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Options 101

Options 101
We had a request for an Options 101 commentary.  Although this is not an option based trading service we do have an options message board that some members use to discuss options.  Because of this I will try to give a basic overview of options trading.  It can be an extremely complex venture and would take many commentaries to go over all of the different strategies however for our purposes I will just cover the very basics. 

An option is a contract giving the buyer the right but not the obligation to buy or sell a stock at a specific price on or before a certain date. An option is a binding contract.  When you buy an option you have a right but not the obligation to exercise that option. You can always let the expiration date go by at which point the option is worthless. If this happens you lose 100% of your investment (the money you used to pay for the option).  Options are called derivatives because they derive their value from the underlying stock. 

Calls and Puts
There are two types of options Calls and Puts.  A call gives the holder the right to buy a stock at a certain price within a specific period of time. Calls are similar to having a long position in a stock.  Buyers of calls hope that the stock will increase substantially before the option expires.  A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position in a stock. Buyers of puts hope that the price of the stock will fall before the option expires. 

Option Participants
There are four types of participants in the options market depending on the position that they take: buyers of calls sellers of calls buyers of puts and sellers of puts.  People who buy options are called holders and those who sell options are called writers.  Buyers have long positions and sellers have short positions.  The important distinction between buyers and sellers is that call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose.  Call writers and put writers (sellers) however are obligated to buy or sell. This means that a seller may be required to make good on their promise to buy or sell. Writing is much more complicated than buying and is a very risky endeavor.  You need special approval from your broker to write options and it is not something for the beginner.  For this reason I am just going to concentrate on the buying side of options. 

The Strike Price
The strike price is the price the underlying stock can be purchased or sold.  This is the price that a stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit. This must occur before the expiration date.  Each option represents 100 shares of stock and is known as a contract.  For call options the option is said to be inthemoney if the share price is above the strike price. A put option is inthemoney when the share price is below the strike price. The total cost (the price) of an option is called the premium. 

Speculation is betting on the movement of a stock. The advantage of options is that you are not limited to making a profit only when the market goes up. Because of the versatility of options you can also make money when the market goes down or even sideways. Speculation is where the big money is made and lost. Options have the reputation of being risky because when you buy an option you have to be correct in determining both the direction of the stock's movement as well as the time it is going to take to move.  To be successful you first have to correctly predict whether a stock will go up or down.  Then you have to be right about how much the price will change.  And then if you get both those right you have to pick the time frame that it will take for the stock to move through the strike price.  This is why out of the money options are a losers bet.  The odds are stacked against you but if correct can yield astronomical profits.  When you are controlling 100 shares with one contract it does not take much of a price movement in a stock to generate substantial profits from the option. 

The other function of options is hedging. Think of this as an insurance policy. Just as you insure your home options can be used to insure your stock positions in case your stock moves against you.  For example if you are long 1000 shares of XYZ at $50.00 and you wanted to protect your position against any down side in the stock you would buy 10 put contracts at a strike price of $50.00.  If the stock goes down you still have the right to sell 1000 shares at $50.00 before expiration.  If you just bought the stock you would simply place a stop order to protect yourself rather than a put option.  However this hedging strategy may be for someone who may have bought the stock 5 years ago at $10.00 and does n

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