Options 101

This information is designed to help those who are new to options trading or those who want to gain a better understanding of options. It is intended to provide you with a BASIC understanding of what options are and the terminology associated with trading options. Please see the definitions.

Successful investing in the stock and bond markets boils down to two simple rules: ‘Buy Low and Sell High’ or ‘Sell High and Buy Low’.

However, while these rules are simple to understand, implementing them is not. This is because no one knows how ‘high’ is high enough and how ‘low’ is low enough. It is a fact that over 70% of ‘professional’ money managers fail to beat the market averages or indices. In other words, less than 30% of the ‘professionals’ actually earn their management fee, the fee paid for their ‘expertise’.

So if we can’t depend on the ‘professionals’ to increase our odds, what can we do? We simply change the rules! We put the odds in our favor by investing just a little money to potentially earn a huge amount of money if we are right and lose just a little money if we are wrong. How? With an instrument called ‘OPTIONS’.

Options make it possible for investors with a relatively small investment to potentially realize a substantial profit due to their inherent ‘leverage’ capability and because options have a known and defined risk. No other investment vehicle provides this combination of absolute risk limitation on the losing side plus virtually unlimited profit potential on the winning side. This is the reason why options have become an increasingly popular investment tool in today’s volatile and often uncertain investment environment.

Although options are relatively simple to learn they are difficult to understand at a level necessary to make money. You’ve probably heard stories of people who made a ton of money trading options, in some cases people have made millions. However, at the other extreme are those who have lost millions trading options. The sad fact is most people lose money. According to David Caplan, author of “The New Options Advantage”, statistical research confirms that the public ‘lose’ in option trading over 80% of the time.

This is where WiseOptions® services can help put the probability in your favor! We have created a proven system based on a mathematical formula that has delivered a success rate better than 80% since July 2003! Both OptionsMAXimizer (OM) and IncomeMAXimizer (IM), give you better odds to succeed at trading options.

What are options?

In essence, options are legal contracts between two people to buy and sell stocks or indices for a pre-determined price within a given time period. Option contracts are traded on an exchange just like shares of stock and can be purchased or sold through a broker just like purchasing or selling stock. There are 2 types of options: CALLS and PUTS.

A CALL option buyer pays a premium to purchase the option contract and has the ‘right’, but not the obligation, to buy stock or indices at a pre-determined price (called ‘strike’ price) within a specified period of time. A call option is purchased when the buyer thinks that stock or indices will go up in value.

The CALL option seller receives the premium from the buyer and has the ‘obligation’ to sell the stocks or indices at a pre-determined price, within a specified time span, if the option buyer decides to ‘exercise’ his/her right to buy the stock or indices.

A PUT option buyer has the ‘right’, but not the obligation, to sell the stock or indices at a ‘strike’ price within a specified period of time. For this ‘right’, the put buyer pays a premium for the stock or indices. A put option is purchased when the buyer thinks that stock or indices will go down in value.

The PUT option seller receives the premium and has the ‘obligation’ to buy the stocks or indices from the put buyer at the agreed upon strike price within the specified time span, but only if the option buyer decides to ‘exercise’ his/her right to sell the stock or indices. Note however, that many dealers/brokers will automatically exercise option contracts that are in a profitable position.

How are profits realized?

By instructing your dealer/broker to sell your option rights, the sale of the option will be accomplished on the trading floor of the exchange. Your net profit will be the difference between the premium you originally paid for the option and the higher price you were able to sell it for, less brokerage and transaction expenses. There is no upper limit on the opportunity for profit. Alternatively, you could exercise the option and buy or sell the shares at a profit. If you sell the option at a lower price than your purchase price you will incur a loss.

Where can you buy options?

Stock options can be bought and sold via most registered brokers. The options are traded on the American Stock Exchange, New York Stock Exchange, Pacific Stock Exchange, Philadelphia Stock Exchange and Chicago Board Options Exchange.  Commodities/futures options can be bought and sold via registerd brokers. They are traded on several exchanges such as CME (Chicago Mercantile Exchange).

How do I read options quotes?

Options quotes on the Internet, such as Yahoo Finance, offer the following information:

Last Trade – indicates an option’s last reported sales price.

Change – an option’s net price change on the day. If ‘pc’ is displayed it means there is no reported price change.

Bid – the highest price any one is willing to pay for the option contract. These are regularly updated during the trading day.

Ask – the lowest price any one is willing to receive for the option contract. Again, these are regularly updated during the trading day.

Volume – displays the volume (in options contracts) that has traded for the current day.

Open Interest – displays the number of contracts available.

Options Terminology:

Ask (offer)

The lowest price someone is willing to sell at the moment. For the buyer, this is the market price.

Bid

The highest price someone is willing to buy at that moment. For the seller, this is the market price.

Bearish

Bearish is the belief that the market or individual stock will FALL in value.

Bullish

Bullish is the belief the market or individual stock will RISE in value.

Buyer

Pays a premium for the right to buy or sell a stock or index option contract.

Seller (or writer)

Receives a premium from the buyer, in exchange for an obligation to deliver or buy the instrument from the option buyer.

Premium

The premium is the amount of money the option buyer pays for the right, not the obligation, to buy or sell a stock or index contract. The premium price is based on open competition between brokers representing buyers and sellers. Option markets are simply supply and demand marketplaces. Trading is subject to the rules of the exchange and are regulated by the regulatory body(ies).

Contract

Options are traded in units called contracts. One option contract covers 100 shares of stock or index. Therefore, the price of an option must be multiplied by 100 to find the total contract price. For example, if an option is trading at $5 then one contract will cost $5 x 100 = $500 plus brokerage and transactions expenses. Option contracts can only be purchased in whole numbers.

Credit Spread (or Limit/Credit)

The difference in value between two options, where the value of the short position exceeds the value of the long position. Note: The long position may not expire before the short position.

Debit Spread (or Limit/Debit)

The difference in value between two options, where the value of the long position exceeds the value of the short position. Note: The long position may not expire before the short position.

Vertical Credit Spread

The difference in value AND strikes between two options, where the value of the short position exceeds the value of the long position. Note: The long position may not expire before the short position AND both options must expire in the same month. The width of the spread is determined by the difference in strike prices in the spread.

Vertical Debit Spread

The difference in value between two options, where the value of the long position exceeds the value of the short position. Note: Both options must expire in the same month.

Exercise

When you exercise your option you submit instructions to your broker to buy or sell the shares at the strike price on which the option is based. The transaction will be settled on the third business day following exercise. Stock options are settled in shares and indices are settled in cash.

Expiration Date

It is extremely important to understand that options expire and their price can decline solely from the passage of time. Options can expire in as little time as a few days or as far out as 2 years and more (called LEAPS). Options expire on the Saturday following the third Friday of the month. The last day to trade them is the third Friday of the expiration month. Many index options expire a day earlier on the Thursday. Note: you do not have to wait for the expiration date to sell or buy your option. Just like a stock, you can sell or buy it at any time – it is entirely up to you.

Intrinsic Value

The intrinsic value of an option is the amount by which the option is ‘in-the-money’. For Call options, your option is considered in-the-money when the stock price is above the strike price. If the stock price is below the strike price it is considered out-of-the-money.

The opposite holds true for Put options. If the stock price is above the strike price the option is considered out-of-the-money and if the stock price is below the strike price it is considered in-the-money.

LEAPS

Leaps = Long-Term Equity Anticipation Securities, an option that can run 2 years or more in time.

Leveraging

Options provide ‘leverage’ which means that even a small favorable movement in the stock or index price can yield a high percentage rate of return on your investment.

Limit Order

You instruct your dealer/broker to buy or sell an option at a pre-determined or better than market price.

Long (long position, going long)

For options and stocks, purchasing or owning (stocks). For example: If you purchased and own Microsoft shares you are long the Microsoft shares.

Market Order

You instruct your dealer/broker to buy or sell an option at the market  (current) price. The broker does his/her best to fulfill your instructions as quickly as possible.

Limit Order

You instruct your dealer/broker to buy or sell an option at a predetermined or set price. The dealer/broker MUST buy the shares or options at the limit price or better (lower price). For example: Buy MSFT (Microsoft) shares at $36 per share or better (lower the $36). The opposite is for a limit sell order. The dealer/broker MUST sell the shares or options at the limit price or better (higher price).

Margin Account

A securities account with a brokerage firm where you can borrow from the brokerage firm to buy stocks or indices.

Options Styles

The term American and European are simply names given to the two styles of options. American style options can be exercised at any time prior to expiration whereas European options can only be exercised at expiration. Both styles of options are available in the United States.

Short (Shorting, going short, short position)

For options: The sale (also known as “writing”) of an options contract.  For stocks: The sale of stock(s) that are not currently owned. Usually the sold stock must be borrowed, typically from a broker. For example: If you sold options or stocks that you do not own you are short the position (short the stock or option).

Stop-Loss Order

You instruct your broker to close a position at a certain price if the market turns against you. A stop-loss order becomes a market order if the price of the item hits the stop limit.

Strike Price

The strike price, or pre-determined price, is a term used to refer to the price at which the ‘deal’ – the contract – was ‘struck’.

Time Value

Time value is the portion of the option premium that is attributable to the amount of time remaining to the expiration of the option contract. Another way of understanding time value is that it is the difference between the value of the option (the premium), and it’s intrinsic value. The formula would look like this: Time Value = Premium – Intrinsic value.

 

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