Many people are intimidated by the notion of trading options, fearing that they need to be rocket scientists in order to understand them. My weekly Options Hotline e-alert is one of the longest-running option advisory services available, boasting an almost unbeatable track record. The stock, index or future that you buy the option for is known as the underlying instrument. Options are bought and sold to take advantage for the prices movement in the underlying asset.
There are several benefits to buying stock options as opposed to buying the stock outright. They are relatively inexpensive, particularly when compared to the cost of the underlying instrument. For instance, you might be able to buy stock in XYX Corp. You can control the same amount of stock for a fraction of that price by buying an option instead. The options might be listed for 8 points.
Keep in mind, you are NOT buying stock, you are leasing its profit potential for a given amount of time. The second reason to buy options is because they are flexible. You can profit from options even if the stock goes down. Your maximum risk is known and strictly limited. The final benefit of options is that, like stocks, they are traded on regulated exchanges.
You can expect the same rights and privileges of entering order for options as you can for stocks. Call options give buyers the right to buy a set amount of an underlying instrument usually shares per contract at a specified price the strike price within a set time prior to expiration. Put options give buyers the right to sell a set amount of an underlying instrument usually shares per contract at a specified price the strike price within a set time prior to expiration.
Why would you want to buy calls? You can learn about buying a call by studying the following example: In this example, you are considering acquiring the right, but not the obligation, to buy shares of Home Depot HD: The first part of the offering from left to right is the expiration date. This is the month in which the option will expire, usually on the third Friday of the month. A stock option usually begins trading about eight months before its expiration date.
As a result of the sequential nature of the expiration cycles, some option have a life of only one to two months. A stock option trades on one of their expiration cycles. At any given time, an option can be bought or sold with one of four expiration dates as designated in the expiration cycle table. The can be a bit confusing, so remember, if you buy an option, you must pay attention to the expiration date or risk having your option expire worthless.
After the expiration date, you may no longer exercise your rights and the option becomes worthless. For equity options, the expiration date is typically the third Friday in the expiration month in our example, that month is March. Next, the offering specifies the name of the underlying instrument, the stock, index, or future that the option gives you the right but not the obligation to buy.
In this case, the underlying instrument is Home Depot HD: In this example, you are given the right to buy Home Depot HD: Exercise means the action taken by a call holder if he wishes to purchase the underlying instrument at the option strike price.
If you choose to exercise your option, you are taking a position in the underlying instrument, that is, you are buying the stocks. The next this is to look at is what type of contract it is, call or put. This is a call option to buy option. The final entry is the premium or option price.
This is the price you pay for the option. It can be expressed, as it is here in points, i. The cost per share of the premium, expressed as dollars. Or it can be expressed as dollar. Or it can be expressed as the cost for an option on shares since option contracts are typically in share lots.
You are likely to see the option premium quoted as 2. Real Value is also known as intrinsic value or minimum value. Time value is also known as extrinsic value. It is the amount of the option premium over and above the minimum value of the option. Time value is a function of various factors, including time until expiration and the volatility of the underlying instrument.
It is calculated using a complex formula that helped win its developers the Nobel Prize in economics. When the Home Depot HD: If Home Depot HD: Your call option gives you the right to buy shares of Home Depot HD: If you would have purchased shares of Home Depot HD: When you consider that no matter how badly the movement of Home Depot HD: That power is only afforded to options buyers.
Writers sellers of options are obligated to sell you the underlying instrument at a strike price below the current market price. Likewise, seller of puts are obligated to buy back the underlying instrument from the option buyer you at a higher prices that it is currently worth on the market.
Sellers of options have a limited return and an unlimited risk. But more people lose money buying options, so you need to find a market analyst who you can trust. Here is the key point to ponder: Why would you want the right to buy Home Depot HD: You would do it if you anticipate a sharp rise in the price of Home Depot HD: With Home Depot HD: Its only value is time value — its potential to increase in value over a period of time.
Call options whose underlying instrument is below the strike price are called out-of-the-money options. If the price of the underlying instrument is equal to the strike prices, those calls are at-the-money. Call options whose underlying instrument is trading above the strike price are called in-the-money options. Farther out-of-the-money options are less expensive to purchase and will outperform when the underlying instrument makes a big move in your favor. They are less expensive. At- or near-the-money options cost more, but they are less risky.
This completes the first segment of my research report, Understanding Options. Stayed tuned… Understanding Options, Part 2 will be posted soon. The difference between Call and Put Options Call options give buyers the right to buy a set amount of an underlying instrument usually shares per contract at a specified price the strike price within a set time prior to expiration.
The importance of the expiration date A stock option usually begins trading about eight months before its expiration date. The options premium is made up of real value and time value. Are you beginning to see the powerful leverage provided by options? And option like this is said to be out-of-the-money. Happy Trading, Steve Sarnoff.More...