2. Value Line:
Understanding and Using Options
Before we go any further we must define the basic
terms of what options are and how we use them.
Call: a contract in which the buyer pays a premium
for the right but not the obligation to buy the stock
(usually 100 shares) at the exercise (or strike) price
anytime until the expiration of the contact. (Calls are
so named because the call buyer can “call” the stock
from the option seller at the exercise price.)
3. Value Line:
Understanding and Using Options
Put: a contact in which the buyer pays a premium
for the right but not the obligation to sell the
stock (100 shares) at the exercise price anytime over
the life of the option. (Puts are so named because the
put buyer can “put” stock to the option seller at the
exercise price.)
4. Value Line:
Understanding and Using Options
Premium: this is the price that the buyer pays for
the call or for the put. An option premium consists of
time value (basically an insurance premium) and, if
the option is in-the-money, tangible value
5. Value Line:
Understanding and Using Options
Tangible value: This is the amount that you get if
you exercise the option. For a call, it is the difference
between the stock price and the strike price if the
stock is above the strike. For a put, it’s the difference
between strike and the stock price if the strike is
above the stock. Since you are not obliged to exercise
an option if it is not profitable to do so, an option can
never have negative tangible value.
6. Value Line:
Understanding and Using Options
Practical examples:
Using a single contract, based on 100 shares, we can
see how options can make or loose us money;
If I buy a call option (right to buy) from A for 100
shares of stock at $6.00 and the stock currently sells
for $5.00 and the premium is $1.00, then I will pay
A $100.00 ($1.00x 100 shares) for the right to buy
the stock at $5.00 If my option is for one month, it
means that by the specified date, the stock may do
several things..
7. Value Line:
Understanding and Using Options
It may go down from $5.00 to $4.00, in which case
the option is “out of the money” $6.00 - $4.00 =
-$2.00. I have lost $100.00.
If the stock remains the same, $5.00 to $5.00 I am
“at the money” The option has no value, $5.00-
$5.00=0.
But if the stock goes from $5.00 to $6.50 then I have
made money, $1.00 - $1.50 = $50.00 and I can ask
to exercise my option
8. Value Line:
Understanding and Using Options
The same effect applies if, in this case I am the seller. I
purchase a put, or the right to sell a stock at a certain
price. If the put is for a $7.12 stock and I think that it will
go down, the put may be set for $7.12. If you were the
buyer you would be hoping that the price would go up. If
the stock goes up to $8.12 then you would make back the
$100.00 you paid for the option to buy and $100.00
more. But if the stock goes down to say $5.00 then you
would buy it from me for $7.12
I as the seller would have made a wise decision. The
worst case situation for me would be if I had sold you a..
9. Value Line:
Understanding and Using Options
A “naked” put. “Naked” means I do not own the stock
that I am selling. I would have to go out on the market
and buy for you the stock. I would have to pay $8.17 or
whatever the asking price was at the time that you send
the request for your stock. I could loose a lot of money
very quickly. This is called “covering your shorts”
Remember, with options you are controlling a block of
stock for a small percentage of what it is “worth”.
The option may become worth more or it may become
worthless. Caveat Emptor.
10. Value Line:
Understanding and Using Options
There are other types of options:
“Straddle Option”:
In a Straddle strategy, you buy both a Call and
a Put for the same stock, with identical expiration
dates and strike prices. This strategy is good for
stocks where you expect volatility but don't
know which direction it will go. You will profit
whether the stock jumps or falls.
11. Value Line:
Understanding and Using Options
We have discussed only a few of the different ways that
options can be used.
Remember that even though the put or call may be
“cheap”, you will have to have a “margin” account. This
means for example, that 100 shares of X may cost
$10.00. The put or call may only be $2.00 a share or
$200.00. But the broker will require that you have in
your account say 40% of the current price of the stock, or
$400.00. If the stock goes up or down, the margin
requirement does as well. That is one of the problems
with “naked” shorts. What you could loose may be more
than what you are prepared to loose.
12. Value Line:
Understanding and Using Options
Options trading is not for everyone. You must decide
much risk you want to take. Know the risks and the
opportunities before you invest.
And again I say “caveat emptor”.
