Option Basics

Note from the PitMaster:
If you are new to options trading, this section will define what options are and explain the most basic concepts. It is important that you understand these basic concepts and terminology before you get into the more advanced topics, which are much more interesting (and profitable).

First, there are only two kinds of options -- calls and puts. You can purchase a call or sell a call. The same goes for puts, you can purchase a put or sell a put.

Call Option

When you buy a call option, it gives you the right to buy a given asset at a fixed price (known as the strike price) anytime before a specified expiration date. The option writer (the person who created the option which you purchased), has the legal obligation to sell the asset to you at the strike price, if you exercise the option before the expiration date.

Put Option

A put option is just the opposite. When you buy a put option, it gives you the right to sell a given asset at the strike price anytime before the expiration date. The option writer has the legal obligation to buy the asset from you at the strike price if you exercise the option before it expires.

Underlying

The asset is usually referred to as the Underlying (underlying asset). Options are available for the following types of underlyings:

Futures (Commodities, Indexes, Currencies). Gold, silver, soybeans, wheat, crude oil, treasury bonds, eurodollars, foreign currencies, S&P 500 index, and many others.

	Stocks. Over 1900 stocks for which options are available in the U.S.A.
	Stock Indexes. SPX (S&P 500), OEX (S&P 100), computer software index, biotech index, gold/silver index, oil index, and around 50 others.
	Others. Cash foreign currencies and interest rates.

Examples of Options

Soybeans August 850 Put option. The option buyer has the right to sell one August Soybeans futures contract at the strike price of 850 cents per bushel anytime before the option expires in August. If the option buyer exercises the option, the option writer has the legal obligation to buy the futures contract under those terms.

Microsoft July 110 Call option. The option buyer has the right to buy 100 shares of Microsoft stock at the strike price of $110 per share anytime before the option expires in July. If the option buyer decides to exercise the option, the option writer has the legal obligation to deliver (sell) 100 shares of Microsoft stock under those terms.

Why buy options?

Two reasons, limited risk and leverage. When you buy an option, your risk is limited to the price you pay for the option. And from a leverage standpoint, it allows you to control an expensive asset for a fraction of what it would cost you to purchase the asset outright.

So, if you think that the price of a commodity is going to increase, you can buy a call option instead of buying the futures, or if you feel the price will decrease, you can buy a put option instead of selling the futures.

Now before you start buying options, a word of caution...

Most people who trade options lose money.

Why? Because they buy options and that's all they do. They don't take advantage of other option strategies. You should be aware that eighty percent of all options expire worthless. And to make matters worse, the general public buys options without paying attention to the fair value of the option and the implied volatility (all of this is explained later). As a result, they buy overpriced options and often wind up losing money even when they were correct about the price direction!

When you finish reading everything on this site, you will know how to actually take advantage of the factors that cause most people to lose money. You will learn how to put together safe, yet powerful, option strategies that can pull profits out of the markets under all kinds of conditions.

Exchange Listed Options

Options are traded on organized exchanges. This makes it possible for you to buy and sell options the same way that you would buy or sell futures. You need to open an account with a stock brokerage firm to trade stock and index options. Trading futures options requires that you open an account with a commodity futures broker.

Exchange listed options have standardized strike prices and expiration dates.

	Strike Price. This is the fixed price at which the option can be exercised. It is also known as the exercise price. Options are available for lots of different strike prices for stocks and futures contracts. Your broker will give you a strike price table.
	Expiration Date. This is the date on which the option expires. For stock options and index options, this is always the Saturday following the third Friday of the expiration month. For example, July 1996 stock & index options will expire on Saturday July 20, 1996. Futures options have their own expiration dates. Again, your broker will give you a list.

American Style versus European Style

American style options can be exercised anytime before the expiration date. European style options can only be exercised upon expiration (right before they expire). Most options that trade on exchanges in the United States are American style. One noted exception, however, is the very popular SPX (S&P 500 index option) which trades on the Chicago Board Options Exchange (CBOE) and is a European style option.

Option Writer

An option writer is any person who writes (creates) an option. When you sell an option that you don't already own, you have just created a new option, and this makes you an option writer.

In-the-Money

Call options that have a strike price below the current market price of the underlying asset are said to be in-the-money. And likewise, put options that have a strike price which is above the current market price of the underlying asset are in-the-money. For example, when corn is trading at 270.00, a corn 260.00 call option (260.00 strike price), would be 10 points in-the-money, and a 280.00 put option would be 10 points in-the-money.

Out-of-the-Money

This is the opposite of in-the-money. Call options that have a strike price which is above the current market price of the underlying asset are out-of-the-money. Put options that have a strike price which is below the current market price of the underlying asset are out-of-the-money. Continuing with the same example above, when corn is trading at 270, a corn 280 call option would be 10 points out-of-the-money and a corn 260 put option would be 10 points out-of-the-money.

At-the-Money

When an option's strike price is the same as the current market price, the option is at-the-money. Actually, whichever strike price is closest to the market price, is considered to be at-the-money. So, if the corn's price is 270, the 271 call option and the 269 put option would both be considered at-the-money (even though the call option is technically 1 point out-of-the-money and the put option is 1 point in-the-money).

Option Premium

This is the price of the option.

Options on futures contracts, index options, etc. each have their own specified quantities. For example, each soybean futures contract covers 5,000 bushels of soybeans and the price is stated in cents per bushel. So, if an option on a soybean futures contract has a premium of 11.50, it means the cost of one option is 11.50 cents per bushel times 5,000 bushels, for a total cost of $575.00. Your broker will give you a copy of the contract specifications for all exchange listed options.

Each stock option covers 100 shares of stock. For example, when you see a stock option's price (premium) quoted at 4.50 it means that one option costs $4.50 per share times 100 shares, for a total cost of $450. So for stock options, just multiply the quoted premium by 100 to get the total cost.

An option's premium consists of two components:

	Intrinsic Value is the amount that the option is in-the-money. It is the amount that you would receive if you were to exercise the option right now (see "exercising an option" below).
	Time Value is the additional amount that people are willing to pay over and above the intrinsic value. The sum of intrinsic value plus time value equals the option premium. So, if an option's premium is 5.25 and its intrinsic value is 3.00, the time value is 2.25.

Exercising An Option

Owning an option gives you the right to exercise it.

Call Options When you exercise a call option, you buy the underlying asset at the strike price and you can then sell it at the current market price. For instance, suppose you own a corn 270 call option and corn is trading at 274. Exercising the call option, you would buy your corn future at the strike price of 270. You could then sell the corn future at the current market price of 274. Your profit would be 4 points per contract, which was the intrinsic value of the option.

Put Options With a put option it is a little different. First, you buy the underlying asset at the market price. Then, you exercise the put option, selling the asset at the strike price. Let's say you own a corn 270 put option and corn is trading at 264. First you would buy one corn contract at the market price of 264, then you would exercise your put option, selling the futures at the strike price of 270. Your profit would be 6 points per contract. (again, the intrinsic value of the option).

Remember, when you exercise an option, you only receive the intrinsic value. If the option still has time value, you would be throwing that away. For this reason, you normally don't exercise options that still have time value remaining.

In fact, only two percent of all options are ever exercised. Normally, when you buy an option, you will sell it before it expires (and take your profit or loss), or just let it expire worthless.

Delta

This is the rate of change in an option's price relative to a one unit change in the price of the underlying asset. For example, if a call option has a delta of 0.50 and the price increases by one dollar, the option's price should increase by 50 cents ($1.00 times 0.50). The characteristics of an option's delta, and how to use it, is covered in much more detail in our Delta Neutral strategy.

Gamma

This is the rate of change of the delta. Let's continue with the example above where a call option has a delta of 0.50. If the call option has a gamma of 0.03 (for instance), it means that the delta will increase from 0.50 up to 0.53 when the price increases by one. It also means the delta will decrease from 0.50 down to 0.47, if the price decreases by one.

Time Decay

The time value of an option's premium erodes as the option approaches the expiration date. Time decay accelerates and becomes most noticeable during the last month before expiration.

Theta

This is a measure of the rate of time decay. It is the amount that an option's premium will lose per day due to time decay. It is usually stated in dollars per day.

Vega

This is a measure of how much an option's premium will increase or decrease due to a change in volatility.