How do stock options work trade calls and puts – part 2

Getting Acquainted With Options Trading. Many traders think of a position in stock options as a stock substitute that has a higher leverage and less required capital. After all, options can be used to bet on the direction of a stock's price, just like the stock itself. However, options have different characteristics than stocks, and there is a lot of terminology beginning option traders must learn. There's a common misconception that options are confusing and overly complex, but that simply isn't the case. Build on what you learn from this article and see how you can leverage options to build a more robust through taking Investopedia Academy's Options for Beginners course. Two types of options are calls and puts. When you buy a call option, you have the right but not the obligation to purchase a stock at the strike price any time before the option expires. When you buy a put option, you have the right but not the obligation to sell a stock at the strike price any time before the expiration date. One important difference between stocks and options is that stocks give you a small piece of ownership in the company, while options are just contracts that give you the right to buy or sell the stock at a specific price by a specific date. It is important to remember that there are always two sides for every option transaction: a buyer and a seller. So, for every call or put option purchased, there is always someone else selling it. When individuals sell options, they effectively create a security that didn't exist before. This is known as writing an option and explains one of the main sources of options, since neither the associated company nor the options exchange issues options. When you write a call, you may be obligated to sell shares at the strike price any time before the expiration date.

When you write a put, you may be obligated to buy shares at the strike price any time before expiration. Trading stocks can be compared to gambling in a casino, where you are betting against the house, so if all the customers have an incredible string of luck, they could all win. Trading options is more like betting on horses at the racetrack. There they use parimutuel betting, whereby each person bets against all the other people there. The track simply takes a small cut for providing the facilities. So, trading options, like the horse track, is a zero-sum game. The option buyer's gain is the option seller's loss and vice versa: any payoff diagram for an option purchase must be the mirror image of the seller's payoff diagram. The price of an option is called its premium. The buyer of an option cannot lose more than the initial premium paid for the contract, no matter what happens to the underlying security. So, the risk to the buyer is never more than the amount paid for the option. The profit potential, on the other hand, is theoretically unlimited. In return for the premium received from the buyer, the seller of an option assumes the risk of having to deliver (if a call option) or taking delivery (if a put option) of the shares of the stock. Unless that option is covered by another option or a position in the underlying stock, the seller's loss can be open-ended, meaning the seller can lose much more than the original premium received.

You should be aware that there are two basic styles of options: American and European. An American, or American-style, option can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American style and all stock options are American style. A European, or European-style, option can only be exercised on the expiration date. Many index options are European style. When the strike price of a call option is above the current price of the stock, the call is out of the money when the strike price is below the stock's price it is in the money. Put options are the exact opposite, being out of the money when the strike price is below the stock price and in the money when the strike price is above the stock price. Note that options are not available at just any price. Stock options are generally traded with strike prices in intervals of $2.50 up to $30 and in intervals of $5 above that. Also, only strike prices within a reasonable range around the current stock price are generally traded. Far in - or out-of-the-money options might not be available. All stock options expire on a certain date, called the expiration date. For normal listed options, this can be up to nine months from the date the options are first listed for trading. Longer-term option contracts, called LEAPS, are also available on many stocks, and these can have expiration dates up to three years from the listing date.

Options officially expire on the Saturday following the third Friday of the expiration month. But, in practice, that means the option expires on the third Friday, since your broker is unlikely to be available on Saturday and all the exchanges are closed. The broker-to-broker settlements are actually done on Saturday. Unlike shares of stock, which have a three-day settlement period, options settle the next day. In order to settle on the expiration date (Saturday), you have to exercise or trade the option by the end of the day on Friday. Most option traders use options as part of a larger method based on a selection of stocks, but because trading options is very different from trading stocks, stock traders should take the time to understand the terminology and concepts of options before trading them. How do Stock Options Work? Trade Calls and Puts – Part 1. by Darwin on August 10, 2009. Since I routinely post about stock options trading, investing, hedging and income generation and get the occasional question, “ How do Stock Options Work? ” or “ How to Trade Stock Options “, I figured I’d do a series on the various types of stock options strategies out there (they are numerous!) by starting with the most basic stock option strategies: Trading put and call options.

I’ll start with some definitions and then get into some real-life examples. Stock Option Trading Basics: A Stock Options Contract is a contract between a buyer and a seller whereby a CALL buyer can buy a stock at a given price called the strike price and a PUT buyer can sell a stock at the strike price . 1 Stock Option contract represents 100 shares of the underlying stock Think of a CALL and a PUT as opposites. You can be a CALL Buyer OR Seller You can be a PUT Buyer OR Seller Given PutsCalls and BuyerSeller status, there are 4 main types of transactions we’ll cover today – Put Buyer, Put Seller, Call Buyer and Call Seller If you are an option buyer, you pay the listed “premium” for the option conversely, as a seller of an option contract, you derive income equivalent to the “premium” Key Options Terms are the following: Strike Price: This is the key price that drives the transaction. For a Call option, if the underlying share price is BELOW the strike price, the option is “out of the money” and if so at expiry, it will expire worthless. For a Put option, if the underlying share price is ABOVE the strike price, the option is “out of the money” and if so at expiry, it will expire worthless. Expiration: This is the last date the option can be traded or exercised, after which it expires. Generally, there are options traded for each month and if they go out years, they are referred to as LEAPS. The same concepts hold for LEAPS as the stock options contracts we’re discussing here. Premium: This is just another word for the price of the option contract. Underlying Security: For our purposes, we will be discussing stock options. If you’re holding a contract on Microsoft, you have the right (but not the obligation) to exercise 100 shares of MSFT. Buyer or Seller Status: If you are the buyer, you have control of the transaction.

You purchased the option contract and can execute the transaction or close it out or you can choose to allow the options contract to expire (usually only in the case where it is worthless). If you are a seller of an options contract, you are at the mercy of the buyer and must rely on the holder at the other end of the contract. There is the opportunity to “close out” the position. Stock Options Trading Example #1 – Call Buyer: People trade stock options for myriad reasons. Often times, it is purely for speculative reasons. For example, if you believe that the Swine Flu pandemic is going to become particularly troublesome and a stock with a vested interest in supplying vaccines in large quantities would stand to benefit from such a scenario, then perhaps you purchase an out of the money call option on Novavax. If shares are at $4.28 today and you think they could rocket past $10 on a massive epidemic, then perhaps you buy the January (expiry) 10 (strike) Call option. The cost (premium) is .70. The .70 is “per share” so .70*100=$70. This means it’s going to cost $70 to buy a single option contract, plus whatever trading commissions exist. Since you paid .7 or $70 and the strike price is $10 per share, by January expiry (the third Friday of every month), NVAX shares would need to be at $10.70 in order for you to break even. In order to have made money (in lieu of commissions), shares would need to exceed $10.70. If, for example, shares rocket to $20.00 at expiry and you sell the options back to close it out just prior to expiry, you’d pocket the difference between $20 and $10 and reap (10*100shares) = $1000. Given your initial $70 investment, even though shares only went up about 5-fold from $4.28 to $20, the option returned over 14-times the initial investment ($1000$70). As you can see, utilizing these leveraged instruments can lead to big gains quickly. However, most options actually expire worthless – about 23 by most conventional estimates. There’s no free ride. For everyone looking for a speculative home run, there’s a seller on the other side deriving income from a speculative buyer thinking that the stock WILL NOT reach the strike price they sold at, so they’ll get to keep that .7 at the end of the expiry in January.

Note that at the other end is a Call Seller which is often someone engaging in covered call option writing strategies – this can be a lucrative option method worth checking out as well. Stock Option Trading Example #2 – Put Buyer: When wondering if anyone actually made money during the economic collapse, the answer is a resounding YES! People who were holding puts on Financial and Real Estate stocks especially, made large returns on investment given the precipitous declines in shares of those companies. If for example, you feel we’re in for another economic calamity due to commercial mortgages collapsing next, and all Financials are going to fall, you could buy a Put option on the Financials ETF XLF, which is representative of the Financial sector at large. With a share price of $13.34, let’s say you buy a Dec09 expiry Put with a strike price of $10. That means that you expect the XLF ETF to drop well below $10 per share by December. The premium (or your cash outlay) for such a play is .25, or $25 per contract. That’s relatively cheap. But keep in mind that you’re talking about a 40% drop to just break even. If the XLF collapses and returns to its March lows of around $6 per share, your put would be worth about $4 at expriy (10-6). That represents a 16x return on investment. Imagine the players that had the foresight to buy out of the money puts in 2007 and 2008?

How to Trade Stock Options? There are various online brokerage outfits that allow you to trade stock options. For most outfits, you can buy options without any special requirements. If you’re looking to sell options, because your risk is much greater (or unlimited for selling nakeduncovered calls), you generally need to sign up for a margin account and agree to risk notifications. Here are the top online options trading brokerages based on reviews and costing: 1. optionsXpress – Awesome $100 Signup Bonus Running Now. Plus, $12.95 for 1,5, or 10 contracts – flat fee if hitting 35 tradersquarter. Otherwise $14.95trade. A good price for newersmaller options traders. Stocks are $9.95 per trade if greater than 8 trades per quarter or $14.95 for 8 or less trades. 2. Zecco – Another incredible pricing scenario – Get 10 free stock trades every month with $25,000 balance or 25 trades each month $4.50 otherwise. 3. tradeMONSTER – $7.50 Stock Trades across the board. $12.50 Options Trades for up to 20 contracts. 4. OptionsHouse.

com – An incredible $2.95 Stock Trading Price and $9.95 Options Contract Pricing. 5. Tradeking is widely knows as best in class for service and cost. I endorse TradeKing and I have an account myself. $4.95 stock trades and competitive on everything from Options to Margin. Check it out! No related posts. I love TradeKing. I thought that I would never leave Etrade, but I was wrong. There is so much you can do and make with stock options. If you don’t use stock options currently then learn how to because you will make a killing with your little money that you have. Richard Gulino Reply: October 5th, 2011 at 2:52 pm. @Earn Cash Now, I am interested in learning about options and would be grateful for your teaching me.. Hi, I’m looking to invest in mobile app stocks and smartphone stocks.

Can you provide any suggestions? So far I have SWKS, ARMH, MIMV, ZAGG, RFMD and NVDA from this list: wikinvest. comwikiMobile_app_stocks but I need need additional positions. If there are any ETF’s with a focus on mobile that would be great too. Thanks – Phil Cantor. Very useful. I think that options trading has great potential for the non-professional investor as well as the professionals. I think it is necessary to learn about some of the strategies beyond straight forward buying calls and puts. Is it realistic for the home trader to engage in selling options, or should he stick to buying only? Than you so much for all of this great information. Your explanations on the ‘call buyer’ and ‘put’ buyer really helps. Another site that I have found to be very helpful for beginners is ( optionsimple. com). Thanks again.

You have helped me very much 🙂 Where can I find out the prices for put options? I would like to find out how much a put option cost if I had a strike price of the same amount that I bought a stock for and only need it for a short time say 5 days. I want to use it as insurance or protection that my stock doesn’t go below what I bought it for. Binary Options are a Scam to take your money. They are offshore and unregulated by the US. Don’t be fooled if you go to youtube also search for binary options scam. You can give them your money they will take it you can make $50,000 but they will never send you a dime. Also if you give them your personal info. Instant Identity Theft. Good explanation. I always find options to be more complex than stocks but this is a good start. Call Option. A call option is an option contract in which the holder (buyer) has the right (but not the obligation) to buy a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration). For the writer (seller) of a call option, it represents an obligation to sell the underlying security at the strike price if the option is exercised. The call option writer is paid a premium for taking on the risk associated with the obligation.

For stock options, each contract covers 100 shares. Call buying is the simplest way of trading call options. Novice traders often start off trading options by buying calls, not only because of its simplicity but also due to the large ROI generated from successful trades. A Simplified Example. Suppose the stock of XYZ company is trading at $40. A call option contract with a strike price of $40 expiring in a month's time is being priced at $2. You strongly believe that XYZ stock will rise sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ call option covering 100 shares. Say you were spot on and the price of XYZ stock rallies to $50 after the company reported strong earnings and raised its earnings guidance for the next quarter. With this sharp rise in the underlying stock price, your call buying method will net you a profit of $800. Let us take a look at how we obtain this figure. If you were to exercise your call option after the earnings report, you invoke your right to buy 100 shares of XYZ stock at $40 each and can sell them immediately in the open market for $50 a share.

This gives you a profit of $10 per share. As each call option contract covers 100 shares, the total amount you will receive from the exercise is $1000. Since you had paid $200 to purchase the call option, your net profit for the entire trade is $800. It is also interesting to note that in this scenario, the call buying method's ROI of 400% is very much higher than the 25% ROI achieved if you were to purchase the stock itself. This method of trading call options is known as the long call method. See our long call method article for a more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points. Selling Call Options. Instead of purchasing call options, one can also sell (write) them for a profit. Call option writers, also known as sellers, sell call options with the hope that they expire worthless so that they can pocket the premiums. Selling calls, or short call, involves more risk but can also be very profitable when done properly. One can sell covered calls or naked (uncovered) calls. The short call is covered if the call option writer owns the obligated quantity of the underlying security.

The covered call is a popular option method that enables the stockowner to generate additional income from their stock holdings thru periodic selling of call options. See our covered call method article for more details. Naked (Uncovered) Calls. When the option trader write calls without owning the obligated holding of the underlying security, he is shorting the calls naked. Naked short selling of calls is a highly risky option method and is not recommended for the novice trader. See our naked call article to learn more about this method. A call spread is an options method in which equal number of call option contracts are bought and sold simultaneously on the same underlying security but with different strike prices andor expiration dates. Call spreads limit the option trader's maximum loss at the expense of capping his potential profit at the same time. Continue Reading. Buying Straddles into Earnings. Buying straddles is a great way to play earnings.

Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. Read on. Writing Puts to Purchase Stocks. If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. Read on. What are Binary Options and How to Trade Them? Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. Read on. Investing in Growth Stocks using LEAPS® options. If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. Read on. Effect of Dividends on Option Pricing. Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date.

Read on. Bull Call Spread: An Alternative to the Covered Call. As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call method, the alternative. Read on. Dividend Capture using Covered Calls. Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. Read on. Leverage using Calls, Not Margin Calls. To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. Read on. Day Trading using Options.

Day trading options can be a successful, profitable method but there are a couple of things you need to know before you use start using options for day trading. Read on. What is the Put Call Ratio and How to Use It. Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. Read on. Understanding Put-Call Parity. Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. Read on. Understanding the Greeks. In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as "the greeks". Read on. Valuing Common Stock using Discounted Cash Flow Analysis. Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. Read on. Follow Us on Facebook to Get Daily Strategies & Tips! Options Strategies. Options method Finder. Risk Warning: Stocks, futures and binary options trading discussed on this website can be considered High-Risk Trading Operations and their execution can be very risky and may result in significant losses or even in a total loss of all funds on your account.

You should not risk more than you afford to lose. Before deciding to trade, you need to ensure that you understand the risks involved taking into account your investment objectives and level of experience. Information on this website is provided strictly for informational and educational purposes only and is not intended as a trading recommendation service. TheOptionsGuide. com shall not be liable for any errors, omissions, or delays in the content, or for any actions taken in reliance thereon. The financial products offered by the company carry a high level of risk and can result in the loss of all your funds. You should never invest money that you cannot afford to lose. Options: The Basics II. To employ option strategies, you need to know how to find and understand options pricing. If you're going to employ option strategies as part of your portfolio, you need to know how to find and understand options pricing. July 2007 Expiry. October 2007 Expiry.

The first thing you'll notice is the plethora of option symbols, all for just one company! But fear not. It's really quite easy to decipher. An option symbol consists of three components: Option symbol = base symbol + expiration month code + strike price code. The base symbol may be as many as three letters in length, and may be as simple as being the same as the general stock ticker. So, the base symbol for Ford (NYSE: F) is F, the base symbol for General Electric (NYSE: GE) is GE, et cetera. Other companies, particularly those listed on the Nasdaq that may have tickers longer than three letters, are assigned base symbols that may or may not have any relation to the underlying stock's familiar ticker. The expiration month code tells us, in a single letter, when the option expires and whether it's a call or a put. The letters "A" through "L" are assigned to call option, with "A" denoting a January expiry, "B" denoting February expiry, and so on. Letters "M" through "X" represent put options, "M" assigned to January, "N" to February, and so forth. Expiry takes place the third Friday of the associated expiration month. The strike price codes are a little more complicated, given that stock prices themselves can be all over the map. At its simplest, "A" refers to a $5 strike, "B" a $10 strike, and so forth.

The highlighted call in the table has the symbol QAAGR , telling us that the base symbol for Apple options is " QAA ," expiration month code is " G" and signifies July expiry, and the strike price code of " R" corresponds to a $90 strike price. You'll also see three prices quoted. The " Last Price " is simply what it says it is -- the last traded price of the option. However, this last price may have been at a very different price than what the next transaction will occur at. Like any security, the " bid" price is what the counterparty is willing to buy the security for, and the " ask " price is what the counterparty is willing to sell the security for. With options, there can be substantially less liquidity in the market. Consequently, you definitely need to watch the bid-ask spread. You'll note that call prices decline, while put prices rise, as the strike price on the option increases. This is as it should be. If IBM (NYSE: IBM) trades at $95, which call option would you anticipate as more valuable? The one letting you buy shares at $90 (which you could immediately turn around and sell in the market for a $5 profit), or the one letting you buy shares at $100 (which would cost you $5 more than what you would pay on the open market today)? Invoking the old "bird-in-the-hand" idiom, you'd happily pay more for the one that comes with the built-in profit. We'll get to option pricing in our next article. Finally, know that options are sold in contracts for 100 shares. In buying that $90 Jul '07 Apple call, you're buying the right to purchase 100 shares of Apple for $90 before the third Friday in July 2007, and paying $870 ($8.70 * 100) for the privilege.

The last column in the table shows the "Open Interest" on that particular option -- the net number of outstanding open contracts. An opening transaction occurs with an initial buy or sell of an option. A closing transaction takes place at a later date to offset the initial buy or sell. An investor who initially buys a put option adds to the open interest. If the investor later sells that put option to close out his position, it subtracts from open interest. Generally, we don't worry too much about open interest, with one exception -- if you're dealing in options where the open interest is only a few hundred contracts, it signifies that low liquidity I mentioned, likely leading to a wide bid-ask spread. Exercise and assignment. The mechanics of matching an exercising option holder with an assigned option writer is handled behind the scenes by the options clearing corporation. But once assigned, the writer must fulfill hisher end of the bargain, either delivering shares already owned, buying shares on the open market, or shorting shares and delivering those in fulfillment of the contract (of course, the writer then has the obligation to go back at some point and cover the short). Know, too, that exercise at expiry is generally automatic and handled by the options clearing corporation, but again recall that most option traders close out their positions with offsetting contracts prior to expiry -- unless expiry happens to be advantageous to the trader. European or American? Reading option quotes is fairly straightforward, but prices often come with wider spreads than do much more heavily traded stocks. Next up: You know how to get option prices.

Now, what do they mean ? Check out more of our options series here. Jim Gillies has the following options: long January 2018 $175 calls on International Business Machines, short January 2018 $175 puts on International Business Machines, short July 2016 $105 calls on Apple, long January 2018 $95 calls on Apple, and short January 2018 $95 puts on Apple. The Motley Fool owns shares of and recommends Apple and Ford. The Motley Fool owns shares of General Electric Company. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. NotWallStreet. com. Helping Main Street Beat Wall Street Since 1995.

What is an option? In a nutshell, an option is a contract that gives its holder the right (but not the obligation) to buy or sell a certain item at a specific price on or before a specific date… and while an option contract can be written for almost any asset class imaginable, our focus here will be on options that are written for specific stocks andor baskets of stocks (such as those that make up the S&P 500 Index, for example). Options that give their holder the right to buy a specific stock (or index) are called call options, and options that give their holder the right to sell a specific stock (or index) are called put options. Whenever stocks (rather than indices) are involved, all of the major U. S. exchanges have agreed that each contract represents the right to buy or sell exactly 100 shares of the underlying stock… and trading of partial contracts is never allowed. In addition to identifying whether it is a right to buy or to sell, each contract also lists the specific price (called the strike price ) at which the holder of the option can sell the underlying security, as well as the date at which the contract expires (called the expiration date ). On the major U. S. option exchanges, strike prices for stocks are usually set at multiples of $5, though some stocks also have options with strike prices that are multiples of $2.50… and due to demand from traders, many stocks now instead have strike prices at every whole dollar level as well. In addition to this standardized practice for strike prices, the exchanges have also uniformly agreed that the expiration dates for regular “monthly” stock options will always fall on the third Friday of the month named in the contract (however, in recent years, “weekly” options have also started traded on number of the more active stocks). However, it should be noted that index options usually expire around the same time of the month as stock options however, each index option has its own set of rules, so be sure to seek clarification from your broker before entering into any index option trades! How are option contracts identified?

In the same way that each individual stock has its own unique ticker symbol, each option contract is also identified by a unique combination of letters and numbers. In the old days, the option symbol was different than the stock symbol, a “code” system was used to identify the month and strike price… and though it made for shorter symbol lengths, it could be very confusing for investors who weren’t used to the system! Luckily, this system was scrapped a number of years ago, and though the “symbol” associated with each option is now several characters long rather than it used to be, it is also much, much easier to read and understand! Under this new system, the symbol for an option contract is made up of five straightforward components that are all scrunched together into one long symbol – the underlying stock symbol, followed by the date of expiration (which will be the Saturday after the third Friday of the month, listed in the format yymmdd), a “C” or “P” to identify whether it is a call or a put, then five digits represent the whole dollar portion of the strike price followed by three digits representing the “cents” part of the strike price. For example, to generate a symbol for an Affymetrix call with a strike price of $5 expiring in November 2013, we would need to first find out the underlying symbol of Affymetrix (it is AFFX) and the actual date of the Saturday after the third Friday in November 2013 (which happens to be the 16th). Putting all this information together in the format described above, we get a symbol of AFFX131116C00005000. Which months can you buy options for? Though there are also “weekly” options available to trade these days, when it comes to the “monthly” options, they are always available for the month that contains the upcoming expiration date, the month after that, and then a series of months that are spaced three months apart. When options are first made available on a stock, that stock gets assigned to be on either a January-, a February-, or a March-cycle… and this designation determines which months will be used for options going forward (a company on the February cycle, for example, will always have the options available for the following months: a) the current month of expiration, b) the next month after that, and 3) some combination of February, May, August, and November).

In addition the short-term options that trade on this cycle, some stocks also have LEAPS traded on them. LEAPS is an acronym for Long-term Equity AnticiPation Securities, which is just a fancy way to say “longer-term option.” The life of these contracts is often measured in years rather than months, and they always expire on the third Friday of January in the year specified by the contract. Who sells options, and how are they priced? In addition to buying options, it is also possible for both individuals and institutions to sell (write) options however, much of the writing is done by institutions and professional investors rather than individual investors (who tend to like prefer to take the gambler’s side of the trade, i. e. to buy the options rather than sell them). When it comes to option prices, the primary determinant of an option’s price is the perceived likelihood of the option being exercised on or before its expiration date. Of course, there are numerous factors that influence this variable: the amount of time left on the option contract, the distance the stock is from the strike price, and the chance of the stock traveling that distance before the option expires are three of the big ones. In addition to these three primary forces, there is also a dose of supply-and-demand thrown into the mix, and thus option prices also tend to be influenced by the level of demand (or lack thereof) seen for them in the marketplace. Of these factors, the passage of time is the only one that investors can predict with 100% certainty, and thus it plays one of the largest roles in determining option prices (options with more time left on them will have a higher price than options with similar strike prices but less time remaining). It is important for both sellers and buyers of options alike to realize that all options lose a portion of their value as time goes by, and this “time decay” accelerates as the option gets closer and closer to expiration. Though a discussion of it is beyond the scope of this discussion, investors who are interested learning more about how the pros value options are encouraged to investigate a nifty bit of mathematics called the Black-Scholes Equation. What are the “basic” option trades?

Though more advanced option traders love to spend their time talking about spreads, butterflies, strangles, naked calls and naked puts (actual things – not porn for option junkies!), collars, condors, and all sorts of other fun and exciting strategies that can be employed when trading options, it is important to gain a basic understanding how options work in their simplest form before tackling some of those more advanced strategies. The following four actions represent the most common “first option trades” that investors new to options trading often make: What it is: Buying a call gives the holder of the contract the right to purchase 100 shares of stock at a certain price on or before a certain date. When to use: Investors would execute this method if they were bullish and felt that a stock going to move up towards (and hopefully past) the strike price before the expiration date. How money can be made: money is made if the stock rises quickly enough. How money can be lost: as time goes by, the option loses time value (shorter duration = shorter time premium) if the option is below the strike price at expiration, it results in a 100% loss of capital. Potential risk: limited to 100% of investment. Potential reward: unlimited. What it is: Buying a put gives the holder of the contract the right to sell 100 shares of a stock at a certain price on or before a certain date. When to use: Investors would execute this method if they were bearish and felt that a stock going to move down towards (and hopefully past) the strike price before the expiration date. How money can be made: money is made if the stock falls quickly enough. How money can be lost: as time goes by, the option loses time value (shorter duration = shorter time premium) if the stock is above the strike price at expiration, it results in a 100% loss of capital. Potential risk: limited to 100% of investment.

Potential reward: unlimited* *in reality, the reward is bounded by the magnitude of the strike price itself, since no stock can fall below $0. What it is: selling a call obligates the writer of the contract to sell 100 shares of stock at a certain price if the holder of the contract exercises their right to buy on or before the expiration date. When to use: Investors would execute this method if they were bullish enough on a stock to own it but bearish enough to think it was not likely to rise above the strike price before the expiration date. How money can be made: money is made if the stock rises slowly (or not at all), thus causing the option to lose time value if the stock is below the strike price at expiration, the option expires worthless and the seller keeps 100% of the premium received for writing the contract. How money can be lost: the stock rises quickly if the stock rises above the strike price, the seller of the contract may have their stock called away from them (thus resulting in a “missed opportunity” cost as the rally in the stock is missed out on). Potential risk: limited to the losses that might be attained through depreciation in stock price (less the premium for writing the contract). Potential reward: limited to the difference between the stock price and the strike price at the time the contract is written, plus the premium received for writing the contract. Please visit Covered Call Basics on our website for additional information on this method! What it is: selling a put obligates the writer of the contract to purchase 100 shares of stock at a certain price if the holder of the contract exercises their right to sell on or before the expiration date. When to use: Investors would execute this method if they were interested buying a particular stock at a price lower than the market price but were not sure if the stock would ever drop below that price. How money can be made: the stock stays above the strike price and the option loses value due to time decay the stock is above the strike price at expiration, the seller keeps 100% of the premium received for writing the contract. How money can be lost: money can be lost if the stock falls too quickly. Potential risk: limited to the difference between the stock price and the strike price at the time of expiration (less the premium received for writing the contract). Potential reward: limited to the premium received from the writing of the contract. How do stock options work?

Job ads in the classifieds mention stock options more and more frequently. Companies are offering this benefit not just to top-paid executives but also to rank-and-file employees. What are stock options? Why are companies offering them? Are employees guaranteed a profit just because they have stock options? The answers to these questions will give you a much better idea about this increasingly popular movement. Let's start with a simple definition of stock options: Stock options from your employer give you the right to buy a specific number of shares of your company's stock during a time and at a price that your employer specifies. Both privately and publicly held companies make options available for several reasons: They want to attract and keep good workers. They want their employees to feel like owners or partners in the business. They want to hire skilled workers by offering compensation that goes beyond a salary. This is especially true in start-up companies that want to hold on to as much cash as possible. Go to the next page to learn why stock options are beneficial and how they are offered to employees. Related Content. Recommended.

Get the best of HowStuffWorks by email. Keep up to date on: What is an option – Part 1. Options are financial instruments that provide flexibility in almost any investment situation. Options give you options by providing the ability to tailor your position to your situation. You can protect stock holdings from a decline in market price. You can increase income against current stock holdings. You can prepare to buy stock at a lower price. You can position yourself for a big market move, even when you don’t know which way prices will move. You can benefit from a stock price’s rise or fall without incurring the cost of buying the stock outright. The following information provides the basic terms and descriptions that investors should know about equity options. Describing Equity Options. An equity option is a contract that conveys to its holder the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) shares of the underlying security at a specified price (the strike price) on or before a given date (expiration day). After this given date, the option ceases to exist. The seller of an option is, in turn, obligated to sell (in the case of a call) or buy (in the case of a put) the shares to (or from) the buyer of the option at the specified price upon the buyer’s request.

Equity option contracts usually represent 100 shares of the underlying stock. Strike prices (or exercise prices) are the stated price per share for which the underlying security may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract. Do not confuse the strike price, a fixed specification of an option contract, with the premium. Premium is the price at which the contract trades. This price fluctuates daily. Equity option strike prices are listed in increments of .5, 1, 2.5, 5 or 10 points, depending on their price level. Adjustments to an equity option contract’s size, deliverable andor strike price may be made to account for stock splits or mergers. Generally, at any given time, you can purchase a particular equity option with one of at least four expiration dates. Equity option holders do not enjoy the rights due stockholders (e. g., voting rights, regular cash or special dividends). A call holder must exercise the option and take ownership of underlying shares to be eligible for these rights. Buyers and sellers set option prices in the exchange markets. All trading is conducted in the competitive manner of an auction market. The two types of equity options are calls and puts. A call option gives its holder the right to buy 100 shares of the underlying security at the strike price, anytime before the option’s expiration date.

The writer (or seller) of the option has the obligation to sell the shares. The opposite of a call option is a put option, which gives its holder the right to sell 100 shares of the underlying security at the strike price, anytime before the option’s expiration date. The writer (or seller) of the option has the obligation to buy the shares. An option’s price is called the premium. The option holder’s potential loss is limited to the initial premium paid for the contract. Alternately, the writer has unlimited potential loss. This loss is somewhat offset by the initial premium received for the contract. For more information, visit our Options Pricing section. Investors can use put and call option contracts to take a position in a market using limited capital. The initial investment is limited to the price of the premium. Investors can also use put and call option contracts to actively hedge against market risk. Investors can purchase a put as insurance to protect a stock holding against an unfavorable market move while maintaining stock ownership. A call option on an individual stock issue may be sold to provide a limited degree of downside protection in exchange for limited upside potential. Our Strategies Section shows various options positions and explains how options can work in different market scenarios.

The underlying security (such as XYZ Corporation) is the instrument that an option writer must deliver (in the case of call) or purchase (in the case of a put) upon assignment of an exercise notice by an option contract holder. Most options that expire in a given month usually expire on the third Friday of the month. Therefore, this third Friday is the last trading day for all expiring equity options . This day is called Expiration Friday. If the third Friday of the month is an exchange holiday, the last trading day is the Thursday immediately preceding this exchange holiday. Many products now offer short-term options with weekly expirations, so investors should know the exact contract terms, including expiration dates, for all contracts they trade. After the option’s expiration date, the contract ceases to exist. At that point, the owner of the option who does not exercise the contract has no right and the seller has no obligations as previously conveyed by the contract. Content Licensed from the Options Industry Council. All Rights Reserved. OIC or its affiliates shall not be responsible for content contained on Company’s Website, or other Company Materials not provided by OIC.

Content licensed from the Options Industry Council is intended to educate investors about U. S. exchange-listed options issued by The Options Clearing Corporation, and shall not be construed as furnishing investment advice or being a recommendation, solicitation or offer to buy or sell ant option or any other security. Options involve risk and are not suitable for all investors. Lightspeed. products and services. Copyright © 2001-2017, Lightspeed Trading, LLC. All Rights Reserved. How Stock Options Work Series: Covered Call Writing. by Darwin on September 11, 2009. Covered Call Option Writing is the subject of this edition in a series on how to trade stock options for income, hedging or pure speculation (see How Stock Options Work: Puts and Calls for intro). As outlined in my introductory article, a call option grants the holder the right to exercise the option when a stock is “in the money” after the call seller had captured a premium for initiating the transaction. The call option owner (for all practical purposes) then captures the difference between the current share price and the strike price times 100 since an options contract controls 100 shares. What is a Covered Call?

In the case of covered call option writing, the investor holds 100 shares of the underlying stock for each option sold. If you own 100 shares of corporation XYZ trading at $50 per share and sell 1 Call Option Contract with a strike price of $60 and January expiration for $500, as long as shares are below $60 upon expiration in January, you’d keep the $500 because the contract would expire worthless. If shares move past $60 and the option holder exercises the option (which they generally do at the very last moment, unless there’s a dividend date in play), you can either buy back the option or when exercised, your shares will be unloaded at $60, regardless of where the stock is trading. Covered Call Option Writing Example – Real Life: Apple. Here’s an example I actually employed with Apple earlier in the year (and I continue to roll the same position as Apple shares continue to appreciate). Note that even though Apple shares DECLINED during the period of the transaction, I actually made money! $600 in 3 months time for holding a stock I wanted to hold anyway. Bought 100 shares APPLE (AAPL) at 94.6 = $9460 Outflow. Sold a Call with April09 Expiry 110 strike for 11.30 = $1130 Inflow. Closed out Call (bought back) for $120 = $120 Outflow. Purchase ($9460) – Current ($9050) = $410 loss on shares. Option Inflow ($1130) – Outflow ($120) = $1010 gain on option. Net Gain of $600 in 3 months when shares declined.

When shares move in the right direction, such as the move from when this was first published in Feb09, the gains are astounding. You can get both the capital appreciation AND the option income. Benefits of writing covered calls. Selling covered calls works out great in a flat or moderately declining market. The investor captures income from the sold calls while holding the underlying stock that they want to hold anyway. Tax Benefit method – Let’s say you’re sitting on a huge gain on shares of a particular stock and it’s September. For tax reasons, you don’t intend on selling the shares until next tax year to avoid having to pay taxes next April. You’re resolved to hang on to the stock into the new year whether it moves up or down. So, why not sell a covered call with January expiration? In addition to the capital gain you already have and any additional gains, you can guarantee yourself the income from the sold call as well.

If the share prices have run up significantly, an options contract is going to carry a nice premium for income. If the stock moves past the strike price , it’s trouble right? Well, only if you sit on your hands – and even then, you’ve just reached your max gain, but you still made money – don’t we all wish we had that problem! You can always “move the chains”. This is what I’m doing now with Apple shares since they’ve almost doubled from when I first began this method. As long as there’s still some time left on the option, the holder at the other end isn’t going to exercise it because they’re leaving money on the table. There is plenty of “time premium” left on the option. They will ride it out. For full disclosure, I’ve been selling covered calls against Apple shares for some time now and at this point, shares have risen so quickly that the sold call is actually in the money now. I have a Jan 160 call outstanding against my 100 shares. But that’s OK! I’m sitting on a $7000 gain on the shares and I’ve made a few thousand dollars now selling covered calls on the way up. And what happens between now and January? Who knows – read on… What do I mean by time value being left?

Take a look at Apple as of 91109. Share price is 172. The January 160 strike Call is 21.1, which means it’s worth $2100. The difference between 172 and 160 is 12. So, 12 (or $1200) is the intrinsic value (this is easy to calculate yourself). However, 21.1 minus 12 is 9.1. There’s $910 in extra value left on this option. If the holder exercised the 160 Call that I had sold, they’d be leaving all that time on the table, and I’d be given a free $910 today because I could just enter into the same exact position again. You get Paid to Wait Around and do Nothing – With $910 of time value on the option and about 5 months to go until expiry, (this is a rough calc), I’m making about $9105 = $182 per month for riding it out. The riskreward toward January is such that a holder of that call option just might get around to exercising it though. If Apple shares are at 200 and there’s only $100 left in time value, they’ll give up the $100 to capture the $4000 gain (200-160)*100. So, that’s why I need to keep my eye on that position toward the end of the year, but for now, I’m just letting it ride. What are the Risks of Covered Calls? There’s no free ride. If there were, everyone would be doing it and market equilibrium being what it is, any easy gain would quickly be wiped out through arbitrage.

Some obvious and not so obvious risks include the following: You need to buy 100 shares of stock to be fully protected with a covered call. This puts many stock plays out of reach of investors. With Google shares in the stratosphere, do you want to be dropping $50,000 to start a covered call position? There are cheaper stocks and there are ETFs as alternatives (see this list of ETFs with their mid-year performance for some ideas). You shares can decline. While obvious, if you weren’t doing a covered call method, perhaps you would have purchased only 30 shares of something. Now you’re buying 100. Keep in mind that you won’t lose “as much” money because your stock losses are offset by the option premium you received. However, to write another call option once your shares have already taken a haircut requires you to distance yourself from the purchase price emotionally and sell another call for what might be a net losing position. You CAN have your shares called away. This can happen at any time. While it’s unlikely to occur with a lot of time value left on the option for the reasons I mentioned above, you do have to engage in a little dance with riskbenefit and perhaps close the position yourself. Fees – Not only do you incur a trading commission each time you sell a new call option, but if your shares are exercised out from under you, you can incur significant fees as well plus you need to buy back shares again if you want to start over and then you’re subject to the Wash Sale Rule. Here are the top online options trading brokerages based on reviews and costing: optionsXpress – Awesome $100 Signup Bonus Running Now.

Plus, $12.95 for 1,5, or 10 contracts – flat fee if hitting 35 tradersquarter. Otherwise $14.95trade. A good price for newersmaller options traders. Stocks are $9.95 per trade if greater than 8 trades per quarter or $14.95 for 8 or less trades. Zecco – Another incredible pricing scenario – Get 10 free stock trades every month with $25,000 balance or 25 trades each month $4.50 otherwise. tradeMONSTER – $7.50 Stock Trades across the board. $12.50 Options Trades for up to 20 contracts. OptionsHouse. com – An incredible $2.95 Stock Trading Price and $9.95 Options Contract Pricing. Tradeking is widely knows as best in class for service and cost. I endorse TradeKing and I have an account myself.

$4.95 stock trades and competitive on everything from Options to Margin. Check it out! No related posts. 1) “as long as shares are below $60 upon expiration in January, you’d keep the $500 …” The call seller keeps the $500 no matter what happens and no matter where the stock is trading. 2) “You get Paid to Wait Around and do Nothing” Although that statement feels true, you are not ‘doing nothing.’ You are (i>accepting the risk that the stock will tumble. In your case it’s a stock you want to own anyway – but that’s not going to be true for all covered call writers. Good explanation of the method. Love it. Thanks for the compliment Kevin. Mark – Thanks for the note – on #1, wording could have been a bit better – meant to convey that the $500 is yours to keep with no strings attached. However, if shares bust past the strike, the $500 could be offset by the outflow you’re going to need to buy back the option to close it out to not have your shares swept away.

#2 – yes, was a bit oversimplified. Thanks for keeping me honest! Hi – With weekly options now being more widely available and on stocks like Apple, Amazon, Bidu, the potential returns are huge per week. And, it’s a lot easier to look out just one week rather than whole month to see what the best strikes will be. I like your example (AAPL). I’ve been writing calls on AAPL for so long that my adjusted cost basis is below zero. And as Tim says, now they have weeklys on AAPL so you have 52 expirations per year. Nice. Good covered call screener here: Born To Sell (as well as free covered call tutorial, newsletter, and blog). Good summary. For another example see this link: This is a good method for people who only have a couple grand in their account but want to gain some experience. There are lots of good stocks that trade $20-$30 you could use a CC method on.