What is an Option?
An option is a contract that gives the right, but not the obligation, to buy or sell 100 shares of the underlying stock at a particular price.
Option contracts expire. The value of the option is based on how many days it has to expiration and how near the profit target (strike price) is.
As an example:
SPY stock is trading at $140 per share and you believe the stock is headed up. You could buy 100 shares of the stock ($140 x 100 shares = $14,000) or you could buy an option that has a strike price of $140, as an example, for $200 that expires in the next 17 days. That means instead of investing $14,000 you can participate in the stock’s up move with just $200. Controlling $14,000 worth of stock option with $200 is LEVERAGE.
If you are right and the stock rises to $144 per share before option expires in 17 days, it will be worth $14,400 ($144 x 100 shares).
Here is how you would calculate the profit:
Sale price – Purchase price – premium paid for the option.
$14,400 - $14,000 = $400 - $200 = $200 profit or 100% profit.
Most options are not held until the expiration date, but are sold at a profit when the value of it appreciates. Conversely, options are sold at a loss when the value of it depreciates.
Here is an example of how options work using purchase of a house: You are not sure if the housing market is going up or down, and you want to buy a house only if it is going to appreciate in value. You approach the seller and offer to buy the house six months in the future, but you want to lock in the current price of the house with no obligation to buy it in the future. For the seller to agree to such terms asks for a $6,000 premium. That means, if you buy the house in six months it will cost you $306,000 instead of $300,000.
If the price of the house appreciates to $320,000, you would buy the house for $300,000 plus the $6,000 option premium. Since the value of the house has gone up to $320,000, you will make a profit of $14,000.
However, if the value of the house declines down to $280,000 then you wouldn’t buy the house for the agreed price of $300,000, and forgo the $6,000 premium. In this situation instead of losing $20,000, you only would lose $6,000.
Basic Option Facts
Options are quoted in per share prices, but only sold in 100 share lots. For example, a call option might be quoted at $2 per share, but you would pay $200 because options are always sold in 100-share lots.
If SPY option expires 1 cent in profit then you will be obligated to buy 100 shares of SPY. If at the time of the expiration SPY is trading at $140 per share it will cost $140 x 100 shares = $14,000. So make sure if the option is trading in profit to exit your option unless you want to own the shares. We trade options so we are not interested in buying the stock.
- The premium price is based on how many days are left to expiration and each day the premium devalues. As a simplified example if an options has 20 days to expire and it costs $2 then each day the value of the option will decline 10 cents ($2 / 20 days).
- Options increase in value when the underlying stock goes up. Inversely, options decline in value when the underlying stock goes down.
- Options have volatility. When the volatility of the stock goes up the option premium goes up and when the volatility goes down the option premium goes down.
- The maximum amount an option can lose is the premium price.
- An option can increase in value many fold.
More option information: www.eoption.com/option_basics.html
Why Options can Generate Big Profits?
Options are leveraged investment tool, and they limit the loss. The disadvantage of buying an option is the premium that one has to pay. The premiums erode with time and eats away at the profit and that is why it is important to know…
… when to buy an option
… and if the stock is more likely to go up or down
The most attractive parts of options are the leverage, and the fact that the losses can be limited if there is a major adverse price move. Even though the premium erodes the profits, due to the high leverage one can earn more money using options then stocks. Key to success in options trading is timing. If the timing is not right then the option's value will erode with time before a profit can be made.
On the other hand, if the timing of the option purchase is right the value of the investment can gain 100%, 200%, 300% or more within days.
Three major factors will influence the price of the option.
- Value of the stock.
- Time value - number of days left to expiration.
We have explained how options get effected by Stock Appreciation and Time. Here we explain the effect volatility has on options. The indicator below the chart shows how much volatility can fluctuate in a short period of time. At the lower end of the indicator the volatility was $1.80 per day and at the upper end of the indicator the volatility jumped to $6.50. When the volatility is greater the premium on option goes up.
Best Time to Buy Options
Timing: To minimize the erosion of the option premium due to time it is important to buy an option just before it turns back up. Our trading system for many years has been an excellent timing tool. With over 70% of the time it has been able to predict the day a stock will turn within a day or two. For illustration on how well our trading system predicts the turning points of a stock see the blue arrows on the chart.
Low Volatility: To minimize the cost of option due to high volatility, buy options when the relative volatility of the stock is low. An option could be twice as expensive when the volatility is high. That means during low volatility you could buy, as an example, twice as many options, and earn twice as much money for the same risk.
Near Expiration Date: Since the option premium erodes with time near the expiration date the option costs very little, but it still controls 100 shares of the underlying stock; therefore, if the market rallies soon after the purchase of the stock it will increase in value substantially.
What Exactly are Strike Prices?
The strike price of an options contract is the price that the underlying asset is agreed to be traded at. For example, a strike price of $50 allows you to buy the underlying stock at $50 any time prior to expiration no matter what price that stock is trading at.
The further away the strike price of an option is from the current price of the stock the less expensive the option is. If a stock is trading at $50, then an option with a strike price of $52 will be less expensive than an option with a strike price of $51.
If you have a brokerage account it is very likely they give you real time options data access. However, if you do not have real time data feed, finance.yahoo.com provides 15 minute delayed data at http://finance.yahoo.com/q/op?s=SPY+Options
Call and Put Options
A call option, often simply labeled a "call" gives you the right to buy the underlying option. If you think a stock is going up, you would by a call option.
When the price of the underlying instrument surpasses the strike price, the option is said to be "in the money". When the price of the underlying instrument is below the strike price, the option is said to be "out of the money". When the price of the underlying instrument is equal the strike price, the option is said to be "on the money".
Here are three examples:
If as stock is trading at $140, then an option with the strike price of $139 is “in the money” one dollar.
If as stock is trading at $140, then an option with the strike price of $141 is “out of the money” one dollar.
If as stock is trading at $140, then an option with the strike price of $140 is “on the money”.
A put option, often simply labeled a “put” gives you the right to sell the underlying option. If you think a stock is going down you would by a put option.
To learn more about options you could visit the below link