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Options 101 – A Beginner Guide To Options

Summary

I'm going to write articles on how I use options to enhance income.  This is a primer for those not knowledgeable in this arena.

Options can be very profitable and buying them provides you with leverage.  That same leverage can be deadly if you write uncovered calls.

Writing options for income can be profitable but does still have limited risks you need to be aware of.

My plan was to include this in my first options writing article but decided to put this on my blog instead and reference it in articles where needed. I hope you find it educational.

Calls & Puts - Buyer or Writer:

As a call option buyer, that gives you the right to buy a stock (a contract is usually for 100 shares per option bought) at a set price (strike price), on or before a certain date (expiration date). For that right, you give the option writer a premium. As a call buyer, you expect the stock to raise past the strike price and per-share premium paid. Your maximum lost is the cost of the option with an unlimited upside potential. Such a trade might make sense if you know/think a company has a big announcement coming and believe it will be positive but want to limit your risk if you are wrong or want to play the leverage game.

As a put option buyer, that gives you the right to sell a stock at the strike price on or before the expiration date. For that right, you give the option writer a premium. If you also own the stock, you are buying “insurance” against a major drop. Put buyer is best done when the stock and market are weak.

As a call writer, you expect the stock will be below the strike price on expiration date so you keep the premium. Your maximum gain is the premium but your lost potential is unlimited unless you own the underlying stock; in which case you are a covered-call writer. Writing covered-calls can be used to add income to your account at the risk of having your stock “called away” so this only makes sense if you want to keep the stock but think a major move isn't likely between now and the expiration date or are okay selling at the strike price.

As a put writer, you earn a premium for giving someone else the right to “force” you to buy the stock at the strike price on or before the expiration date. Your maximum gain is the premium with a maximum loss of the strike price * # of shares covered (i.e., the stock goes to $0). Beside earning income, people use put writing as a way of owning a stock at less than the current market price.

When reading articles on option trading, you will see these three terms mentioned and all reference the relationship of the option strike price versus the underlying stock's price.

                                          Call Option                         Put Option

ITM: In the money          Strike < Stock price         Strike > Stock price

ATM: At the money         Strike = Stock price         Strike = Stock price

OTM: Out of the money   Strike > Stock price        Strike < Stock price

Other important terms:

Time Value: An option will always cost more than the difference between the strike and stock price. This is called the Time Value of the option. This is one of the values the writer wants to capture. This chart illustrates that tme decay accelerates closer to expiration.

Source: Fidelity.com Covered Call writing webinar

Implied Volatility: A measurement of how much movement the underlying stock has shown over the past number of days being measure. It is one of the key measurements, along with days-to-expiration and interest rates that help determine the value of the option. I recent webinar from Fidelity included this chart which explains important option terminology known as the “Greeks”. The explained risks were from their covered call writing webinar.

Source: Fidelity.com Covered Call writing webinar

Source for both charts: Fidelity.com Covered Call writing webinar

The above charts covers the basics for covered calls. Beside expiration date, the relationship of the stock and strike price is the other major decision a writer needs to make.

Picking the price to bid at:

Even if the bid/ask spread is narrow, having an idea what the theoretical price is. The best part of the CBOE option calculator is once you enter the strike price and expiration date, it supplies all the other values. This indicates the $3.31 I received was the theoretical price of the option. If the theoretical price was not within the bid/ask spread, you then have to decide to either wait, take less, or bid the theoretical price.

Source: Calculators

www.CBOE.com has numerous articles on option trading in case you want to learn more than the overview I presented here. There are several SA contributors providing articles on how they use options. You can search on “option” and find some of these.