Beginning With The Basics

Assuming you’re just getting into options – before you make your first trade, you need to have a clear idea of what you’re trying to accomplish. Options can be many things to many different types of investors and their portfolios. Determining your goals beforehand helps you to determine the option strategy or strategies to help you achieve those goals.

Options are a great way to jumpstart your portfolio or to even add extra cash flow each month. This comes from their versatility as a security. As things change during the contract period of an option, you can also make changes to your position. Options can also be as conservative or speculative as your investment style dictates.

Examples of investment goals using options could be getting more income from the stocks you already own. Or, You might want to protect the value of your portfolio in the event of a market downturn. Although there are many option strategies to choose from according to your objectives, once you’ve digested everything available at All In The Money, you’ll have a better understanding what strategies you want to use to achieve your investment goals.

Now, with all the aforementioned praise, the versatility of options, just like all securities, involve risks. Even though All In The money focuses on what we feel are among the easiest strategies to comprehend, options as a whole are not simple. Since they’re not, the result is they can definitely be risky. That’s why it’s best to understand at least the strategy you’ll employ and then invest no more than you’re willing to lose. Start with these most conservative strategies and then graduate to more complex strategies as your comfort level and knowledge of Options increases. Regardless of the success you achieve with options, you’ll have a greater knowledge of all types of investing just by learning all about options.

An Option Defined

An option is a contract executed between two parties to buy or sell a financial product (the option) based on an underlying instrument or interest. The underlying instrument can be a stock, an exchange traded fund, or similar. The standard definition is an option is a contract that gives the Buyer the right, but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date. An option contract, just like stocks or bonds, is also a security. Just as important, it is a binding agreement with specific terms and conditions.

An option contract sets a specific price, the strike price. When this strike price is met, the contract can be acted on by the party having the right to do so - as dictated by the contract. There is an expiration date for each option bought and sold. Once an option expires, it is of no value and does not exist anymore.

The Difference Between Options & Stocks

Options seem a lot like stocks. They’re both securities traded on an exchange and orders to buy or sell both are placed through a licensed broker. Option orders are executed on the trading floor of the exchange handling securities in a competitive auction style marketplace. Just like stocks, options also are traded with buyers bidding and sellers making offers. However, with options, the bids and offers are on the rights to buy or sell contracts (100 share increments) of the underlying stock at a predetermined price & period of time. With options, you also follow price fluctuations, volume and other information just like with a stock.

The differences between stocks and options begins with the limited lifespan of an option. Remember there is an expiration with each option bought or sold. A stock can be held for as long as you like with the value rising and falling according to a myriad of factors. If an option is not exercised prior to its expiration, it is no longer a financial instrument. For this, there is a time value for each option. With options, there is not a limited supply available. An option is just a contract between a buyer and a seller supporting defined rights at a predetermined price. The number of outstanding options (which more often is termed Open Interest) is dependent on the number of buyers and sellers willing to receive and confer rights to the underlying stock. The benefit of options is generally only from potential price movement of the stock and premiums that may be received from the initial option trade.

Kinds of Options

There are two types of options, calls or puts. Each option type can be bought and sold according to an investor’s specific strategy they wish to employ in options trading.

A Call gives the holder the right to buy the underlying asset at a certain price within a specific timeframe. Calls are really like having a long position on a stock. Call Buyers count on a stock’s price increasing before the Option expiration date.

A Put gives the holder the right to sell the underlying asset at a certain price within a specific timeframe. Puts are really like having a short position on a stock. Buyers of Puts count on a stock’s price decreasing before the Option expiration date.

Players In The Options Game

People who purchase Options are called Holders and people who sell options are called writers; also, as in the description of Calls and Puts, Holders are understood to have Long Positions and Writers are understood to have Short Positions.

Most importantly, there are two main differences between an Option Buyer – Holder and an Option Seller – Writer. The Holder has no obligation to buy or sell. By paying a fee, the Option Premium, they have secured the right to buy or sell. However, the Writer is obligated to sell. Meaning they may be required to sell based on the direction of the Holder at the time of the Option Expiration.

Just A Little Controls A Lot

Option contracts are only sold in 100 share increments with a specific price, the Strike Price. If and when the stock reaches the Strike Price, the contract may be exercised, or trade can be acted on. Options also have an expiration date upon which the option loses all its value and ceases to exist. Expiration dates always occur on the 3rd Friday of each month.

Main Reasons Investors Like Options

The two main reasons investors use Options are to speculate and to hedge.

SPECULATION

Understand that speculation generally is defined as betting on the price appreciation of an asset. The beauty of Options is that you’re not restricted to price appreciation, you can bet on price depreciation too. Even a sideways market can be your friend toward profits.

Let’s strongly emphasize here that speculation is where big money is made and big money can definitely be lost. Using Options for speculation without limits contributes to the reputation that Options are very risky. This is because, prior to buying an Option, you have to best determine where you think the stock is going to move during the contract period. Because the odds are stacked against anyone without good knowledge and resources, you also need to have a good idea of the financial effects your anticipated position could have should it not turn out the way you anticipate. Once these factors are best determined, make any necessary adjustments and decide whether to enter the trade.

Speculation doesn’t really paint a pretty picture in theory. But the draw of speculation when it comes to options is Leverage. Because just one Options Contract controls 100 shares of the underlying stock, a small movement in that stock’s price can realize a substantial return.

HEDGING

Another main reason people gravitate toward Options is Hedging. Hedging is really like buying insurance to protect against a Stock price downturn. Although this term & concept is a little more advanced for this section, we thought it should be mentioned as a main benefit because of its use by very large institutional investors. Both large and small investors use Hedging to restrict the downside potential of a stock while enjoying the upside cost-effectively.

Buying And Selling Options

If you purchase a call, you are entitled to buy the underlying instrument at the strike price on or before the expiration date. If you purchase a put, you are entitled to sell the underlying instrument on or before the expiration date. In both cases, you are the option holder and also have the right to sell the option to another buyer before expiration or just let it expire.

If you write an option, you have already owned or must buy the underlying security on which the contract is based. This can be done on margin, which can greatly enhance your returns. The flip side is your risk of loss can also be enhanced according to what strategy you are employing. Risk is covered in more detail in other sections of the education area.

As a buyer of an option, you must pay the purchase price called the premium. When you sell an option, the premium is the amount you receive from the buyer. The premium fluctuates constantly until expiration. The premium is basically what buyers are willing to pay at the given time and what sellers are willing to accept at the given time. Much like stocks, buyers and sellers base their decision to buy or sell on a host of factors before a transaction occurs.

When you’ve purchased an option, you start out at a loss or net debit. This basically means if you don’t sell your option profitably or exercise it, you will not recover your money with the trade because the trade does not exist at expiration. Remember, as an option buyer, determining your actual profit you must subtract the cost of the premium from the income you receive from the underlying stock.

If you sold an option, you start out with a gain or net credit, because the option buyer paid the premium to you. If the option is not exercised, you keep this money. If the option is exercised, you still keep the premium, but must sell the stock at the strike price, if assigned, and are not able to take advantage of any price appreciation.

Exercising An Option Instead of Exiting 

A lot of Options aren’t actually even exercised by the Buyer even though they had the right to exercise throughout the contract. However, the majority of Option Holders choose to take their profits by trading out their position. This means Holders sell their options in the market and Writers (Sellers) buy their positions back to close. Analysis compiled by the Chicago Board Options Exchange shows that approximately 10% of Options are exercised, while 60% are traded out and 30% expire worthless

Beginning Option Pricing

We’ll start with the question, is the option “in the money”, or “out of the money”? This is a starting point of what the option may be worth to a buyer or seller. The parties place expectations on where exactly the stock price will be at expiration. A call option is in the money if the current market value of the underlying security is above the strike price and out of the money if it is below it. Conversely, a put option is in the money if the current market value of the underlying security is below the strike price and out of the money if it is above it. If the current market value for the underlying security is equal to the strike price, it is considered “at the money” and assumed worthless.

The Value of An Option Premium:

Options are priced according to Intrinsic Value and Time Value. Both of these variables are forever changing throughout the contract

Intrinsic Value

The amount by which the option is in the money. This means how close the stock price is to the strike price. Only in the money options reflect an intrinsic value. Generally, Options always trade between a Buyer and Seller above the Intrinsic Value.

Time Value

The difference between the current intrinsic value and the current premium. Therefore, the farther you have until expiration, the greater chance the market can work to the benefit of an investor’s strategy.This is why time value is considered to decay as the expiration date nears.

Options Prices

There are many factors that effect individual option prices. Plain supply and demand, just like stocks, is one of the factors. However, you’ll find overall condition of the market and economy effecting option prices. That’s it’s important to gain a knowledge of the market and how it might effect the price of the underlying security in an option contract. It is even more important to study the fundamentals of the underlying security and how conditions might effect pricing to the advantage or disadvantage of your options strategy.

Risks To Weigh Against The Rewards

Most options investors employ strategies that limit the risk. But, when limiting risk, they also limit the potential reward. Investors are attracted to options because the contract allows them to control a larger number of stock shares (and possibly benefit from price appreciation of each of those shares) at lower initial cost. Options allow leverage that a traditional stock purchase and sale does not.

The above is not telling you that you can get rich overnight. In fact, options, just like any investment using the stock market, is a speculative business. The only guarantee is the premium you receive for the contract. Everything that happens afterward outside of what is specified in the contract is left to chance - with the potential loss tied to the underlying security often unlimited.

Options are actually a very flexible investment vehicle. Investors use options daily to safeguard their portfolio, increase cash flow or a host of other objectives. There are so many strategies available to use in a bull market, a bear market or anything in between, more often than not, options are just the right fit.

How To Reduce The Risks

Many option investors use options for risk management against falling a stock price.  If an investor hold shares of a specific stock and there is potential for a dramatic drop in share price, the investor can buy a puts that give the right to sell the stock shares at the chosen strike price if met at any time before the option expires. The only cost to the investor for this insurance policy is the option premium. This is also known as hedging. Options investors can also profit from an option premium’s rise. They might feel better about the potential of underlying security and may choose to sell the option back to the market at an increased premium rather than exercising the option.

There are quite a few option strategies that minimize risk by hedging an existing portfolio. While options can serve as an insurance policy, they’re never without risk. Most option contracts transact within a short timeframe, so great gains can be realized very quickly, but losses can also mount very quickly. You can never learn enough about the risks associated with trading options.

Risk To Principal

Like most securities, options carry no guarantees. You can lose all of your invested principal and, with some strategies, sometimes more. As the holder of an option, your risk is the amount of the premium you paid. As an option writer, the risk can be unlimited. For example, you may be forced to buy shares of stock to cover the position stated in the option contract. Since the contract was written, these shares may have risen in price to a level unacceptable to your initial strategy greatly reducing your working investment capital. However, since option investments usually require less capital than an equivalent stock purchase to control the shares, your potential losses are usually smaller than if you had purchased the underlying stock or sold it short. There is exception when you use options for leverage. With leverage, your returns are often very high, but accordingly, your losses can be high as well.

As you see, it’s just the beginning and there are many considerations. The obvious next step is to begin determining your strategy.

Learn Strategies & Make Them Work For You

Before buying or selling options, you will determine the strategy that best suits your intended investment objective. How do you want options to work for you and your portfolio? If you hope to increase cash flow from your portfolio you will use a different strategy from the investor wanting to hedge against a potential drop in a stock’s price over a specific time period.

A Very Flexible Stock Portfolio

The greatest benefit options have to the investor is their flexibility. They can enhance your portfolio in a myriad of ways. When you’ve determined each of your goals, you’ll be able to marry to them the correct option strategy to help achieve those goals successfully.

Although there are many option strategies, some are relatively simple to understand and implement. For example, All In The Money’s main focus, the Covered Call, is one such simple strategy that we’ve been using for years to present examples of outstanding returns to our members. Of course, we also focus on the Spread and Straddle strategies that allow flexibility in other market conditions as well as safeguard against potential downside.

Of course, we feel it’s important to start simply. By educating and employing these simple strategies with success, you’ll have much better experience when graduating to more complex strategies.

First set the goals, then the strategy you’ll use to meet the goals. Now, it’s time to stay very focused. Some would say that goes without saying. All In The Money can’t say it enough, “Stay Focused”. Option trading is fast paced and can be complicated. Therefore it’s important to also have an exit strategy or a plan when to get out. This can be simple percentage check-points on losses or gains you would be comfortable with and that help out with meeting the goal.

Summary

You've now learned the very basics of options. However, this presentation was not exhaustive of all there is to know from the beginning.

Most important, before you begin trading options it's critical to have a clear idea of what you hope to accomplish. Once you've decided upon your objective, you can begin to examine options strategies to find one or more that can help you reach that goal. For example, if you want more income from the stocks you own, you might investigate strategies such as writing covered calls. Or, if you're trying to protect your stocks from a market downturn, you might think about purchasing puts, or options on an index that tracks the type of stocks in your portfolio

You’ve learned that an option is a contract between a buyer and seller. The buyer of the option has the right, but not the obligation to purchase the underlying security at or before the option expiration. As with most securities, there are no guarantees against risk of losing your entire investment. However, the flexibility of options allows you to employ strategies that limit the downside according to your objective. Knowledge is key and All In The Money can help you to reach your goals with 10% to 25% returns and more each month!