OptioNewton

Options Basics  

General - there are two classes of stock options, Calls and Puts. Although they may be called different names, all option spreads, combinations, etc strategies are founded on these two basic derivatives. The nomenclature for options recently changed.

A call is now designated by  XYZ-YY-MM-DD-C-000SS000 and

a put by XYZ-YY-MM-DD-P-000SS000.

Where

XYZ is the stock ticker symbol (this could be more or even a single letter dpending on the ticker symbol),

YY is the year the option expires,

MM is the month the option expires,

DD is the day the option expires (note this date is usually listed ad the saturday after the 3rd Friday of the month, but options cannot trade on Saturdays, so if it is to be traded they need to be done so on Friday before the close.) 

C or P means Call or Put and

the numbers following indicate the strike price. There are so many zeros because there are some stocks that trade in the $100k range.

The dashes are included above to accentuate the parts. The real names don't have the dashes.

Options are traded in units of contracts. 1 contract is usually provides control of 100 shares of the underlying stock, however there can be exceptions. Before placing an order, the number of shares controlled should be verified.

Call - gives the purchaser the right, but not the obligation to purchase a stock at the strike price up to the expiration date. The price of a call moves in the same direction as the price of the underlying stock. Risk of loss is limited to the premium paid for the call. Profit potential is unlimited as is the stock.

Put - gives the purchaser the right, but not the obligation to sell a stock at the strike price up to the expiration date. The price of a put moves in the opposite direction of the price of the underlying stock. ie If the stock goes down, the put price goes up and vice versa. Risk of loss is limited to the premium paid for the put. Profit potential is limited to the difference between the strike price and the underlying stock going to zero.

Strike Price - the price at which the option may be exercised. Strikes are usually whole numbers, ie 10, 12,... 20, 25, 100, 125.... They also may be incremented at 0.50 intervals, ie 7.50, 12.50.... The strikes are established by the exchanges that created the series of options with some restrictions, such as strike increment and strikes within a certain range of the current stock price. Market makers provide the market for the options.

Expiration - the month up to which the option may be exercised. The day of the month of expiration is usually the close of trading on the third Friday of the expiration month. Note, opex = option expiration.

Exercise & Assignment - exercise is the options purchaser's execution of an option. US style options are exercisable at any time up to expiration. European style options are only exercisable on expiration day. Assigning is the other side of the exercise. If a trader has "sold to open" (more on this below) a call and it's in the money (ITM), the call purchaser will exercise and the call seller will get assigned, meaning he has to provide the shares of stock to fullfill the call purchaser's right to purchase the shares. For a put, when a purchaser exercises his right to sell the shares, the seller is assigned and must buy the shares at the strike.

LEAPs - are options that have an expiration date a year or more away.

Calls and puts can be bought, also referred to as "going long" or sold short, also referred to as "writing".

Buying options - the price of an option is called the premium. The total price for an options contract will be the option premium multiplied by the number underlying shares it controls. As with stocks, when buying options, the goal is to buy low and sell high or in some cases exercise them. Orders for buying unowned options contracts in the brokerage account are called "buy to open". Orders for selling owned options contracts are called "sell to close".  When an option contract is bought, it is shown as a debit on the brokerage account. If the price moves against the trade it shows up on the account as a negative change. If it moves with the trade, it shows up as a positive change.

Selling or Writing naked or (stock or cash) covered options - There are always two sides to a transaction. If one party is buying an option contract, then another party is selling it. Selling an option contract that is not owned (also referred to a "write" to differentiate it from selling an owned option) is called a "sell to open" order. These can be naked or covered transactions. Naked means the underlying stock is not owned. Covered means the option seller either owns the underlying number of shares of the stock or has the cash to cover the the options contract if exercised. The goal in selling an unowned option contract is to sell high and buy back at a lower price or ideally have them expire worthlessly where the seller's profit is the entire premium.  Orders to buy back options contracts are called "buy to close". When option contracts are sold or written, the price is shown as a credit to the brokerage account. The account tracks the movement of written options as well. If it moves against the trade, it shows up on the account as a negative change. If it moves in favor of the trade, it's shown as a positive change. The rights and risks when writing an option are different from buying an option. 

Selling a Call - again gives the purchaser the right, but not the obligation to buy the underlying stock from the seller. The seller (writer) has the obligation to sell the stock at the strike price if exercised by the purchaser. The risk to the seller of a call is if the stock is above the strike price at options expiration (opex), the seller keeps the higher premium, but is obligated, if exercised, to sell shares at the strike price no matter how high the stock price is. A larger loss can incur if the stock obligated to be sold at the strike is sold above the strike plus the premium received. To minimize the risk of loss, sometimes a call at a higher strike is bought at the time the lower strike call is sold. This provides some protection of the premium credit in the case of an unsuspected large gap up in the stock price occurs. The net premium is still a credit to the account. This is a bear call spread. See Bear Strategies for more information.

Selling a put - again gives the purchaser the right, but not the obligation to sell the underlying stock at the strike price. The seller (writer) has the obligation to buy the stock at the strike price if exercised by the purchaser. The risk to the seller of a put is if the stock is below the strike price at opex. The seller keeps the higher premium, but is obligated, if exercised, to buy shares at the strike price no matter how low the stock price. A larger loss can be incurred if the stock obligated to be bought at the strike is sold below the strike minus the premium received. To minimize the risk of loss, sometimes a put at a lower strike is bought at the time the higher strike put is sold. This provides some protection of the premium credit in case of a large catastophic drop in the stock. The net premium is still a credit to the account. This is called a bull put spread. See spread strategies for more information.

Brokerage accounts - Options can be traded in individual and IRA accounts. Trading options imposes additional requirements such as minimum balances, setting up margin accounts and signing an options agreement. Those that want to trade options should check with their broker for the specific requirements. Note - Writing options and trading spreads may impose additional requirements. Those that want to be able to sell options and trade spreads should check with their broker for the specific requirements. Also, commissions will vary from broker to broker. Select one that is reputable, has good service and low commission rates. Good service means, not only customer service, but allows you to trade stocks in the premarket and evening hours (although options can only be traded during normal trading hours 9:30am & 4pm eastern) company breaking news generally comes out before and after the market's regular session), has a good stock trading software platform and other benefits. Do a comparison.