If you want the definition, there are many websites you can go to, one of them is http://stocks.about.com/od/advancedtrading/a/OptionBa022705.htm
It says that:
An option is a contract that gives the owner the right, but not the obligation, to buy or sell a security at a particular price on or before a certain date.
Investors buy and sell options just like stocks. There are two basic types of options:
- The call option
- The put option
The Call Option
The call option is the right to buy the underlying security at a certain price on or before a certain date.I will explain what call and put options are in a moment. Basically, an option is a derivative. This is because it derives it's price from the share price itself. Unlike pizza voucher which you get for free, options have premiums, i.e. you need to buy if you want to get the options. On the other end someone has to sell them to you as well, if not where can you buy them from isn't it? The seller is also known as the writer of the option because he is the one who writes the contract to be sold, including the strike price and expiry date. In the US, 1 share option contract represents a bundle of 100 shares. So if the premium of the option is $0.2, it actually means $20 per contract because $0.2 x 100 shares = $20 premium. So for the writers of call options, you cannot sell a covered call option if you only have less than 100 shares. Writing naked options is not recommended unless you are already an expert. Naked options are written when you do not own the shares to cover for it.
To explain what premium is, it is basically the same as insurance premiums you pay for your car or your house insurance. You pay around $1000 premium per year for your car insurance right? Well the insurance you receive is actually the same as the option. You have to pay to get it, it has an expiry date, and if the insurance / option is not used after the expiry date it will go to waste. So who sell them? Insurance companies of course. But for options, invidividuals like you and me can also sell them to make money, but very high risk. More on this later. Read the above 2 paragraphs again if you want to because it can be confusing at first. You have to get the general understanding that options are basically similar to the way a pizza voucher or insurance premium works before you can go further.
Option is also called as a wasting asset. This means if not exercised by expiry and not sold, this asset will then expire worthless. An example will be buying a bottle of water and leaving the cap off for a certain period. The water will then evaporate and you will lose the 'asset', which is the water that you bought.
So how is options the same as pizza voucher? 3 Similarities
1. Predetermined price shown on both the voucher / option (eg: $4)
They have a predetermined price to buy the pizza or share. If the pizza voucher say you can buy the pizza for $4 per piece, then even if the pizza's retail price is $7 which everyone else has to pay, you only have to pay $4 when you present the voucher. Same goes to share options, although they call it the Strike Price. If the option you hold says you can buy the shares at $4, then even if the shares are trading at $7, you can still use your option to buy the shares at $7. But when buying options, you can choose the price you want in the option. So instead of $4, you can choose to buy the strike price of $5, or $6 options and this will mean different premiums.
2. Predetermined expiry date
All vouchers and options have expiry dates. You will always see in a pizza voucher that you have to use it before XX date, which is the expiry date of the voucher. Same goes to options. They also have expiry dates. The thing is, when you are shopping for options, there are many expiry dates for you to choose from and the longer the expiry date, the more you have to pay because there is longer time for the price of the share to move in your favour, make sense? I have to point out that for share options, it always expire on the third Friday of the month shown on the option. So if the option says it will expire in March, it means whatever date the Third Friday of March is will be the expiry date. Unless the third Friday is a public holiday and the market is closed. If this is the case the expiry date will be on Thursday, 1 day before the normal expiry day. If you want to know what the third of Friday in March 2009, just go to your monthly calendar and count down towards the 3rd Friday of the month, so first Friday of 2009 will fall on the 6th, second Friday will fall on the 13th and the third is on the 20th. This means the march option will expire on 20/03/2009. For april options they will expire on 17/04/2009. Get it?
3. The right to use / exercise
Voucher / options gives the owner the right to use them. If you have a legit pizza voucher that gives you the right to buy a pizza for $4, the owner of the pizza shop that gives the voucher cannot refuse the deal. He/she has to sell the pizza for you at $4 even if the retail price is $7, as long as it is before the expiry date. I'm sure you know what I mean right? So it is also the same as options. If you have the right to buy the shares at $4/share, you can use the option to buy them at $4 even if the share price is currently at $7. Now the question is who's giving you the shares at $4? That's the person who sold you the option, the same person who received your premium when you bought the option from him/her. Which is why I said before that sellers of options have very high risk because right now this seller have to lose $3/share. Why? Because he should be able to sell the shares at $7/share to the market, but because he's bound by the options contract, he has to sell to you at $4/share, should you wish to exercise the option contract before the expiry date.
CALL OPTIONS
So its time to put all the 3 characteristics of an option to work. Let's start with the call option (just because people gets confused with put options). From the above definition, The call option is the right to buy the underlying security at a certain price on or before a certain date. Let's break this down in laymen's terms. Basically the option giver the owner/buyer the right to buy, and the seller is obigated to sell because it is a binding conract between the buyer and the seller, as I've explained in point 3. The underlying security can be shares, index, ETFs and many more. But for now we will focus just on shares. Certain price has been explained in no.1 above. It is the predetermined price which you have to pay if you want to exercise/use the option (eg: the $4 example in the pizza voucher). Before a certain date just means before the expiry date written in the option contract which is explained in point 2 above.
There are many services out there that offers you trade alerts on which options to buy. These services basically have their own technical / fundamental analysis that tells them which options is good to buy. When they send you a trade alert they will tell you like this:
Buy the C Mar $4 Call for $3.5 or better
This means you should buy Citigroup's call option ( C is the share symbol for Citigroup) that expires on the 3rd Friday of March, with a strike price of $4, for $3.50 premium or less. Better means cheaper premium so it's better for you since you do not have to fork out more money. As said before, the strike price is the predetermined price for the option. So if you decide to exercise this option, it doesn not matter whether the share price of Citigroup is currently $2 or $10, you still have to buy them for $4.
Intrinsic Value (Monetary Value) and Extrinsic Value (Time Value)
From here on it gets a little bit more technical and confusing, but these are the important parts of the option that you have to understand if you want to trade successfully. The premium is made up of these 2 parts, intrinsic and extrinsic value.
Intrinsic value means monetary value of the premium. So if the share is trading at $7 and you have the right to buy it at $4, the intrinsic value is $3. But if the share price is $2 and you have the right to buy at $4, there is no intrinsic/monetary value, but it has a extrinsic/time value of $2. TO make things simple, just minus the share price by the strike price. If the remainder is positive, that is the monetary value. Practical example: You bought an option to buy Citigroup's shares at $4.
1. Citigroup shares are trading at $7 and you paid $3.50 for the premium:
7 - 4 = 3
So $3 is the intrinsic/monetary value.
3.5 - 3 = 0.5
So $0.50 is the time value, more on time value later.
2. Citigroup shares are trading at $2 and you paid $0.2 for the premium:
2 - 4 = -2
So there is no intrinsic/monetary value since the result is negative and therefore $0.20 is the time value.
Time Value
Why is there time value? This is because there is a degree of uncertainty and there is an amount of time where the share price can move. Basically speaking those 2 are the risk for the writer of the option. To compensate for this risk the buyer have to pay the seller some amount of time value for the seller to think it is worth it to sell the option at this price. Think about it if you are the seller, would you sell the $4 for just $3 (making a total of $7)? Of course not because you can just sell the share for $7 straight away to the market right? So there has to be an incentive for the seller which is the $0.5 time value. Why is the writer willing to sell? Simple. That is because the seller has the inverse mindset to the buyer. The buyer thinks the share is going to go up, but the seller will thing the share price is either going down or stay the same, i.e. $7 or less. Because if at expiry the share price is still $7 or less, they will get to keep the $0.5 premium and the shares as well. Even if you decide to foolishly exercise the option when the share is $7, they will just let you buy the shares from him and he can buy them from the market again for the same or lower price should he wish to do so.
In The Money (ITM) and Out of The Money (OTM)
So we have determined what the strike price and the premium values mean, we are going to look at ITM and OTM. Simply speaking if your option premium has an intrinsic value it will be called in the money. If following example 2 above where Citigroup's share price is $2 and you bought an option with strike price of $4, the $0.20 premium will be all time value and is therefore called OTM.
So what is so important about these 2? Very important because generally, basic traders should buy options which are in the money and sell options that are out the money. This is because amateur traders do not have a good feel of the market and how options really works yet. If by any chance the share price does not move at all, at least there is still intrinsic value left for the buyer to sell the options back to the market before it expires. Same for sellers, if the price does not move then the OTM option will not be exercised since no one will not buy the shares from you since the strike price is more expensive than the current market price.
Expiry dates are also important, typically buyers should buy options that are expiring in 3 months or longer. Whereas writers should sell options that expires in the current month or 1 month later. This is because the time value of an option depreciates the fastest in the last 30 days of the option's lifespan.
PUT OPTIONS
This option is basically the inverse of the call option. Whereas the buyers of call options think the share price will go up in the near future, the buyers of the put options think the share price will go down in the near future. But let me make this clear. There are buyers and sellers of call options and buyers and sellers of put options. Sellers of call options are NOT buyers of put options. Please do not get confused between the 2.
Put options gives the buyer the right to sell the shares at a predetermined price before the expiry date. Most share owners buy put options as insurance against their own shares so that if the share price fall below the strike price, they have the right to sell the shares at the strike price. All share owners should have put options as a hedge against their shares. You can buy put options even though you do not own the shares. But why do you want to do that?
Think about watching a football match. You really want to buy a ticket to see this match, but its all sold out. There is this guy sitting near a tree with loads of tickets that he's willing to sell at a higher price. This guy is actually not going to see the match but is making money because there is no tickets left in the ticket booth and the others have no choice but to buy from him. Same goes for options. You do not have to exercise them, but if the options go very deep ITM, you can sell them to someone who wants them at a much higher price. So in the put option's case, is you may not have the shares but you buy them because you can sell them later on to someone else who is willing to pay the appropriate premium for their own reasons.
So what is the difference between a writer of a call option and a buyer of a put option? Both want the share price to go down to make money isn't it? That's true. But the main difference is the level of risk. As a buyer of a put option, if the share price does not go down and in fact, goes up, all you lose is just the premium, or even less if you put a stop loss. But if you write a covered call option, you will regret it if you wrote the option with strike price of $7 and it goes to $20 because you can only, and will have to, sell the shares at $7. Naked call options are even worse. Because you do not own the shares and still have to sell the shares to the buyer at $7, you have to buy the shares at the current market price if the buyer decides to exercise their rights. If the current market price is $20 you have to fork out $1300 [(20-7) x 100] from your account!!! That is why I said selling naked options is a big NO NO, especially for beginners.
Tips for beginners:
1. Buy options instead of selling, you will learn how to sell after you are comfortable with buying options
2. Buy options that are 3 months out or more, if you want to sell options, sell those that are expiring in the current or the next month
3. Buy options that are in the money, or sell options that are out of the money
4. Put limit on loss and limit on profit. Because you should not and cannot be staring at the computer for the whole 8 hours a day that the market is trading so you never know when the share price hits your desired target or crushed your options
5. Create a trade limit. This means how many percent of the money in your trade account will be used as trading. This way if the share prices did not go your way, you will not be crushed. If for example you have $10000 in your trading account and you want to put a trade limit of 10%, that means the other $9000 will not be touched until the $1000 worth of open position has been closed, whether profit or not. After they are closed, then you can use another 10% of the total to open some more positions.
There are many more topics that have not been covered in here but I hope this is enough for me to provide you with the basics of options trading. There are many strategies involved in options trading like the condor, butterfly and the spreads, not to mention the more detailed information of the premium calculations involving the Greeks. If you would like to know more you can search on the internet or e-mail me at barn_83@yahoo.com.sg. Till then, have fun and good luck on your trading!!!
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