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Beacon Equity Research

Introduction to Options

Table of Contents

Options Basics

Before you get started trading options, we'd urge you to forget the stories you may have heard about how risky they are, and how some investors have gone bankrupt using them. The truth is that options are designed to help investors limit and manage risk. Over the course of this multi-part series on options we will show you how to not only make money using options, but more importantly, how to save money as well.

THE TWO MAIN USES OF OPTIONS

Investors use options for two primary reasons -- to speculate and to hedge their risk. All of us are familiar with the speculation side of investing. Every time you buy a stock you are essentially speculating on the direction the stock will move. Wall Street has coined the phrase "investing" so that buying stock does not sound so risky, but the truth is that we are always uncertain about which direction any equity investment is going to go. You might say that you are positive that IBM is heading higher as you buy the stock, and indeed more often than not you may even be right. However, if you were absolutely positive that IBM was going to head sharply higher, then you would invest everything you had into buying the stock. All rational investors realize that there is no "sure thing" when it comes to investing, as every investment incurs at least some risk. This risk is what the investor is compensated for when he or she purchases an asset. When you purchase options as a means to speculate on future stock price movements, you are limiting your downside risk, yet your upside earnings potential is unlimited (we'll explain this in more detail later).

Aside from speculation, investors also use options for hedging purposes. A hedge is not just a little green bush in your front yard, it is a way to protect your portfolio from disaster. Hedging is like buying insurance -- you buy it as a means of protection against unforeseen events, but you hope you never have to use it. The fact that you hold insurance helps you sleep better at night. Consider this -- almost everyone buys homeowner's insurance, right? But why exactly do they do this? Since the odds of having your house destroyed are relatively small, this may seem like a foolish investment to make. After all, most of us will never have a fire, flood or any other hazard that would cause us to cash in on our insurance. However, we all continue to pay our insurance premiums every year. Why do we go on paying these hefty fees year after year instead spending the money on something we would perhaps enjoy more? The answer to this question is obvious -- our homes are very valuable to us and we would be devastated by their loss. Because of this fear of loss, most of us will happily pay someone else every year to bear this risk for us, no matter how remote the chances of loss might be. If you employ certain options strategies as a means to hedge your portfolio, you are essentially doing the same thing -- paying someone to protect you from unforeseen risks. (We'll teach you how to do exactly that over the course of this multi-part options trading series.)

OPTIONS CHARACTERISTICS

Options are derivative instruments, meaning that their prices are derived from the price of another security. More specifically, options prices are derived from the price of an underlying stock. This will all become very clear shortly.

Another important thing to understand is that every option represents a contract between a buyer and seller. The seller (writer) has the obligation to either buy or sell stock (depending on what type of option he or she sold -- either a call option or a put option) to the buyer at a specified price by a specified date. Meanwhile, the buyer of an options contract has the right, but not the obligation, to complete the transaction by a specified date. When an option expires, if it is not in the buyer's best interest to exercise the option, then he or she is not obligated to do anything. The buyer has purchased the option to carry out a certain transaction in the future -- hence the name.

Here are a few terms you must first become familiar with before trading options:

Option Buyer (Option Holder) -- Party that purchases and holds the options contract.

Option Seller -- Party that writes, or creates, the options contract.

Strike Price -- The price at which the option seller agrees to buy or sell a certain stock in the future.

Expiration Month -- The month in which the option will expire.

Expiration Date -- This is always the third Friday of the month in which the option is scheduled to expire.

Option Contract -- Each options contract represents an interest in 100 shares of a certain underlying stock.

Put Option -- This type of option gives the option holder the right, but not the obligation, to sell 100 shares of a particular underlying stock at a specified price (the strike price) on a specified date (the expiration date). For example, let's say you were to purchase a put option on shares of Microsoft (MSFT) with a strike price of $50 and an expiration date of March 19th. This option would give you the right to sell 100 shares of Microsoft at a price of $50 on March 19th (the right to do this, of course, will only be valuable if Microsoft is trading below $50 per share at that point in time).

Call Option -- This type of option gives the option holder the right, but not the obligation, to purchase 100 shares of a particular underlying stock at a specified strike price on the option's expiration date. For example, let's say you were to purchase a call option on shares of Intel (INTC) with a strike price of $40 and an expiration date of April 16th. This option would give you the right to purchase 100 shares of Intel at a price of $40 on April 16th (the right to do this, of course, will only be valuable if Intel is trading above $40 per share at that point in time).

Option Buyer (Option Holder) -- An option that, if it were exercised today, would be worth more than $0. In the case of a call option, the option is only considered to be "in-the-money" when the price of the underlying stock is greater than the option's strike price. So, in the case of our Intel example above, the call option will be "in-the-money" when shares of Intel are trading above $40. Meanwhile, in the case of a put option, the option is only considered to be "in-the-money" when the price of the underlying stock is less than the option's strike price. So, in the case of our Microsoft example, the put option will be "in-the-money" only when shares of Microsoft are trading below $50 per share.

Option Buyer (Option Holder) -- An option that, if it were exercised today, would not be worth a single cent. In the case of a call option, the option is considered to be "out-of-the-money" when the price of the underlying stock is less than the option's strike price. So, in the case of our Intel example above, the call option will be " out-of-the-money " when Intel is trading below $40 per share. After all, if Intel is trading for less than $40 (let's say it is at $35), then the right to purchase Intel at a price of $40 per share is completely worthless (if you can buy the stock in the open market for $35, then you certainly wouldn't want to buy it for $40). Options traders use the term "out-of-the-money" to describe this type of situation. The analysis is similar when it comes to put options. In the case of a put option, the option is considered to be "out-of-the-money" when the price of the underlying stock is greater than the option's strike price. So, in the case of our Microsoft example, the put option will be "out-of-the-money" when shares of Microsoft are trading above $50 per share.

"At-The-Money" Option -- An option is considered to be "at-the-money" when its strike price is exactly equivalent to the price of the underlying stock.

EXAMPLE: CALL OPTION CONTRACT

As a quick example; let's say IBM stock is currently trading at $100 per share. Now let's say an investor purchases one call option contract on IBM at a price of $2.00 per contract. Note: Because each options contract represents an interest in 100 underlying shares of stock, the actual cost of this option will be $200 (100 shares x $2.00 = $200).

Here's what will happen to the value of this call option under a variety of different scenarios:

When the option expires IBM is trading at $105.
Remember: The call option gives the buyer the right to purchase shares of IBM at $100 per share. In this scenario, the buyer could use the option to purchase those shares at $100, then immediately sell those same shares in the open market for $105. Because of this, the option will sell for $5.00 on the expiration date (since each option represents an interest in 100 underlying shares, this will amount to a total sale price of $500). Since the investor purchased this option for $200, the net profit to the buyer from this trade will be $300.

When the option expires IBM is trading at $101.
Using the same analysis as shown above, the call option will now be worth $1 (or $100 total). Since the investor spent $200 to purchase the option in the first place, he or she will show a net loss on this trade of $1.00 (or $100 total).

When the option expires IBM is trading at or below $100.
If IBM ends up at or below $100 on the option's expiration date, then contract will expire out-of-the-money. It will now be worthless, so the option buyer will lose 100% of his or her money (in this case, the full $200 that he or she spent for the option).