Tuesday, July 10, 2012

The Basics of Understanding Stock Options

A stock option is a derivative product that gets its life from a publicly traded stock. The value of this derivative is derived from the underlying stock price plus the value of time to expiration.
Options that expire next month are more expensive than options that expire this month. Additionally, options that are in-the-money (ITM), Apple Inc. (AAPL) shares at $590 and call options at the $580 strike price will be more expensive than the out-of-the-money (OTM) $610's, $620's, and so on. 
When you buy shares of AAPL for cash you can hold it forever as long as it doesn't go bankrupt; whereas an option has a strict expiration date (traditionally the 3rd Friday of every month yet today there are expanded expirations offered), thus an option has a shorter lifespan than a stock.  Options are riskier than stocks but the rewards can be much bigger.
There are also options on currencies, indexes and interest rates, but POTC will limit this write-up to stock options.
A distinguishing factor of a stock option is that is a depreciating asset in the sense that it has a limited time horizon and thus you have a smaller window to be right on direction. You can make money when a stock goes up (call options), or down (put options).
 And you have to take action (book profits or losses) before the expiration date. As time passes the option value erodes in value/price as it moves closer to its expiration date.
When we speak of options in terms of volume, we refer to contracts instead of shares.
One (1) stock option contract is equivalent to 100 shares of stock. And two (2) contracts are equal to 200 shares of stock, 20 contracts; we are talking about 2,000 shares, 100 contracts 10,0000 shares, etc. etc.
Equivalent Amount of Option Contracts  Equivalent Amount of Shares 

You have to understand the dollar cost of options before deciding on trading. When an option is quoted at $1.00 per contract, the investor must realize that the $1.00 represents a price of $1.00 per share, not per contract.
Please understand that each contract is worth 100 shares. This means that if you bought y a single (1) option contract at a quoted price of $1.00 your total cost would be $100.00 (1 contract x $1.00 per share x 100 shares per contract). If you bought 10 contracts for $1.50 per contract your total cost would be $1,500.00.
Use this basic formula when calculating total dollar cost of the option.
Total Dollar Cost of Trade = Amount (#) of Contracts x Price per Contract x 100
Option contracts are a sales agreement between two parties. The parties are the buyer (or holder) and the seller (or writer). When you buy an option contract you are long the option. When you sell an option contract you are short the option. This assumes you had no previous position in the said option at time of entry.
Thank You,

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