Options Basics

• Buying an option gives you the right to buy or sell an underlying security.
• As an options buyer, you have the right, but not an obligation, to buy or sell an underlying security at a specified price.
• As an option seller (writer), you have obligations to the options buyer.
• There are two types of options: Calls (call options) - give you the right to buy an underlying security. Puts (put options) - give you the right to sell an underlying security.
• Each option corresponds to 100 shares of an underlying security.
• The price of an option depends on several factors: The current price of the underlying security; the strike price of the option; the amount of time remaining until the option expires; the volatility of an underlying security.
• Strike Price: The price at which an underlying security can be purchased or sold, if an option is to be exercised.
• Expiration Date: The date on which an option expires. It is the 3rd Friday of the expiration month. Each option has an expiration day. After expiry, you have lost the right to buy or sell the underlying security at the strike price.
• Premium: The price of an option. If an option costs $3 per contract, your total premium is $300 (one contract = 100 shares), plus commission (transaction) costs. Please note that options are not available on every stock (i.e., not all stocks are optional).

Option Buyer

The premium paid by an option buyer is the maximum possible amount that the buyer can lose in the trade. Yet the buyer's potential for profit can be unlimited. Because there is no further risk for the option buyer beyond the premium paid, margin is not required. This enables the buyer to maintain a market position, despite any adverse moves, without putting up additional funds. At the end of the expiration date, all those call options whose strike prices are higher than the price of the underlying stock or index will be worthless. On the other hand, those options series, whose strike prices are lower, will have some intrinsic value and may be exercised. In the case of put options, the opposite applies.

Option Seller

The option seller, on the other hand, knows that the initial premium paid up front is the maximum potential profit. The potential for loss may be unlimited. Therefore, the option seller must post margin to demonstrate the ability to meet potential obligations. A trader who sells call options believes that the market will fall. To make money on a short call, the price of the underlying security must stay below the call's strike price. The profit is limited to the credit received from the sale of the call. If the price of an underlying security rises above the short call strike price, the option will be assigned to an option holder, who may choose to exercise it. In other words, the option seller must buy the underlying stock or index at the current price and sell it at the call's lower strike price (Current Price–Strike Price=Loss). When selling call options, the maximum loss is potentially unlimited, because the underlying stock’s upside is theoretically infinite.

Stock Options

Stock options are similar to options on futures. With stock options, the buyer pays a premium for the right to buy or sell specific stocks at a pre-determined strike price. Options on futures, however, convey the right to buy or sell a specific futures contract at a pre-determined strike price. Orders to buy and sell options are handled through brokers in the same way as orders to buy and sell stocks. Like stocks, options trade with buyers making bids and sellers making offers. In stocks, those bids and offers are for shares of stock. In options, the bids and offers are for the right to buy or sell 100 shares (per option contract) of the underlying stock at a given price per share for a given period of time. Option investors, like stock investors, have the ability to follow price movements, trading volume and other pertinent information day by day or even minute by minute.

Unlike common stock, an option has a limited life. There is not a fixed number of options, as there is with common stock shares available. An option is simply a contract involving a buyer willing to pay a price to obtain certain rights and a seller willing to grant these rights in return for the price. Thus, unlike shares of common stock, the number of outstanding options depends solely on the number of buyers and sellers interested in receiving and conferring these rights. Unlike stocks which have certificates evidencing their ownership, options are certificate less. Option positions are indicated on printed statements prepared by a buyer's or seller's brokerage firm. Certificate less trading, an innovation of the option markets, sharply reduces paperwork and delays. Finally, while stock ownership provides the holder with a share of the company, certain voting rights and rights to dividends, option owners participate only in the potential benefit of the stock's price movement.

Difference between Options and Others:

Some major differences between options and others are:

• No margin required for the option buyer.
• Option buyer's risk is limited to premium paid .

Depending on your risk tolerance, you have to choose the investment tool. For the risk adverse investor, buying options provide limited risk (the cost of the premium) combined with unlimited profit potential. For the risk tolerant investor, other contracts offer a highly leveraged instrument for a low capital outlay.

Risks of Trading Options

In planning any options strategy, it is important to consider the risks of options trading. There are several factors that influence the price of an option. These include time to expiry, volatility and interest rates. As an uncovered option writer, you face potentially unlimited risk. The risk faced by the taker of an option is limited to the premium paid for the option. However, as an option writer, you face potentially large losses if the stock has a significant move in an unfavourable direction. If a call option you have written is exercised, you must sell the underlying shares at the exercise price of the option. If the shares are trading a long way above the exercise price of the option, you may make a substantial loss. The leverage inherent in options means you can suffer large losses in percentage terms. Leverage means that you can make large percentage profits from option trades when your view on the underlying stock proves correct. However, it also means that if your view is incorrect, your losses in percentage terms will be correspondingly large.