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  • Basic Options Strategies, A Beginner's Perspective 0 comments
    Feb 13, 2013 2:09 AM

    What are options?

    When you are a new trader options are scary, there's no denying it. The first thing many people see of options is oblique notices from their brokerage about "options risk" or discussions of how the options are trending for Apple (NASDAQ:AAPL).

    Options don't have to be scary though and they don't have to be some foreign entity. There are definitely complex options strategies but I am going to cover two relatively simple to understand options concepts here.

    Options Basics

    An option is like a ticket (carnival or movie, not speeding or parking) that entitles, but does not require the holder, also known as the purchaser, to buy shares in a stock (called a Call option) or sell shares in a stock (called a Put option) at a given price on or before a given day.

    Every option has a strike price. The strike price is the price of the underlying stock or other listing at which the option can be bought or sold if you exercise your option. In some cases a brokerage may automatically exercise an option at expiration if it is at or beyond the strike price.

    A standard option is for 100 shares of stock and expires a week, or month after it is issued. Be aware though that there are non standard options that may have a different expiration schedule and/or may be for more or fewer shares.

    If you are the holder of an option then you are considered to have the long position, if you are the seller, also known as the issuer, of an option then you are said to have the short position. The buyer has the choice to exercise his or her option(s) on or before their expiration date. The seller must fulfill their obligation if their option position is exercised before the expiration date and sell or buy the shares as stated in the option. If the option expires then the seller gets to keep the premium (more on that below) and the buyer gets nothing.

    Option Premiums

    You may be asking at this point, what's the catch? The catch is that options come with a price which is called the premium. Premiums are expressed as a monetary value per share. For a standard contract of 100 shares that means that if the premium is $0.10 then the cost of buying one contract will be $10 (in addition to any brokerage fees).

    If you are taking a long position (purchasing) on an option you have to pay the premium, however if you are taking a short position (selling) an option you get to keep the premium. Using the example above, instead of paying $10 you would make $10 by selling a contract. More on that a little lower down but the important point is that you can use that to make money or to offset a loss in value.

    Strategy 1 - Long Call

    The first strategy I am going to go through is buying call options. The reason that a person would use this strategy is that they believe that the stock price is going to up, however rather than buy the stock now they want to be able to buy it in the future for the price of buying it now.

    CallsBidAskLastChangeVolumeOpen InterestStrike
    770 Call11.8012.2011.80-2.462702342770
    775 Call7.808.308.10-2.2810902325775
    780 Call5.005.205.10-2.0226513230780
    785 Call2.753.102.93-1.6735732320785
    790 Call1.501.751.56-1.2851504405790
    795 Call0.800.950.85-0.8624752414795

    Near the money call options for Google Inc. (GOOG)

    In this strategy the goal is to buy an option in a company before the prices goes up. An example, if you bought a call option for Google with a 795 price that has a 0.80 premium you would not want to exercise your option until/unless the share price reached or exceeded $795.8 per share. Your goal price is the $795 strike price which you'll pay per share when you exercise the option and buy the shares, plus the premium you paid when you bought the option.

    An easy way to remember the goal with this strategy is that, expiration price should equal or exceed the strike price plus the premium cost or (exp >= (strike+prem)). Again, brokerage fee may add to your costs so keep that in mind too.

    The risk with this strategy is that the share price will go down. If that happens then the options are worthless, because exercising them would mean buying shares at above the market rate, and the purchaser of the option loses their premium. The purchaser of the option however has only lost the premium they paid whereas had they bought the shares outright much more could have been lost in share value.

    Strategy 2 - Short Call

    The second strategy is selling call options. To accomplish this you must already hold the shares of the underlying listing that you wish to short and you have to hold enough shares to fulfill the contract which you are selling (generally but not always 100 shares per contract).

    The goal of the short call strategy is to make money when the value of a listing is flat (also called sideways) or the price is going down but the owner does not wish to sell the shares outright. This can be especially a good strategy when the share price is flat but slightly below the cost per share that was paid, allowing for the owner to sell at a profit if the share value rises and/or make money while the share value stays below the price paid.

    CallsBidAskLastChangeVolumeOpen InterestStrike
    770 Call11.8012.2011.80-2.462702342770
    775 Call7.808.308.10-2.2810902325775
    780 Call5.005.205.10-2.0226513230780
    785 Call2.753.102.93-1.6735732320785
    790 Call1.501.751.56-1.2851504405790
    795 Call0.800.950.85-0.8624752414795

    Near the money Call options for Google Inc.

    This strategy is the opposite of strategy one in that the goal in this strategy is for the price to stay flat and below the strike price. In this strategy, if you were to sell a call option with

    If you sold a call option for Google with a 795 price that has a 0.95 premium you would receive $9.50 upon selling the option. During the time between selling the option and the option expiring the shares that are used to back the option cannot be sold. The person selling a call option is hoping that the share price does not exceed the strike price of the option. Unlike buying call options however, the seller cannot exercise his or her options at any time and is at the mercy of the market until the option expires, or gets exercised (generally at expiration). Whether the option is exercised or expires the seller keeps the premium.

    There are two risks with this strategy. The first is that the stock price will rise which forces the seller of the option to sell his or her shares that back the option. If that happens then the seller is out of any gains in share price above the strike price and (depending on the broker) have to pay transaction fees in conjunction with the option(s) being exercised and/or with selling the shares. The second risk is that the stock price might drop, in which case the stock loses value and the owner may be forced to buy back the option at a higher premium and sell the stock at a greater loss than he or she might prefer.

    Conclusions

    Options should be treated with caution and are not for everyone; however, these two strategies when used properly in conjunction with research on the stocks and options that you may wish to use them on can be part of a complete trading strategy.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Themes: options
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