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Stock Options Basics Tutorial

Once the basics of trading stock options are explained in this tutorial, many investors realize options are an excellent way to reduce their risk, while increasing the return that comes from owning stocks.

Many people hear that options are risky investments. If you speculate with options then it is true, options are risky. However, properly used stock options can generate income and reduce risk, making them very suitable for most investors.

The purpose of this stock options basics tutorial is to help you understand the options. Many investors employ conservative option strategies, once they understand how to reduce the downside risk in their portfolios and enhance their returns. Here we are discussing options that are traded on the exchanges and not employee stock options.

The Chicago Board Options Exchange has a wonderful free Learning Center that offers excellent explanation of options and how you can use them. I encourage you to take advantage of their information.

Stock Option Basics

Stock options give the owner the right but not the obligation to buy or sell the underlying security at a predetermined price. The reason investors might buy options is they cost less then the underlying stock they represent. There are two types of options, "calls" and "puts". For each type you also will see the name of the stock, the strike price, the expiration date and the cost of the premium paid to buy the option.

Investors can buy or sell a stock option to create an option contract. For example, if you buy a call option, you have the right but not the obligation to buy a stock at a specified price called the strike price before a predetermined date, the expiration date. To complete the option contract there must be someone willing to sell you this right at an agreed upon price. The seller of the option has the obligation to sell the underlying security at the strike price should the buyer demand it.

For this right to buy or sell a stock, an investor pays a premium. The amount of the premium varies depending on several factors that are covered in other articles. The person who sells the option receives the premium as cash in their account. They also receive the obligation to buy or sell the underlying stock should the owner of the option demand it. However, according to the Chicago Board of Options Exchange (CBOE), most options are never exercised. The option holder does not exercise their right to buy or sell the stock.

Many option investors close out their options before it makes economic sense to exercise the option. If they bought an option, they sell it either for a profit or for a loss depending on how the trade performed. If they sold an option, they buy one back to close out their position. In other cases, the option that was sold might expire worthless on the expiration date, ending the contract.

Buying and Selling Stock Options

When you buy a call or a put option, the price you pay is called the option premium. You have the flexibility to decide whether to buy the underlying stock at the agreed upon strike price. If you decide to buy the stock you have established the purchase price (strike price). On the other hand if you decide not to buy the underlying stock all you lose is the premium you paid.

Buying a put option is like buying insurance against a drop in the price of the underlying stock. If all goes well and the price of your stock rises, the insurance is not needed and all you lose is part the premium paid for your policy. Buying put options is one way investors reduce their risk.

Ok, this might still be confusing. Actually, you faced with option opportunities many times each year. A couple of examples might help. Let's say you are interested in building your dream home. You have found a piece of land that meets your expectations. You agree on a price of $100,000 for the land, however, the owner wants to be paid in full. It will take a couple of months for you to arrange the necessary financing to buy the property. You have $2,000 in cash. So you offer to give the owner the $2,000 in return for the sole right to buy the property at the agreed upon price over the next three months. The owner of the land agrees. You have created a call option contract. Now let's look at what can happen over the next three months.

This example presents three very important concepts regarding options. First, when you buy an option contract you lock in the price at which you will buy the underlying asset. If the value of the asset rises you still have the right to buy the property at the agreed upon price, no matter how high the price might go.

Second, you are not obligated to buy the property. You can let the option contract expire without having to complete the deal. Should the value of the property fall, you do not have to pay the higher price.

Stock Option Notation

Stock options are described with common notation. When you first look at this notation it can be quite confusing. The symbol for the Cisco August 22 call option is CYQHL. Let's see if we can help make this more clear.

The first part of the stock option notation includes a reference to the underlying stock, then it includes the expiration date, the strike price and the type of option (put or call). For example, CYQ HL call describes a call option for Cisco Corporation with an August expiration date at a 22 strike price.

Often the stock option will follow the symbol of the stock, though not always. In Cisco's case the symbol is CYQ.

The strike price is normally spaced uniformly across the spectrum of current trading range. Lower price stocks could see the strike spaced $1.00 apart. Higher prices stocks might be spaced apart by $2.50. Even higher by $5.00 with the highest spaced apart by $10.00. The strike price is set by the option exchange officials at intervals they believe will offer the best depth and liquidity.

Options traders use a code for the strike price. The Chicago Board Options Exchange (CBOE) has a table that shows the codes for the strike price. Do not worry, you will not have to memorize it to get started with options.

When investing with options the expiration date is one of the most important factors to consider. Options have expiration dates that follow one of three fixed cycles The Chicago Board Options Exchange (CBOE) has a Monthly Expiration Cycles table that shows the option expiration months.

When you look at the quote of listed options you will notice that the options will follow one of these cycles plus the two nearest months. In other words, options expire in the two nearest months and using one of the three cycles mentioned above.

Normally, the longest expiration dates are no more than nine months away. there are longer term options known as LEAPS that are available on some stocks. LEAPS expire in January of the following year and in January of the year after that.

The exact date of expiration for public investors is fixed for each month as the Saturday following the third Friday of the month. Options actually expire on Saturday, though public investors must make their decision to either buy or sell the stock by telling their broker by 5:30PM New York time on the last day of trading.

Option traders use codes to determine the expiration month of the call or put. Again, the Chicago Board Options Exchange (CBOE) has a table that shows the codes for the Expiration Month.

Now you have a way to interpret the option codes when you see them. Fortunately, most times the option is also described in English so we do not have to look up the option codes each time we see them.

Pricing of Options

The option premium that is quoted on exchanges is for one option. When you buy an option you pay the quoted premium times 100 for one option contract. Let's say the the quote of company XYZ is $3.00. This means you must pay $300 ($3.00 * 100) for each option contract plus commissions and fees.

Risk of Options

Options can be used to lower the risk of a long or short position. They can also increase your risk if used improperly or without fully understanding the trade. Discussing all the risk associated with options is beyond the scope of this article. There are two widely accepted option strategies that stock investors use to reduce their risk of their stock portfolio, while not adding risk of using options. they are selling covered calls and buying protective put options.

Selling (writing) covered call options provide a low risk way to help reduce some of your down side risk and offer a way to add some income to your portfolio. Covered calls are the only option strategy that is approved for use within Individual Retirement Accounts (IRAs).

Buying Protective Put options is like buying insurance against a loss in a stock holding. you pay a premium to provide protection should the price of the stock fall.

Summary

Stock options are considered by many as risky trading vehicles that only professionals understand. While they can be complex there are two option strategies that sock investors should consider to help reduce their risk. As you learn the benefits and risks of these options, you will give yourself additional investing tools to help improve your overall return.

Additional Articles

If you have a question check Stock Options FAQs. If you do not see your answer there, please feel free to send your question to service@tradingonlinemarkets.com and we will get right back to you.

Writing Covered Calls
Writing (selling) covered calls can improve the performance of your portfolio and reduce risk. Write calls introduces the basics of covered calls.

Total Return Approach to Covered Call Option Strategies
The Total Return Approach provides the framework to analyze the potential returns of owning stock and writing covered call options.

Covered Call Expiration
As options approach expiration an investor is faced with several decisions relating to their covered call option strategy.

Rolling Covered Call Options.
Rolling covered call options introduces how to close out the current option and then write (sell) another one by rolling forward, up and down as strategies.

Protective Put Strategies
Buying protective puts options is like buying insurance against a decline in the price of your stock. Wouldn't that be nice in this volatile market.

Stop Loss Orders vs. Protective Put Options
A comparison of whether stop loss orders or protective put options provide the best down side protection.

LEAPS Option
Long-term Equity AnticiPation Securities (LEAPS) are option contracts that allow investors to take positions with much longer expiration dates, up to three years.

If you want to learn more about using options consider reading Options Made Easy: Your Guide to Profitable Trading (2nd Edition) by Guy Cohen. It is a good way to help you to get started learning how to use call options.


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