Options for Newbies – Part 1

Russ Allen

Options are by far the most versatile trading instrument. There is a lot of money to be made with them, if you do it right. They can be used like an insurance policy, like a lottery ticket, like a bank CD, and many other things besides. And unlike anything else, used in a certain way they can make money from an absence of price movement. But the learning curve can be daunting. If you’ve never traded them, where do you start?

Every week in this space, our instructors give you solid, actionable information designed to help you make more money with options. That information ranges from the basic through intermediate to advanced, as do the experience levels of our readers.

As a long-time instructor for Online Trading Academy, one of my specialties is explaining complex subjects to new traders in understandable terms. As adults with money to trade or invest, almost all of us have come from other fields where we are experts.  But trading is a whole new world. That is especially true for options, with all their moving parts.

Since I came into trading a few years ago as a nearly complete beginner after many years in another career, I have first-hand experience of  what that’s like. So for those of you who are new to options, or who have never really thought about trading them before, I want to help give you a starting point. Over the next few weeks, on alternate weeks, I’m going to go through the subject in the most basic way. Even if you’re a veteran, these articles may give you a deeper understanding of some aspects of options than you had before.

There are a few oversimplifications as each topic is introduced for the sake of clarity, but we’ll clean these up as we go along.

Without further ado, let’s begin.

Profit is made by selling something for more than its cost; if sold for less, there is a loss.

That simple statement describes every possible monetary transaction.

We enter into many monetary transactions every day of our lives, whether we are working, playing or sitting still.  We buy things, including food and utilities, every single day. Those things are sold to us by others. If those sellers paid less than the amounts they collect from us, they make a profit; if not, they have a loss. The same holds in reverse when we are the sellers. Pretty simple.

In our business or employment, we sell our time for more money than the cost of going to work.

Everyone understands this in the context of merchandise or services. Financial markets are fundamentally no different: to make a profit, we must buy something for a lower price, and sell it at a higher price. Buy low, sell high.

Options give us unique ways to do this.

Call options or “Calls” give their owners the right to buy something at a certain price – that is, if things work out right, to buy low. The thing they have the right to buy is called the underlying asset, or just the underlying for short. The underlying can be a stock or something else. For our examples below, we’ll assume that the underlying is a stock.

Put options or “Puts” give their owners the right to sell an underlying asset at a certain price – hopefully, to sell high. The owners of puts do not actually have to own the underlying asset that they have the right to sell. They can plan to buy the underlying later after the price has gone down (buy low).

Let’s look at an example using call options – in particular, call options for a stock.

On the day I’m writing this, August 29, 2012,  the stock of Apple Computer (the underlying) closed at $673.40 per share. There are available Call options that give their owners the right to buy Apple shares (in 100-share lots), for $650 per share. This $650 price is called the strike price or just the  strike. These rights expire in 23 days. That date, 23 days out, is the expiration date for these particular options. There are other dates, both sooner and later, for which options are available.  More about all that later.  For these options, that $650 strike price is a discount of $23.40 per share from today’s price of $673.40. Now that’s buying low! What do we have to do to get this deal?

We have to pay for the option – to be exact, as of today’s close we’d have to pay $27.60 per share for the option. (Option prices are listed just like stock prices, and today the price is $27.60. Much more about pricing later in the series). Since each option covers 100 shares, we’d have to pay a minimum of $27.60 X 100 = $2,760 to play. It would be another $2,760 per hundred for larger quantities.

Oh. So we have to pay $27.60 today to get a discount of $23.40.  What’s the extra $4.20 for?  That can’t be right.  Who would buy these things?

Well, today alone 1743 of those particular September $650 Call options changed hands (so 1743 is today’s volume); and as of the end of the day a total of 12,889 of them are outstanding.  (That number, 12,889 is called the open interest for those options). At 100 shares per, these calls represent 1,288,900 shares. Those shares are worth altogether about $868 million. Somebody believes those options are a good deal. Almost a billion dollars’ worth of somebodies, in fact. What are they thinking?

They’re thinking that in the 23 days remaining before those options expire, the price of Apple could go higher. They’re paying that “extra” $4.20 for what could happen to the price of Apple stock in the remaining time before expiration of the options. They’re putting a value of $4.20 on that time.

In fact, that’s what we call that extra amount – time value. It also has another name, which is extrinsic value. By either name, that $4.20 portion of the option’s value exists only because there is some time remaining in the option’s life, during which the price of Apple could go higher.

The rest of the option’s value, $23.40, represents an actual discount (the amount by which we could buy low) compared to today’s Apple price. We call this discount amount the option’s intrinsic value. If the price of Apple were to go below $650, then these options would have no intrinsic value.

So far, we’ve defined these terms:

  • Options
  • Calls
  • Puts
  • Strike Price
  • Expiration Date
  • Volume
  • Open Interest
  • Time Value (also called Extrinsic Value)
  • Intrinsic value

With this groundwork laid, we’re ready in future articles to take our examples further and talk about the possible outcomes for the buyers of options, as well as for the sellers. We’ll begin to explore the keys to selecting which options to trade and when.

If you have questions or comments on this article, please contact me at rallen@tradingacademy.com.

This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.