Many of you have been asking me about the precise definition of a call option and put options. To alleviate any further questions and to aid in understanding, I am posting the definition and basic function of equity options.
1) Options are a derivative of the common stock. All derivatives have no intrinsic value other than what the underlying entity, which in this case, common stocks. Thus value is "derived" when to parties in agreement create a legally binding contract. A good example would be when you get into an escrow to buy the house, two parties (buyer and seller) essentially agree in principle and contract to purchase the house (the entity) when in agreement. Much the same way, options for stocks are a legally binding contract that will deliver the entity (in this case stocks) to the end purchaser at the end of the contract expiration. When this contract is in "high" demand, the contract premium increases. The mechanism of options pricing is very complex and will be discussed later if needed. Much in the same way, if the contract demand is "low", then the premium decreases and if there is no demand, then the contract is worthless and becomes a worthless piece of paper.
2) Stock options are depreciating asset and should not be looked at as having infinite value. Much like a milk has a shelf life and goes "sour" so does stock options. When it sours, you throw the milk away. The value of stock option is determined by the asset price, time value, and "intrinsic" value. Thus:
Option Premium=intrinsic value + time value.
3) Options can be described as the following three ways:
a) In the money (ITM)
b) at the money (ATM)
c) out of the money (OTM)
Options are contracts with expiration dates. Options expire every third Friday of each month. Options can be bought ahead of expiration in the current month all the way out to few years. These long term (few years) contracts are called LEAPS. Example: Today is August 7th, 2007. You can buy August contracts up to the expiration date of August 17, 2007 (though not recommended). You can buy contracts for September, October, etc... get the drift?
4) A contract of any given stock option gives you the "RIGHT" but not the obligation "TO PURCHASE" the common underlying shares at options expiration date. Stated simply, you pay a "smaller" contract price for the right to purchase the common stock shares at a later date (expiration date). What does this mean?
- One contract of a stock option controlls 100 shares of the underlying stock. That means if Cisco September $30 call today at market close was $1.45 per contract and you wanted to buy 1 contract, it will cost you $1.45X100 (shares)= $145 plus commissions.
- If you are "bullish" on the prospect of the stock price increasing before the stock option expiration date, you would buy CALL OPTIONS. So if you are buying CALL OPTIONS, then you are going "long". For every buyer of the call option, there is the writer of the option contract or the "seller". The writer of the call option is described as going "short" because he is betting that the stock price will not exceed the option contract STRIKE (target) price. The writer of the option contract or the SELLER is hoping or betting that the price of the stock will go down.
The seller gets the "premium" paid by the buyer which in the example above is $145 per share. The buyer gets the options contract for the right but not the obligation to buy the CSCO stock at $30.
Suppose CSCO stock goes up to $33. Then the writer of the options contract is responsible for delivering 100 shares of CSCO stock which is bought at $33 and sold to the buyer who "exercises" his contract at $30. But as you know, you can always "trade" the option contract before expiration. As long as the price of the underlying stock moves up, then the premium will continue to go up.
- If you are "bearish" or negative on the prospect of the stock price rising, then you would buy PUT contract. You are essentially "LONG" the PUT contract. Long means that you are bullish on the direction of the price of the stock that the option contract represents. Nothing more, nothing less. If you are "LONG" PUT cotract, you are "SHORT" the common stock. You are betting that the stock price will decline. In the above example, suppose the stock of Cisco is trading at $27.50. You want some certainty that the options will expire "in the money". So you buy $30 PUTS. You want the price to go down but you also want some insurance that this contract will be worth something at option expiration if the price decides to go against your wishes and goes up to say $29. You would have some value left at the end of the options expiration.
There is a lot of intricacies associated with trading options but digest the above information fully before embarking on more technical aspects of options. Believe me, I am still figuring things out and learning new things every trading day.
