to some of the most important option-trading rules that all investors should know.