Basics of Equity Options

With the purchase of an equity option, you've purchased the right to buy or sell a stock at a specified price. You have not purchased or sold the underlying asset at this point, you've simply purchased the right to do so during a specified period of time. When the stock price moves in your favor, you can either excercise the option or you can trade the option. I'm mainly concerned with trading the option rather than excercising. Options are a great way to hedge a particular position - simply put insurance for you in the event of adverse occurences to help limit your losses.

There are two types of options available: call options and put options.

Call - The right, but not obligation, to buy the underlying asset at a specified price.
Put - The right, but not obligation, to sell the underlying asset at a specified price.

In a nutshell, the value of a put will tend to increase as the price of the underlying stock decreases. The value of a call option will tend to increase as the price of the underlying stock increases.

There are two main components of a stock option:

Strike Price - The price at which the option can be excercised for.
Expiration date - The date the option expires.

With options, time works against you. Every day that passes means you have come closer to the option expiring. Options expire every third Friday of the month. So if you have options with an expiration of August 2007, this means your option will expire August 17, 2007. On this day, your option must be excercised (or traded) if it has value or if not, it will become worthless.

Why options? There are two main reasons one may purchase an equity option. As discussed before, it is a great way to hedge a position. For instance, say you own 100 shares of IBM. Its currently trading at $100 per share. You may want to protect yourself in the event IBM goes down. You may want to be guaranteed that you can sell IBM at $90 per share. So you do this buy purchases a Put option, Strike $90. The expiration date you choose can be however long you'd like to be covered. You also might do this if you wrote covered calls against your shares of IBM. Because you wrote covered calls against IBM, you cannot sell your shares of IBM as long as those covered calls are out there. That means you'll need to hold IBM, even if it starts going down. Puts will help hedge you against this downside.

The other reason, and the reason I'm into it, is trading. Options are traded on the open market. The risk from options comes from the fact that they eventual expire. However, options enables you to gain leverage. You may be bullish on a stock but may not have the funds to have a position in that stock that would make it worth it. Options will allow you to capitalize on stock gains without having to own the stock. Because the price of options are below the price of the actual stock, you can have "control" over a large number of shares than you normally would if you purchased the stock outright. In addition, you've limited your downside to the money you laid out to by the calls (or puts). For instance, if you paid $3,000 for options on a certain stock, worst case scenario is that you lose that $3,000. Nothing more. But on the upside, you can get a lot of leverage. Let's take IBM as an example (I'll make up values, but they'll get the point across). IBM is currently trading at $100. You believe that IBM is going to go up in the near future, let's say it will go up 3 points. You have $1000 available to make a purchase. You can buy 10 shares of IBM and if it goes up 3 points, you've made $30. However, let's say you purchase a call option instead. Let's say you buy IBM calls at a strike of $100. Each option may cost $2. You can buy 500 options (5 contracts). You now have the leverage of 500 shares of IBM with the same amount of money. Ignoring options pricing for now, let's say the option price increases $3 (it won't increase dollar for dollar, but that will need to be another post, but it will increase enough to make good money). You've made $1500 on this transaction. More realistically, with the way options are priced in the market, the option may increase anywhere from .75 to 2 points. Doing the math, you are still in good shape and still making more.

Those are the basics of options. It gets much more complicated, but you should have an idea of the instruments and how they work.