UNDERSTANDING AND USING OPTIONS

Value Line

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.)

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.)

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

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.

 

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..

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

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..

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.

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.

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.

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”.