Most of us know what stocks are. I believe to a lesser extent but still a good majority of us know what an index is. But who can tell me what an option contract is? If you said the ‘option’ to purchase a stock, you are correct! To a point. An option is a contract. In it’s most basic form an option is the right, but not the obligation, to purchase or sell an underlying asset at a certain price, by or before a specified date. That means not only stocks in a company, but shares of an index, which is basically a grouping of companies, like the S&P 500 , or the Standard & Poor’s 500 , which is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ (simply put 500 really big companies). Or you can even have an option on currency pairs or futures.
Ok, let’s get back the basics here, after all that’s what this article is about. So, basically an options contract is the right to buy or sell any of these underlying assets at a certain price, by or before a specified date. That’s why it’s an option…the buyer has the ‘option’.
Some definitions to live by if you ever plan to get into options trading:
CALL OPTION – the buyer has the right to purchase the underlying asset at the strike price, by the expiration date.
PUT OPTION – the buyer has the right to sell the underlying asset at the strike price, by the expiration date.
STRIKE PRICE – the price that the underlying asset can be purchased or sold for
EXPIRATION DATE (EXPIRY) – The last date that the buyer can exercise the option
EXERCISE – simple, when the buyer actual decides to use the option to buy or sell the asset.
PREMIUM – the price that the option sells for
AUTO EXERCISE – The options clearing corporation (OCC) has the right to automatically exercise options that are 0.01 or more in-the-money for the buyer only on expiration date.
IN-THE-MONEY – If the underlying asset has appreciated or depreciated in value enough that the buyer can exercise and have a profit that option is said to be in the money
AT-THE-MONEY – If the options strike price is basically the same price or very near the actual market price of the asset the option is said to be at the money
OUT-OF-THE-MONEY – If the underlying asset has appreciated or depreciated in value enough that the buyer will have a loos if they exercise that option is said to be out of the money
If you purchase a contract you are the buyer, if you sell a contract you are the writer (seller) of the contract. Yes, you can right an option and sell it to someone. When they buy you automatically make money! But that money is very risky because if you write a ‘call’ option and they exercise their right to buy that asset (stock, currency pair, etc.) from you then you ARE REQUIRED BY LAW to sell it to them at the agreed upon price called the strike price. And if you sell them a ‘put’ option they have the right to sell you the stock at that strike price. Remember, this is a contract, so there are rules that must be followed and if not followed there are LEGAL ramifications. But even if you follow all the rules, and you write that option, and you get that ‘free money’ when your option gets purchased….Well, now you better have the funds, or the stocks, available if your buyer wants to exercise their option.
Let’s look at an example. You sell this option: Call JNJ Jun 14 87.50 (this is an option to purchase Johnson and Johnson stock at $87.50 by the 3rd week of June 2014, which would be an expiry date of June 21, 2014)
It’s currently 05/25/2014 and guess what since today is Sunday the last trade on JNJ was on Friday for $100.98. I hope you sold that option at a very high premium. Because if I bought it from you there’s a good chance I’m going to exercise it and buy that stock from you at $87.50 because I just made a lot of money and you probably just lost it.
One more thing, one option contract is for 100 shares of the underlying asset (unless you look at the mini options those are 10 shares, but only on certain stocks and indexes). So, that 87.50 strike price means I just bought JNJ from you at $8750 and it’s worth $10,098 right now. If you didn’t have JNJ stock already in your portfolio then you have to buy it (at market price) around $10,098 is what you will spend for it, and sell it to me for $8750. I hope you can see why this type of option trading may not work out for some people.
I do not mean to deter anyone from the profits that are out there if they trade options correctly. I just wanted to point out a very real risk that exists within the option trading world. There are several other risks to consider, but this one is in my opinion by far the greatest because you not only loss the money that you thought you profited from the original option writing but also the money that you loss by needing to tie up your position in the underlying asset.
There are very good ways to protect yourself against this happening, and most options traders use these methods. And thankfully most brokers wouldn’t even allow a trade like this to take place because they do factor in risks with all of their clients trading abilities. I will write more later about different techniques that can safeguard you from this situation, and several strategies that exist with options.
In Summary, if you plan to get into any type of financial trading I highly recommend research, research, and research. And once you have learned everything there is to know about whatever type of trading you are planning to do, do more research. Options are great tools for hedging against loss in your portfolio, and they are suitable tools when trading for income as well, if you know what you are doing and you are right about the way you think the underlying asset will move in price.