Introduction To Options Trading, Part 2

An option is a contract that provides you with the right to execute a stock transaction—that is, to buy or sell 100 shares of stock. (Each option always refers to a 100-share unit.) This right includes a specific stock and a specific fixed price per share that remains fixed until a specific date in the future. When you have an open option position, you do not have any equity in the stock, and neither do you have any debt position. You have only a contractual right to buy or to sell 100 shares of the stock at the fixed price.

Since you can always buy or sell 100 shares at the current market price, you might ask: “Why do I need to purchase an option to gain that right?” The answer is that the option fixes the price of stock, and this is the key to an option’s value. Stock prices may rise or fall, at times significantly. Price movement of the stock is unpredictable, which makes stock market investing interesting and also defines the risk to the market itself. As an option owner, the stock price you can apply to buy or sell 100 shares is frozen for as long as the option remains in effect. So no matter how much price movement takes place, your price is fixed should you decide to purchase or sell 100 shares of that stock. Ultimately, an option’s value is going to be determined by a comparison between the fixed price and the stock’s current market price.

A few important restrictions come with options:

· The right to buy or to sell stock at the fixed price is never indefinite; in fact, time is the most critical factor because the option exists for a specific time only. When the deadline has passed, the option becomes worthless and ceases to exist. Because of this, the option’s value is going to fall as the deadline approaches, and in a predictable manner.

· Each option also applies only to one specific stock and cannot be transferred.

· Finally, each option applies to exactly 100 shares of stock, no more and no less.

Stock transactions commonly occur in blocks divisible by 100, called a round lot, which has become a standard trading unit on the public exchanges. In the market, you have the right to buy or sell an unlimited number of shares, assuming that they are available for sale and that you are willing to pay the seller’s price. However, if you buy fewer than 100 shares in a single transaction, you will be charged a higher trading fee. An odd-numbered grouping of shares is called an odd lot.

So each option applies to 100 shares, conforming to the commonly traded lot, whether you are operating as a buyer or as a seller. There are two types of options. First is the call, which grants its owner the right to buy 100 shares of stock in a company. When you buy a call, it is as though the seller is saying to you, “I will allow you to buy 100 shares of this company’s stock, at a specified price, at any time between now and a specified date in the future. For that privilege, I expect you to pay me the current call’s price.”

Each option’s value changes according to changes in the price of the stock. If the stock’s value rises, the value of the call option will follow suit and rise as well. And if the stock’s market price falls, the call option will react in the same manner. When an investor buys a call and the stock’s market value rises after the purchase, the investor profits because the call becomes more valuable. The value of an option actually is quite predictable—it is affected by the passage of time as well as by the ever-changing value of the stock.

Tip

Changes in the stock’s value affect the value of the option directly, because while the stock’s market price changes, the option’s specified price per share remains the same. The changes in value are predictable; option valuation is no mystery.

The second type of option is the put. This is the opposite of a call in the sense that it grants a selling right instead of a purchasing right. The owner of a put contract has the right to sell 100 shares of stock. When you buy a put, it is as though the seller were saying to you, “I will allow you to sell me 100 shares of a specific company’s stock, at a specified price per share, at any time between now and a specific date in the future. For that privilege, I expect you to pay me the current put’s price.”

The attributes of calls and puts can be clarified by remembering that either option can be bought or sold. This means there are four possible permutations to option transactions:

1. Buy a call (buy the right to buy 100 shares).

2. Sell a call (sell to someone else the right to buy 100 shares from you).

3. Buy a put (buy the right to sell 100 shares).

4. Sell a put (sell to someone else the right to sell 100 shares to you).

Another way to keep the distinction clear is to remember these qualifications: A call buyer believes and hopes that the stock’s value will rise, but a put buyer is looking for the price per share to fall. If the belief is right in either case, then a profit may occur.

The opposite is true for sellers of options. A call seller hopes that the stock price will remain the same or fall, and a put seller hopes the price of the stock will rise. (The seller profits if the option’s value falls.)

Tip

Option buyers can profit whether the market rises or falls; the trick is knowing ahead of time which direction the market will take.