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If an investor sells a call and the new owner exercisesOPTIONS Options are probably the most versatile trading instrument ever invented. They provide a high-leverage approach to trading that can significantly limit the overall risk of a trade, especially when combined with stock or futures. As a result, understanding how to develop profitable strategies using options can be extremely rewarding, both personally and financially. The key is to develop an appreciation about how these investment vehicles work, what risks are involved, and the vast reward potential that can be unleashed with well-conceived and time-tested trading strategies. First, it is important to differentiate between futures and options. A futures contract is a legally binding agreement that gives the holder the right to actually buy (and take delivery of) or sell (be obligated to deliver) a commodity or financial instrument at a specific price. In contrast, purchasing an option is the right, but not the obligation, to buy or sell a financial instrument (stock, index, futures contract, etc.) at a specific price. The key here is that buying an option is not a legally binding contract. In contrast, selling (writing or shorting) an option obligates the seller to provide (or buy) the instrument at the agreed-upon price if asked to do so. So, option buyers have rights and option sellers have obligations. Option buyers have the right, but not the obligation, to buy or sell a stock, index, or futures contract at a predetermined price before a predefined expiration date. In contrast, option sellers, sometimes called writers, have the obligation to buy or sell the underlying stock shares (or futures contract) if an assigned option buyer or holder exercises the option. There are two types of options contracts: puts and calls. A put option is an options contract that gives the owner the right to sell (or put) the underlying asset at a specific price for a predetermined period of time. Call options, in contrast, give the option holder the right, but not the obligation, to buy a stock at a predetermined price for a specific period of time. Importantly, for every option buyer there is a seller. Buyers and sellers do not deal with one another directly, but through their respective brokerage firms. If an investor sells a call and the new owner exercises Two Types of Options Puts: A bearish type of options contract that gives the buyer the right, but not the obligation, to sell, or put, a specific asset (stock, index, or futures contract) at a specific price for a predetermined period of time. Calls: A bullish type of options contract that gives the buyer the right, but not the obligation, to buy, or call, a specific asset (stock, index, or futures contract) at a specific price for a predetermined period of time. the call, the call seller has the obligation to deliver the financial instrument to the option holder at the call strike price. The call seller will get notice from the broker that he or she must provide the stock or futures contract to the option holder. This is known as assignment. Once assigned, the option writer is obligated to fulfill the terms of the options contract. A put seller, in contrast, has the obligation to accept delivery of the financial instrument from the option holder. If the put seller is assigned, the brokerage firm will notify the put seller that he or she must buy the financial instrument at the predetermined price. In Chapter 3 we explain how to anticipate the assignment of a short option. For now, it is important to understand that a put owner has the right to exercise the options contract and, if so, the option seller will face assignment on the option. Therefore, if you decide to write an options contract, you must be willing to face the prospect of assignmentwhich, as we later see, can involve significant risks. To see how options work, lets consider an example using a stock option. Say that you believe the price of IBM is going to rise over the next three months. But instead of buying 100 shares of IBM, you decide to buy a call option. The IBM call gives you the right, but not the obligation, to buy 100 IBM shares for a specific price until a specific point in time. For this right you pay a price: the option premium. Furthermore, you can exercise the right at any time until the option expiresthat is, unless you close the position before the option expires. You can close an option position at any time through an offsetting transaction. For example, if you buy an IBM call options contract, you can close the position at any time by selling an identical IBM call options contract. In another example, suppose you do not own any options and you agree to sell or write a call option on IBM. Why would you do this? Well, some traders sell options in order to collect the premium and earn income. However, if the stock rises dramatically, the trader may be asked to sell IBM shares to the option holder at the call strike price, which is well below the current market price. Knowing Your Options Exercise: If you own a put or call, you can implement your right to exercise an option. Assignment: If you are an option seller, you face the possibility of assignment. Options on stocks, indexes, futures, and exchange-traded funds are similar. However, each option will have a different underlying asset. It is important to understand the underlying asset, how its price changes, and how those changes impact the price of the option. Options are derivatives, which means their price changes are derived from the value of another asset (stock, futures contract, index, etc.). The asset is known as the underlying security. In addition to understanding the underlying asset, traders must also understand the trading terms used to describe an options contract. For example, every option has a strike pricea price at which the stock or future can be bought or sold until the options expiration date. Options are available in several strike prices depending on the current price of the underlying asset. As a result, the profitability of an option depends primarily on the rise or fall in the price of the underlying stock or futures contract (and its relation to the strike price of the option). An options premium also depends on the time left until expiration, volatility, and other factors discussed later in this book. Stock Options Not all stocks have options available to be traded. Currently in the United States there are more than 4,000 stocks that have tradable options. This number grows daily. Each stock option represents 100 shares of a company. Therefore, if you buy one XYZ stock option, it represents 100 shares of XYZ stock. If XYZ shares are trading at $10 per share, then you are controlling $1,000 worth of stock with one option ($10 per share 100 shares). And you may be controlling this $1,000 amount with only $250, depending on the price of the options premium. This would give you leverage equal to four to onenot too shabby odds. Futures Options Most futures markets have tradable options, including gold, silver, oil, wheat, corn, soybeans, orange juice, Treasury bonds, and so on. However, unlike stocks, each contract represents a unique quantity. Options on futures have the futures contract as the underlying instrument. It is the futures contract that is to be delivered in the event an option is exercised. Each futures contract represents a standardized quantity of the commodity. As you begin to trade futures, you have to become familiar with the specifics of each futures market. (If you have any questions, you can always call your broker.) For example, a gold futures contract is equal to 100 ounces of gold. With gold trading at $410 per ounce, the futures contract is worth $41,000: (100 ounces $410 per ounce). Each futures The Big Picture37Option Characteristics1.Options give you the right to buy or sell an underlying instrument at aspecific price. 2. If you buy an option, you are not obligated to buy the underlying instrument; you simply have the right to exercise the option. 3. If you sell a call option, you are obligated to deliver the underlying as set at the price at which the call option was sold if the buyer exercises his or her right to take delivery. If you sell a put you must buy the underlying if exercised. 4. Options are good for a specified period of time after which they expire and the holder loses the right to buy or sell the underlying instrument at the specified price. 5. Options when bought are purchased at a debit to the buyer. That is, the money is debited from the brokerage account. 6.Options when sold are sold at a credit to the seller. Money is added tothe brokerage account.7.Options are available in several strike prices at or near the price of theUnderlying instrument. . The cost of an option is referred to as the option premium. The price reflects a variety of factors including the options volatility, time left until expiration, and the price of the underlying asset. 9. There are two kinds of options: calls and puts. Calls give you the right to buy the underlying asset and puts give you the right to sell the underlying asset. 10. All the put or call options with the same underlying security are called a class of options. For example, all the calls for IBM constitute an option class. 11. All put and call options that are in one class and have the same strike price and expiration are called an option series. 12. Options are available on a variety of different underlying assets including stocks, futures, and indexes. contract has its own unique specifications, and that can be quite confusing to a novice futures trader. |
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