I get emails daily asking me questions about investing in options.
And just the other day at the local farmers’ market, the girl selling melons and tomatoes said to me, “Christian, what do I have to know to make money trading options?”
She adjusted her overalls with her left hand while taking my money with her right…
“You keep making your Options Trading Pit readers gains — like the 70% in Encana calls one week and 100% in National Bank of Greece the next. I want to get in on that action!” she said, sticking out her bottom lip.
Seeing how I get these types of questions all the time, I decided to write down the basics.
Believe me, if you have just 90 seconds, you’ll realize options are easy…
Up is good. Down is also good.
Officially, an option is a contract that gives an investor the right — but not the obligation — to buy or sell a stock at a specific price on or before a specific date or expiration date.
For the most part, unless you are doing complicated hedges, you simply buy the option and then later sell it, just like stocks. No sweat.
There are two basic types of options: call options and put options.
A call is a bet the stock will go up, while a put is a bet it will go down.
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Call options give the buyers the right to buy an underlying security at a specific price on or before a specific date of expiration.
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Put options give the buyers the right to sell an underlying security at a specific price on or before a specific date of expiration.
Pricing
There are a few simple things you should know about the market.
Read and learn…
Options trade at 100 times the price quoted. A call option, for example, may show a price of $2, but you’d pay $200 (price x 100 shares).
A strike price is the price that the underlying stock can be bought or sold, as detailed in the option contract.
If you have a $1,000 Google call, and GOOG hits $1,000, you can switch it for stock. (Most people just bank the cash.)
Options are identified by month of expiration, whether they are a put or call, and by a strike price (or the price you believe the underlying stock will reach). Thus you have Encana January 2014 $19 calls.
Yahoo! Finance expresses options like this: ECA Jan 2014 19.000 call (ECA140118C00019000).
The ticker code is simple as well: In this example, ticker/ECA, year/2014, month/01, day/18, call or put/C, strike price/$19.000.
See? Easy.
The biggest deal about options is that options have limited lifetimes. At expiration, options cease to exist. If you buy an option, you either exercise it (buy or sell the underlying security), or it will expire worthless.
And finally, options are subject to time decay.
The closer it gets to expiration, the less value it has.
Intrinsic Value and Time Value of Options
Intrinsic value represents how much the option is worth if you exercise it right now.
You can find intrinsic value by comparing the strike price to the market price of the underlying security. Intrinsic value is calculated by subtracting the strike price (X) from the current price (CP).
An option with intrinsic value is “in the money.”
If the stock’s current price is greater than the option’s strike price, the remainder is the intrinsic value. In the case of a call, if the price of the underlying stock is above the strike price, the call is in the money.
If ABC is trading at $40, and you have a $35 call, you can buy the stock at $5 less than everybody else.
If the strike price is greater than the stock price, the intrinsic value is zero.
In the case of a put, the opposite is true: Intrinsic value would be calculated with X minus CP. A put is in the money when the strike price is above the market price of the stock.
If you own an ABC $35 November put, and ABC is trading around $30, you are $5 in the money. This represents the intrinsic value of the put.
If the strike price of a call is above the price of the stock, the call is out of the money.
If you own a XYZ November US$10 call when XYZ is at US$8, there’s no reason to exercise it, since you would automatically lose US$2…
If the strike price of the call is equal to the price of the stock, the call is at the money. In both cases, you don’t gain anything by exercising the call, because the call lacks intrinsic value.
A put is out of the money if the strike price is below the price of the underlying security. An HIJ $80 put is US$12 out-of-the-money when HIJ is at US$92.
There’s also time value. This is any value of that option other than intrinsic.
If ABC is trading at $40, and the ABC 35 call option trades at $6, then we’d say it has a time value of $1 ($6 option price minus $5).
This is the “insurance premium” of the option.
Delta Team
Delta is based on the underlying security value.
Delta is the amount by which an option’s price will change for a one-point change in the price of the underlying asset. Call options have positive deltas, while put options have negative deltas.
A $0.50 delta means that for every US$1 gain in the stock, a call option gains 50 cents in premium. A -$0.50 delta means that for every US$1 loss in the stock, a put option gains 50 cents in premium.
How It Works In Reality
This all might sound complicated, but it doesn’t have to be…
Options trade just like everything else — from baseball cards to companies — with the notable exception that time is a factor.
So instead of thinking, “I think XYZ is cheap here, and it might go up,” you have to think, “XYZ will go from $10 to $12 by the end of November.”
If you can think like that, you can leverage up and make more money than you could just buying the stock.
In this case you would buy the $12 December call option.
For example, you pick up the December $12 XYZ for $1.00. If you are right and it happens quickly (say XYZ goes to $11 in three days), your December XYZ $12 call is now worth $1.50. You hit the exit button and are gone. No muss, no fuss — and you’re 50% richer.
If you think you have what it takes to add the “time dimension” to your trading, then join us for 30 days risk-free and see if it works for you.
By the way, my last three sells were winners of 70%, 140%, and 24.42%.
Good hunting,
Christian DeHaemer
Check us out on YouTube!Christian is the founder of Bull and Bust Report and an editor at Energy and Capital. For more on Christian, see his editor’s page.
