Wednesday, November 5, 2014

Back to basics: a crash course in options

In a decidedly uncharacteristic post, here is (hopefully) a helpful post for option novices.

What are these option things that you keep talking about?

Options are contracts (traded electronically like stock) for buying or selling of 100 shares (or 10 for mini options) of a specified stock at a fixed price for a fixed time.

The specified stock is generally referred to as "the underlying"
The specified price is generally referred to as "the strike price"
The specified time is generally referred to as "days to expiry" (on the "expiration date")
The amount of money that exchanges hands is "The premium" 

But since these are all contracts, the terms of the contract must be met before the option expires. Otherwise, the value of the option plummets to zero.

Now lets take a little aside: in the stock market, when something plummets to zero, that's a bad thing. (Unless you're a short-seller, which I'm not.)  But with options for any given expiry date, 1/2 of them on the board will have no residual value because the terms were not met.

Back to business: how do the terms get met?  The stock price has to be "in-the-money" (ITM). If your option position is "out-of-the-money" (OTM) at expiry, then it will expire worthless.

If your position IS ITM at expiry (and sometimes before) , you will get assigned.  (This could be the forced buying or forced selling of the underlying shares depending on which type of option you have).

Now that doesn't sound all that hard does it?

Unfortunately for the novice, this is where the mind-job begins!

The options that traders trade come in two types: puts and calls.

If you BUY a call, you want to BUY shares if (and only if) the share price climbs up to your strike price.  eg: you like company ABC, but they have been having trouble lately. You're only interested in buying the shares once they have fixed their issues and are climbing in value.  Thus you would buy a call for ABC with an expiry as long as you would like.  (Longer terms cost more though)

If you BUY a put, you want to SELL shares if (and only if) the share price FALLS below your strike. eg: You own shares of ABC. You like them, but are worried that their new drunken CEO might spoil the party.  You BUY a put to insure your position and your profits.  If the drunken CEO bankrupts the company your put will deliver you your desired price thus saving your money from yet another CEO scandal.

Now how do you use this to your advantage?  There are many many ways to do this. But that's well beyond the scope of this brief, introductory post.  Because you can use calls (by selling them) to SELL your shares and you can use puts (by selling them) to BUY shares.  (Yes I know, that's completely the opposite of the above)

Now I can hear your heads shaking and eyes rolling.  Take a break!  Read this again later.  Ask me questions.  Look up the terms, and the strategies online.  Covered call, short-put (naked put).  Once you understand a naked put (or cash-covered put) then we're ready to talk about my go-to moneymaker: the bull-put-spread.

Stay HUNGRY my friends!

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