The Joy of Options

Owning stock has only two, maybe three,Selling an option can cost you far more than what
possibilities. The stock goes up. Or the stock goesyou receive for selling the option.
down. Or, as a third possibility, it does a little ofLet's examine the terminology of calls and puts.
both. If you buy a stock, all you want it to do isThe underlying is the actual instrument such as a
go up.stock or commodity that is being represented by
If you sell a stock short or close a position (orthe options contract. In the real estate example,
consider buying it and then decide not to ;), all youthe house would be the underlying. Options are
want it to do is go down. I call thissaid to be derivatives because their value is
one-dimensional trading. You're long, you're short,directly tied to or derived from that of the
or you're flat. Your gains and losses travel up andunderlying. An option has no meaning without an
down the number line you may remember fromactual asset underlying it. It is the right to buy or
elementary school in lock step with thesell that underlying asset that gives the option a
movement of the stock. Not only that, but itreason for being and some value.
takes a big move to make a big profit. And a bigThe strike price is the agreed upon price for
move against you can mean a big loss. Potentiallywhich the underlying can be bought or sold under
all the way down to zero.the terms of the option contract. In the real
You need to add a second dimension to yourestate example, the strike price was $100,000.
trading. You need more choices than picking aThe expiration date, obviously, is the date when
direction and hoping you are right. You need tothe option expires. The day after expiration, an
limit your losses, improve your returns, andoption is worthless. This is the single most
increase your flexibility. You need options.important fact about options that you must
For many people, options are something to avoid,remember. This is why your friends think you are
being dangerous, complex, and scary. I would likecrazy for your interest in options. Unlike a stock,
to introduce you to the joy of options. Any timewhich you can hold forever, an option has a
you think you want to buy a stock, I'd like to getclearly defined shelf life.
you in the habit of first looking at how you couldOne term remains, and that is the premium. The
do more with less using options.premium is what you pay for the option, when
In the stock and commodities markets, the typeyou are the buyer. Or what you receive for an
of option we just described would be known as aoption, when you are the seller. In our real estate
call. A call typically represents 100 shares of aexample, the premium was $500. That's what it
stock. In the commodities markets, a single optioncost you to hold the right to buy the house any
contract represents a single futures contract. (Fortime in that thirty-day period. The last day of the
simplicity, from this point forward, I will talk aboutthirty-day period would, again, be the expiration
options on stock. Just remember that the samedate.
discussion applies to options on futures.)We have barely scratched the surface. I say that
Owning a call gives the owner the right to buynot to intimidate you, but to make you realize
100 shares (usually) of the underlying stock at thethat you only have enough knowledge to be
agreed upon strike price at or before thedangerous to yourself. Please do not think that
expiration date. (I say "usually" 100 sharesyou are ready to go out and buy calls or place
because, due to splits or acquisitions, there arespread trades. You are not. You don't know how
times when an options contract may representan option moves relative to moves in the price of
something other than 100 shares.) Selling a callthe underlying. You don't know what time does to
gives the seller the obligation to sell, if asked, 100the value of an option. You don't know what
shares of the underlying stock at the agreed uponvolatility is or how it plays into option prices. You
strike price any time up until the expiration date.don't know the types of spreads or what they
The other kind of option is called a put, and it isare used for.
exactly the same as a call with one simplePlease, please get yourself better educated
difference. A put gives the owner the right to sellbefore you start putting money into option
100 shares (again, usually) of the underlying stocktrades. Resist the temptation to buy some cheap
at the agreed upon strike price at or before theoptions, just to try it out. This is expensive
expiration date. You can think of a put aseducation. There are plenty of advantages to
insurance. No matter how badly the stock pricetrading options, but it's still a ruthless market,
crashes, having a put means that you can sellhappy to take your money, your wallet, and your
your stock for the strike price. On the flip side,hand if you give it an opportunity. Learn the rules
selling that put means you may be obliged to buyof the game before you put money on the line.
stock at far more than its current market price.Trading options can be satisfying, rewarding,
An important distinction to always keep in mind:stimulating, and fun. I invite you to add another
Buying an option gives you rights. Selling an optiondimension to your trading by including options to
gives you obligations. Buying an option cannot costyour repertoire.
you more than what you pay for the option.