The Basics Of Investing In Options

If options scare you, or you’re one of those investors that won’t give it a shot, let me preface this by saying options aren’t as difficult as you may think.

Let’s go over the basics of investing in options…

An option is a contract that gives an investor the right, but not the obligation, to buy or sell a stock at a specific price on or before a specific date, or expiration date.

Just like stocks, investors can buy and sell options, including call options and put options.

• Call Options give the buyers the right to buy an underlying security at a specific price on or before a specific date of expiration.
• Put Options give the buyers the right to sell an underlying security at a specific price on or before a specific date of expiration.

When you place options trades, you’ll need to concern yourself with “Buy to Open” and “Sell to Close.”

• Buy to Open allows you to open a long position in an option trade.
• Sell to Close allows you to close that long position in an option trade.

But don’t get hung up on “Sell to Open” or “Buy to Close” at this stage of the game. Selling to Open allows you to take a short position in an option. Buying to Close allows you to cover that short position.

Investing in Options Primer

You may already know that a call option, for example, may show a price of $2, but you’d pay $200 (price x 100 shares).

A strike price is the price that the underlying stock can be bought or sold, as detailed in the option contract. Options are identified by month of expiration, whether they are a put or call, and by a strike price (or the price you believe the underlying stock will reach).

For example, an ABC January 2008 25 call would refer to a call option on ABC with a strike price of 25 that expires in January 2008. Also keep in mind that options expire the third Friday of every month. If for example, you bought the April 25 calls, these would expire the third Friday of April.

Options have limited lifetimes. At expiration, options cease to exist. If you buy an option, you either exercise it (buy or sell the underlying security) or it will expire worthless.

Intrinsic Value and Time Value of Options

Intrinsic value represents how much the option is worth if you exercise it right now. You can find intrinsic value by comparing the strike price to the market price of the underlying security. An option with intrinsic value is in-the-money. It’s current price (CP) minus strike price (X).

If the stock’s current price is greater than the option strike price, the remainder is the intrinsic value. In the case of a call, if the price of the underlying stock is above the strike price, the call is in-the-money. If ABC is trading at $40, and you have a $35 call, you can buy the stock at $5 less than everybody else.

If the strike price is greater than the stock price, the intrinsic value is zero.

In the case of a put, the opposite is true. Intrinsic value would be calculated with X minus CP. A put is in-the-money when the strike price is above the market price of the stock. If you own an ABC $35 November put, and ABC is trading around $30, you are $5 in-the-money. This represents the intrinsic value of the put.

If the strike price of a call is above the price of the stock, the call is out-of-the-money. If you own a XYZ November US$10 call when XYZ is at US$8, there’s no reason to exercise it, since you would automatically lose US$2. If the strike price of the call is equal to the price of the stock, the call is at-the-money. In both cases, you don’t gain anything by exercising the call. The call lacks intrinsic value.

A put is out-of-the-money if the strike price is below the price of the underlying security. An HIJ $80 put is US$12 out-of-the-money when HIJ is at US$92.

There’s also time value. This is any value of that option other than intrinsic. If ABC is trading at $40 and the ABC 35 call option trades at $6, then we’d say it had a time value of $1 ($6 option price minus $5). This is the “insurance premium” of the option.

If I’ve lost you at all, don’t panic. As with everything, “practice makes perfect.”

Delta: Not just an Airline

Delta is based on the underlying security value. Delta is the amount by which an option’s price will change for a one-point change in the price of the underlying asset. Call options have positive deltas, while put options have negative deltas.

A 0.50 delta means that for every US$1 gain in the stock, a call option gains 50 cents in premium. A -0.50 delta means that for every US$1 loss in the stock, a put option gains 50 cents in premium.

That’s it for some of the basics.

Posted in Categories: Contributor, External Research, Options, Stocks, USA.

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