To start, we need to first review stocks. Holding stock is having partial ownership in a company. Any incorporated company has stock, but only some companies make ownership available to the public. These are the publically traded companies and their shares are bought and sold on a stock exchange. Shares are issued to represent the ownership. If a company has 100 shares of stock and you own 10 shares, then you own 10% of the company. All owners have a say in the affairs of the company, though how much of a say usually depends on the number of shares you own. Shares are bought and sold on and off the open market. The open market is called the exchange.

In one way, options basically represent control of stock shares. What this means is that when you buy or sell options, you are buying or selling the right to control that stock. So when you sell an option, you still own the stock, but you have given someone else the right to buy it from you at any time.

A call option is the most basic of stock options., giving the owner the right to buy a specific stock at a pre-determined price, within a pre-determined period of time. An example call option would be 1 OCT $50 .00 ABC Call contract. This means that you have the right to buy 100 shares of ABC, anytime before the third week of October for $50.00 a share. This is because one option contract almost always controls 100 shares of stock. This right to buy is limited to the specified Stock. $50.00 is the strike price. The Strike price is the name given to the pre-determined purchase price. So when you buy a call with a strike of $50.00, when you exercise (decide to buy the stock at the specified price)your option, this is the price you will buy the stock at. The date determines when the option will expire. Unfortunately, all options have expirations. If it is January Now, and your option expires in October, then you have 10 months to decide if you want to exercise that option.

The Strike price is the agreed upon price at which you will buy stock shares. Strike prices are only available in intervals. Typically every 5 dollars. For example, if a stock is trading for $48.79, there will be options available for purchase with strike prices at 20, 25, 30, 35, 40, 45, 50, 55, 60, 65, 70, 75, etc. Yes, a $20 strike gives you the right to buy that stock which is currently trading at $48.79 a share for $20.00 a share, but you will pay at least $28.79 a share for it, while a $50.00 call may only sell for $1.20 a share.

The option price is the price that the option is selling for on the market. If a share of stock is selling for $47.50 and a $45.00 option costs $3.00; this means you will pay $3.00 a share for the right to buy the stock at $45.00 a share. At $3.00 a share, then one contract costs $300 ($3.00 times 100 shares). If you decide to buy that stock, then you will end up paying $4500 ($45 a share time 100 shares) for the stock instead of $4750 (stock selling price of 47.50 times 100 shares). If you buy the option and then eventually the stock, your basis would be $4800 ($300 for the cost of the option contract and the $4500 when you eventually buy the stock.) It will always cost more to buy a stock through options than it would cost to buy the stock directly. So why would anyone ever use an option when it costs more to buy through options than to buy the stock directly? People pay a premium for options because of the flexibility and leverage options give them.

The premium is the difference between the amount of money you would spend buying an option and exercising the option to buy the stock versus directly buying to stock on the open market. In the example above, the stock was trading for $47.50 a share while the $45.00 option cost $3.00 a share. If you sum the last two, the cost of buying and exercising the option is $48.00 a share ($45.00 + $3.00). The difference between these two values is $0.50 a share. $0.50/share is the premium on this option. Options will always cost more than buying the stock directly. Option buyers pay this premium because of the benefits, including flexibility and leverage.

Flexibility. Call Options are the right, but not the obligation to buy the stock. This means there is limited downside risk. So, if a stock is at $47.50 a share and you buy the $45.00 option for $3.00 a share, the most you can ever lose is $3.00, but there is unlimited potential gains. If the stock drops to $20.00 a share, if you had bought the stock you would have lost $27.50 a share, but you would have only lost $3.00 a share with the option. If the stock rises to $70 a share, you can still buy it at the fixed price of $45.00. No matter how high the price rises, the price you buy it at always stays the same.

Leverage. In general, leverage refers to how much you can do with the same amount of money. In the case of stocks, if you have $1,000. You could buy 20 shares of a $50 stock, but if a $50 call option on the same stock only costs $2.00, then you could control 500 shares of stock for the same $1000 price. I use the term control as you are not buying shares of stock. You are buying the right to buy shares of stock. Once you have purchased that right, the shares are effectively yours and the profits of share increase are yours. In this scenario, the same amount of money has been leveraged by 25X (500 shares by options/20 shares by stock = 500/20 =25). The leverage is also what makes options risky and typically where people get in over their heads. If you have $1000 in your account, you should not spend all $1000 on the same stock. Because all that the stock has to do is stay below $50 a share and you will lose everything. Instead, the advantage of having so much leverage is that you can now diversify your portfolio over many more stocks.

To summarize so far, the most basic call option allows you to control another person’s shares of stock. You pay a premium to the person who sells the call and you now control their stock. From there, as the stock moves up in value so does your position, and if the stock declines in value, so does your position. The catch is that your losses are capped at the amount you invested in the option. As an illustration, suppose you really like a house at the end of the street. You think the whole area is undervalued and so prices will rise in the future. You go to the homeowner and offer to pay them $5000 in cash for the right to buy their home from them anytime in the next 2 yeas for its current market value. The homeowner may be elated to make a deal. It means money now for them. His only obligation is that he cannot sell to someone else in the next 2 years. If you are right and it is worth more in two years, you buy it from the current owner and sell it to someone else, if you are wrong, then the current owner stays. He keeps the original $5000 and you thank your luck stars you are not making payments on a depreciating home.

One big difference between this scenario and stock options is that with stock options, you almost never actually take possession of the stock. Because once you buy the call, you can immediately resell it to someone else for almost the same price. So you will almost always get more money by selling the option than you would by exercising the option and then selling the stock, this value is in the time to expiration. The more time before expiration, the greater your chances the stock will move above your strike price, This time makes options valuable and therefore better to sell an option than exercise it. The exception is if the underlying stock pays dividends and the dividend date is about to coming up. One disadvantage of options is you don’t actually own the stock so you don’t get the dividend. The dividend is given to the person how owns the stock, so if it is a large dividend (larger than the time value of the stock), you may be better off exercising your option so that you can get the dividend.

The value of an option is made up of 2 components: The intrinsic value and the extrinsic value, also called the time value or premium. If a stock trades for $47.50 and a $45.00 option is $3.00 dollars, the option price is composed of an intrinsic value of $2.50 and an extrinsic value of $0.50 (also known as the time value or premium). The intrinsic value is the amount of money the stock is trading above your strike price. Specifically, if you exercise your option, how much money will you make. In our case, if you exercise a $45.00 option when it is trading at $47.50, then you will make $2.50. That is your intrinsic value. The other component is extrinsic value. This is the component of the price that has no real value. If you instead of buying a $45.00 call, you bought a $50.00 call, then the option has no intrinsic value. The stock is trading at $47.50, there is no reason to exercise your option and buy at $50.00 a share when you can buy it on the open market for less. So when you buy a $50.00 call, you are anticipating the stock will rise to a price greater than $50.00 dollars. Until to stock does, the option has no intrinsic value. It does not mean the option has no value. It can still be sold as long as there is time enough to the stock to potentially move above $50.00. With respect to the extrinsic value of the stock, time is the option buyer’s enemy. The less time to expiration, the less likely the stock will rise above your price. Therefore, the extrinsic value of the option decays with time. You may pay $5.00 for a $50.00 call on a $47.50 stock, and if the stock price never moved, every day the option would be worth less, because with each passing day, there is less time for the stock to perform. That is why the extrinsic value is also called the time value.

The stock market is driven by buyers and sellers. The exchange is there to match buyers with sellers. Like trading stocks, for a transaction to proceed, there must be both a buyer and a seller. For you to buy a call option, there is someone in the world, who holds stock in the company, selling the call. Why would he sell the call? The same reason our homeowner in the example above accepted the $5000 for his home. It gives him money immediately on an asset that is just sitting there. He still treats the shares like his own, and if someone does opt to buy the shares from him, he gets a fair price.

The most basic option sell is called the covered call. It is called a covered call because you are selling a call and you are backing or covering the sale with shares of the actual stock. If someone decides to take your shares, there is no risk that you can’t deliver because you already own the shares. To initiate a covered call, all you have to do is buy 100 shares of stock in a company, then sell one call option. By selling, you receive a premium for the call, and the price of the call is deposited into your account the next day. So if you wanted to do a covered call on MSFT, buy 100 shares of MSFT at $30.00/share. For a total price of $3000. If you were to sell a short term option (about 30 days til expiration) it would price on average $1.20/share. Therefore, the premium is about 4%. For the stock holder, this is a large amount of money. 4% as much as his money would earn in 1 year in a CD. It now means to the stock owner that his stock can drop by 4% and he will break even. The seller gives up two things in exchange for collecting that premium. First, any profits from stock growth are lost. His selling price is fixed. Second, he gives up the right to sell the stock to anyone else. So if the stock drops in value. The seller of the call cannot unload his stock. He is obligated to hold onto it until the option expires.

So is it better to buy or sell a call option? That depends on the opinion you have of the underlying stock. If you are very bullish (expect the stock to move up substantially), then it is best to buy the call option, because there is no limited upside potential. If you expect the stock to drop in value, you should do neither one, there is no reason to buy a call and the person owning stock should probably sell the stock. If your opinion is that the stock is good but will remain flat or move up slightly, then selling a call is probably best, because when you sell a call, you are paid upfront and you don’t care how far the stock moves up, as long as it does not drop substantially. Plus, an option seller had a distinct advantage that time is now on their side. The value of any option position declines with time. This works against the option buyer as the option they bought is worth less every day. For the Seller, the option they sold is worth less every day. This means that if he wants to buy his option back every day it will cost him less to buy it back; and eventually the option will expire and he will never have to buy it back. Selling options provides a more consistent and steady income with cash flow, making it ideal in some circumstances, and in general more options expire worthless (expire out of the money as opposed to in the money), therefore, there is a higher probability of success with each sell, but the tradeoff is that the return is capped at the amount of the premium.

The ultimate success in either buying or selling options is dependent on the movement of the stock. Your ability to accurately predict the direction of the stock plays the biggest role in whether an individual trade is successful. Since we cannot always be correct, investors must take adequate measures to ensure an overall success rate by properly diversifying their portfiolio and developing an investment strategy and strictly adhering to it. Becoming emotionally involved in a trade, trading too often, or trading capriciously will drain an account faster than any other practice. Especially in options.

Up to this point we have discussed the first of two basic options: the call. In Chapter 3 we will discuss the basics of the put option.

Proceed to Chapter 3.