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Sunday, April 22, 2012

Options - Baby Step Introduction

WHAT ARE OPTIONS, ANYWAY?

Options are not stocks, but contracts based on stock and other instruments (like indexes, ETFs, futures, commodities, et al, and thus piggyback the instrument that is optioned. For the sake of simplicity, let's just discuss stocks. (For example, one can buy an option on Apple stock without actually owning any Apple stock. It is a way of playing the stock market for less money than the stock investor.) Options are traded in quantities of 100 shares, which equals one contract. You cannot trade less than one contract (100 shares) using options. So you can control 100 shares of a stock for a limited amount of time, without actually buying the stock. It provides avenues for making profits that exceed buying/selling stocks. But you have to know what you're doing.

There are two types of options: Calls and Puts

You can think of options trading as 2 persons betting against each other. Stock Options are simple contracts with an expiration date that allow the owners to buy or sell a stock at a specific price (called a "strike price") before the contract expires.

Just the language of options is confusing to the newcomer, so I'm going to try to break it down into simple examples:

HOW DO THEY WORK?

Let's use Apple for our stock option example. (Apple is the flavor of the day anyway, and selling for around $600 per share. Keep in mind it would cost $60,000 to buy 100 shares of the actual stock).

First you have to have an expectation of where the stock price is going. Then you go to an "Options Chain" on your broker's website to find how much it will cost or pay to trade the stock. Here is a typical Chain:


Trading a Call

John thinks the price of Apple is going to go up. He buys one option contract, a CALL, and pays premium of $36.25. (x 100 shares = $3,625.00.

Mary thinks the price of Apple is going to go down. She sells one option contract, a CALL, and receives premium of $35.50 (x 100 shares = $3,550.00.

This contract is traded online, anonymously. John and Mary don't know each other. The orders go into buckets, and are matched, Buys to Sells, automatically.

This contract expires next month on the 3rd week of the month.

Trading a Put

In the same way, they could have traded Puts (instead of Calls).

Mary thinks the price of Apple is going to go down. She buys one option contract, a PUT, and pays premium of $35.45. (x 100 shares = $3,545.00.

John thinks the price of Apple is going to go up. He sells on option contract, a PUT, and receives premium of $34.75. (x 100 shares = $3,475.00.

Both of these trades have the same expectation of the stock movement. So what determines the choice of a Call or a Put? Some people just like to play one or the other. The premiums may be different, and that might influence their choice. There are other details (like how many people are trading today, where is the 'action' and the movement? On the Call side or the Put side?) that can affect the choice.

WHAT ARE THE RIGHTS AND OBLIGATIONS?

• The options buyer has the RIGHT to buy or sell the actual stock.

• The options seller (writer) has an OBLIGATION to buy or sell the actual stock

• The Call option: - Provides the buyer the right to buy the underlying stock at a fixed price,($575) if the stock moves favorably. - Obligates the options writer (seller) to sell the underlying stock at a fixed price($575), if the stock moves unfavorably.

• The Put option: - Provides the buyer the right to sell the underlying stock at a fixed price,($570)if the stock moves favorably. - Obligates the writer (seller) to buy the underlying stock at a fixed price,($570) if the stock moves unfavorably.

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