Understanding Options: Lesson One

I was unaware that my blog was being well-promoted by "The Daily Chow" so I thought to myself, before I make predictions, it might be more beneficial to talk about ways to make money in the market, since a lot of my content is catered for sophisticated traders. I've been a firm believer in options for over two years and have been writing them for just as long. While I was working in a brokerage, one of our clients made over $100,000 off an original $5,000 investment. Needless to say, I was quite jealous. Options are very beneficial, but before I go on, please make sure they meet your risks and investment objectives. At this point in time, I believe that people understand the logic of buying a stock. Buy low, sell high. It's straight forward. This lesson will teach people the basics of options. Tomorrow, after the market closes, I will show how you can profit on call options and how to insure your account with put options. Let's quickly review the terminology used in the options market. When you purchase an option, call or put, you will see two values, which gets confused by many novice traders: premium and strike price. I will go more in-depth later on in the blog. Google [GOOG:NASD] is a stock that trades options. "The $600 calls for February is currently $28.20" (as of 1:30 PM EST today). If you do not understand that entire sentence, continue reading below. If you do, skip to Lesson Two (available January 15, 2010). There are four key items in that sentence that are very important: $600, call, February, and $28.20. $600 is the strike price. This is the designated price that the buyer and seller will agree to trade the stock for, no matter where the stock price is in the near-future. Call represents what type of option it is. A call option allows the holder the right, but not obligation, to purchase Google. A put option does the reverse. It allows the buyer of the optoin to sell their shares of Google, if they have it. February indicates the month of expiration. All equity options expire the third Friday of each month. For January 2010, it is tomorrow. For February, it will occur on the 19th. $28.20 is the premium, and it indicates the amount you must pay today to buy this call option. In turn, the seller will receive $28.20 from you. Two other things you must know is that all options contracts trade in 100-share increments, so you must multiple the $28.20 by 100, but NOT the $600 strike price. That is usually where people get confused, since it really costs $2,820 to buy a $600 call. Secondly, the terms in-the-money, at-the-money, and out-of-the-money are also important. In-the-money means your call option is lower than the current market price. So, if Google is now $700, you have already agreed to buy it at $600, a profit of $100 a share (You buy for $600 and immediately sell at $700). At-the-money means the stock is equal to your strike, and out-of-the-money means Google is below your strike price. With a put, everything is reversed, because the purchase of a put signifies you want the stock to go down. So, in-the-money, if the stock is $500, your put allows you to sell at $600, and so on... Confused? Let me know! It took me a month to learn this. Before you think you've understood it, here's a pop quiz! It's .28 for a Microsoft [MSFT:NASD] Feb 33 put. How much does it cost to buy one options contract of Microsoft and what direction do you want the stock to go? The answer is $28 and you want the stock to go down. If you said $33, please quickly go up and review again. So, now that we have the terminology fully understood, you can see how easy it is to make money, if you are right! A few things that novice traders do not understand is the decay of time value. Time value is like the probability value. Let's use Google again. If you bought the Google option above, you are giving yourself a month for the stock to go above $600. If your neighbour purchased a Google option for March, he has given himself two months. Therefore, it should make more sense that the March 600 Google call should cost more, since the probability of Google going above $600 in two months is much higher than one month. Well, that's the basic terminology and the logic of options. Tomorrow, I will discuss going long options. Please take time to understand this, and do not hesitate to ask me before heading on to the next few lessons. Leave a comment: No questions are dumb!