Back-to-basics 1: What’s an option?

What IS an option, anyway? Why might you consider adding options to your investment portfolio? In a new back-to-basics series, TradeKing’s Brian Overby explains options from the ground up.

As you’ll discover, options can help you profit in up, down, sideways and volatile market conditions. But they can also lead to significant losses if you don’t understand the risks. Why not learn how options can expand your investment options – literally?

Sometimes you just need to kick it old-school. At TradeKing, we’ve welcomed thousands of new investors to the markets in the past few years, many of whom are brand-new to investing and trading. For these folks, it’s worthwhile to “begin at the beginning” in explaining options as an investment product: what they are, why you should learn about them, and what kinds of uses you can make for them, even as a newbie.

Those of you already schooled in options basics: read on. Sometimes a refresher course can open your eyes to a basic misconception that’s been plaguing your options strategy all along.

What IS an option, anyway?

There’s no better place to start than here. Options come in two basic flavors, or types: puts and calls.

Buying a call gives you the right, but not the obligation, to BUY an underlying stock (or other security) at a pre-set price, called the “strike” price. You pay for that right when you buy the call option itself; the call’s price is often known as the “premium”. You can exercise it anytime during a set timeframe, and the value of the option declines (or “decays”) over time. When that timeframe is up, it’s known as “options expiration”.

If you choose to use your right-to-buy as a call owner, that’s called “exercising” your option. All that means is that you decide to buy the underlying stock at the strike price, before expiration. But you don’t have to exercise – in fact, most call buyers never do. (You pay a commission both when you buy an option and if you later exercise it.) More on exercise in a later post.

I’m glossing over several points, which we’ll return to later. But the above is the essence of a call option from the perspective of someone buying one.

If you SELL a call option, you aren’t paying for a right – instead you’re BEING paid. But that money doesn’t come free – in exchange for selling the call, you earn a premium and take on an obligation: to sell the underlying stock at the strike price, if asked to do so. This can be an extremely risky move, leading to theoretically unlimited losses, if you’re not already holding shares of the underlying stock, a situation options traders describe as “naked”.  On the other hand, call selling can be a move with limited and defined risk, if you do already have the shares ready to sell, a situation called “covered call” selling. We’ll discuss the different types of call selling in a later post.

On the other hand, buying a put gives you the right, but not the obligation, to SELL an underlying stock (or other security) at a pre-set price, called the “strike” price. Again, you pay for that right, and you have it until expiration. If you “exercise” your right, you’d sell the underlying stock at the strike price before expiration. But nobody will force you to exercise – that’s your decision to do or not.

Buying a put gives you rights; SELLING a put gives you a premium – as well as an obligation. By selling a put you’re saying you stand ready to buy the underlying stock at the strike price, anytime before expiration. Again, there’s a dramatic difference in risk if you sell a put without ready cash on hand to buy (“cash-secured put selling”) versus selling a put without that cash (“naked put selling”). Naked puts are a very risky options trade suitable only for advanced traders.

So let’s sum up:

•    Buying an option gets you limited-time right, while selling an option earns you some money, but also exposes you to an obligation. Losses may be substantial.

•    Options are a decaying asset; they will eventually expire. Time has a negative effect on their value.

•    Nobody HAS to exercise the underlying right of their contract; in fact, there’s lots you can do with options without ever exercising.

•    Each time you trade an option, you pay a commission.

Those are the ground rules of the options game. We’ll unpack the implications of these ground rules over the course of this blog series.

Real-world parallels to options

Options based on securities (stocks, ETFs, or indexes) might seem exotic at first – but in fact, there are lots of option-like examples you’re already familiar with in the everyday world. In my next post, I’ll explain how sports contracts, movie options, and insurance policies all operate very similarly to the investment-variety of options described above.

We’ll also look at a specific options contract and show how the option’s name packs in all the info you need about the terms of the contract it represents. Stay tuned!

Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com

[image: desk by Roberto S. Donovan on Flickr]

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.

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