In this options tutorial article, we'll discuss the very basics of Option Contracts. That is, what is an option? Put simply, an option is a contract which you can buy from someone or sell to someone.
Your responsibilities depend on whether you are the one buying or selling. Now before getting into those responsibilities, lets talk about some important characteristics of an option contract and then we'll build slowly on an example. An option contract will always have an expiration date. An option contract will always have what's called a Strike Price.
An option contract can be one of two types: Call or Put Lets talk about each bullet in more detail. I mentioned that an option is simply a contract, but a contract to do what? It is a contract which gives the buyer the right to trade the underlying stock. One option contract is good for shares of that underlying stock.
The contract will also enforce a time frame to make that trade. An option will expire at the close of the third Friday of the stated expiration month. In addition, the contract will specify a strike price. This is referring to the price of the underlying stock not the option itself. Call vs Put But wait, there is something we're still missing. You may be asking yourself, well so what?
That's where another very important characteristic comes into play and that is Call vs Put. So which one do you choose? That depends on your personal belief on how IBM stock will behave. Remember that an option contract has an expiration date. In our example, it is May 15, Well then you want to buy a Put Option. To summarize, a Call Option gives you the right to buy low while a Put Option gives you the right to sell high. Remember that buying the option contract gives you that right.
Which means the person selling you the contract is actually giving you that right. In both scenarios you are buying low and selling high! Now when I say you are buying and selling shares, it's not exactly correct.
That's called an Option Assignment. And your brokerage firm will charge you a small fee for handling the nitty gritty transactions in the back end. Option Premium The one thing we didn't talk about so far is how much does it cost to buy an option contract? That depends on two factors. How close the current market price is to the strike price and how much time is left before the option expires.
These two concepts are called Intrinsic Value and Time Value. A Call Option is said to have intrinsic value if the current market price is above the strike price. The rest of the option price is the Time Value.
A quick side note about how option premiums are stated. When you see an option price quote, you will typically see the price divided by It's stated that way because one option controls shares. Don't be confused or mislead and buy more options than you can handle! For a Put Option, obviously the Intrinsic Value would be based on how much lower the market price is relative to the strike price.
Time Decay An important factor to consider is the decay of time. The Intrinsic Value doesn't decay, just the Time Value. Buying and Selling Options All this discussion was assuming the fact that you would keep the option contract until expiration. But the fact is you may not want to. In reality many people do not buy and hold the option that long. If they see an increase in the option they bought they will most likely sell the option and take their profit.
Now you know that as time proceeds the decay in Time Value will decrease the value of your option. So the only way to make money is to hope that the underlying stock moves in your favour. But if IBM's market price increases as well, the decay in time value may be offset. You can probably guess by now that the closer the market price is to the strike price, the more the option is worth. Now you can wait and see what happens on May 15th, but if you just wanted to take advantage of a short term price swing you can take your profits right now and run.
This section about reading options chains has been out dated, but it is still worthwhile to read through because you may still encounter these in various other websites. Click here to find out the latest method of reading options chains. Now that you know so much about options, lets talk about how to find them and how to interpret what you see.
You can look at the diagram below or go directly to Yahoo by opening another browser page and entering the URL http: As you can see there is a table like the one below: The red circle indicates this is for May The first column shows all the available strike prices.
The green circle shows a weird looking symbol. It's certainly not the symbol for IBM, but it looks similar. There is a standard for listing option quotes which you can see by going to the cheat sheet see link on the right hand navigation.
You can probably figure out the rest of the circles if you've seen stock quotes. A couple of things to point out is the pricing standard and the highted area. It is divided by and then listed. The volume however, has not been divided by anything! It really is The final thing to note is the area highlighted in yellow. Remember we talked about Intrinsic Value? The yellow highlighted options are referred to as "In the money" options. Buyer Beware Until now I've just been giving pure facts about options.
Now I'm going to give some advice. You have to be very careful when trading options. People often tout the upside to options investing while playing down the risks involved. If you watch T. While it is true that you can realize tremendous profits, the chances of you realizing tremendous losses are just as great.. Even the best and brightest investment professionals cannot predict price movement especially over the short term.
They get it wrong just as often as they get it right. At the end of the day, options are meant to add another dimension to your entire investment strategy, so be careful not to get wiped out as soon as you enter the option world. It's best to start out playing 5 to 10 options at a time. If you find you've made some money doing it, then you can risk more capital.
New Options Chains As mentioned above, there is a new way to read options chains and it is quite easy to understand. You will see below: You can see it is almost self explanatory. The red circle represents the underlying stock symbol, the blue circle represents the expiration date, the green circle represents the type of option "C" for Call, "P" for Put , and the black circle represents the the strike price. The one small catch is that the expiration date is stated as the day after the actual expiration date.
I know weird, but the option actually expires as of close of market the day before. In the example above, the expiration date of '' reads , March 22nd. That is, the option is already expired as of that morning. But for your trading purposes you have to make sure that whatever trade you want to make has to get in before the close of market on , March 21st.
Summary Okay, we've gone through a lot of material here. And you might still be confused. I suggest you read the material again or at least the parts where you got lost. Also from the menu above you can refer to a cheat sheet which lists all the important things you need to know about options without the long boring explanations and examples. And don't forget to come back soon for any updates or new material I add to this site. Options for Dummies Learn how to trade options.
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