Options: A basic guide on this derivative.

Understanding options: What are options?

Options may look far too complex to many casual investors, but the idea is basically straightforward, it is a contract or agreement. Options are written agreements or contracts that allows the buyer of the option to acquire a particular security at an agreed price within a limited time period. The buyer of the options contract has the right to buy or sell the security at any time before the contract expires. The good part about this is that the buyer does not have to purchase or in standard terms, the buyer is not obligated to buy it. The holder of the option can just walk away if the price does not meet expectations. In terms of risk, the amount of loss is limited to the price the investor paid for the option.

The options market is totally separate from the stock market, but the price of each options contract is dependent on the underlying stock that it is based on. The markets are separate but they are closely correlated like an object and a shadow. If a stock on which an option is based on goes up in price, the price for the option contract goes up as well. When the underlying stock goes down, the option goes down in value as well. As the name implies, it offers investors more strategies in maximizing potential gains or generate extra income. 

How options work

Options are basically contracts that states at which price the asset can be bought or sold within a specified time period. Suppose an investor is interested in buying a house that costs $100,000 and really liked it, however, he will keep looking in the market just in case he can find a better house at a better deal. The owner of the house on the other hand is very eager to sell it as soon as possible and will sell the house to the next interested buyer with ready cash on hand. Since the investor liked the house, he asked the owner of the property to hold it for him for a month while he tries to look for a better deal elsewhere. The property owner agrees to hold the house for 30 days if the investor pays $2,000 as a reservation fee, in return, the investor can purchase it at $100,000 regardless if the price of the house goes up or down in market value.

These are the possible scenarios that can happen later on before the contract expires.

- If the investor found a better deal elsewhere, he is not obligated to buy the property, he can simply walk away from the deal.
- If the investor cannot find a better deal, he can purchase the house before expiration at $100,000.
-If the price of the house went up to $110,00 he can exercise the option and buy the house at $100,000 then sell it at $110,00 for a $10,000 profit.
-If the price of the house fell to $90,000 buying it as stated on the contract at $100,000 is unwise so he can just walk away from the deal. The good part about this is that he only lost $2,000 from the payment of the contract instead of losing $10,000 should he bought the house instead at an earlier date.

Options allows both the seller or buyer of the contract to benefit from the deal if it goes the way they planned. However, the risks involved are also present. The example above shows that if the price of the house goes down before expiration, the owner of the house cannot sell it right away to avoid imminent loss because she gave up control of the house to the buyer of the contract. On the other hand, the buyer of the contract technically gives that $2,000 reservation fee to the owner of the house whether or not the buyer would purchase the house.

Before moving on further, trading options would also equate to learning new investment terminologies. To start off, looking at our example, the owner of the house received $2,000 from the investor just to hold the house at a limited time period. The owner of the house made the terms of the contract and sold it for $2,000 therefore she can also be called the writer. The investor who bought the contract for $2,000 to hold the house for a month can also be called the holder since he's the one that "holds" the contract. When referring to options, the writer is the seller of the option and the holder is the buyer of the option. Now that you have a basic idea of options lets move to using other heavily traded equities like stocks on the next.

Two types of options

Since options are basically written contracts, it is separate from the stock market. However, options are worthless without an underlying asset that would support it. In the case of using options when trading stocks, the value of options rise and fall depending on the performance of its underlying stock.

Call
When investors think that a stock is going up in price, they could either purchase it directly and own shares or they can buy a call option. A call option is a written contract that
states at what price the stock can be bought and until when it is valid. The price of the stock has to go up in price in order for the call holder to have significant gains. If the price
does not go high enough to deliver profits for the trader before it expires, the amount paid for the call option will be lost.

Put
When the market is bearish and most stocks are falling, most traders resort to short selling. Shorting stocks involves borrowing shares and selling it right away and then buying them back at a much lower price. Traders who intend to short stocks can do so directly through a broker and sell borrowed shares or they can buy a put option. A put option is a written contract that states at what price the stock can be bought and until when it is valid. The price of the the underlying stock has to fall significantly in order for the put holder to have any gains. If the stock does not fall far enough to be profitable for the put holder, the amount paid for the put option is lost.

Strike price

The strike price is the fixed price that the underlying stock can be purchased as stated on the option contract. In stock trading, most investors buy stocks at market price which is the price of the stock at the time the broker is able to fill their order in. Some investors use limit order, it is a price that they intend to purchase the stock above or below the market price. Limit orders are sometimes not executed due to thin volume. For instance, if shares of Microsoft is currently trading at $24 a share and a trader wishes to purchase it at $23, he can simply put a limit order instructing the broker to purchase shares of Microsoft if it falls to $23 a share. This way the trader can maximize profits when it shoots back up again by buying the stock when it turned weak. In options, it can be done the same way however, the buyer of the option has to pay a premium for the desired target price or strike price in options terminology.

If the trader wishes to purchase a call option of Microsoft at $23 when it is currently trading at $24, the price for the contract would be significantly higher. If the trader is sure that Microsoft would hit $30 by next month, he can purchase a call option with a strike price of $25. At this strike price, the premium would be lower. Lets say the premium for the call option of microsoft at 25 is $1. A standard option contract is 100 shares of the underlying stock, a premium of $1.00 per share would cost the call buyer $100 to control 100 shares of MSFT which would normally cost $2,400 if he bought it at a market price of $24 a share. If the stock hits $30 before expiration of the contract, the call holder can exercise his option by buying the underlying stock at the strike price stated on the contract which is $25. Once $2,500 is paid for 100 shares of Microsoft, the call holder can sell the shares at the current market price of $30 for a total of $500 in profit.

The call holder can choose not to exercise the call option and buy the underlying stock. If the stock price is already at $30 with plenty of time left to expiration, he can simply sell the call option contract which is now at a higher price of $5 for a profit of $400 ($500 current premium - $100 premium paid = $400 profit). Without exercising the call option, $100 can possibly generate 300% return.

Option premium

When buying stocks you simply look at its share price and calculate how many shares you wish to purchase, the original price paid is called the principal. In options, it is called the premium. The premium is the price that the writer or seller of the option receives and on the option buyer side, it is the price paid to acquire the option. Premium has two sides on it, if you are the writer or seller of an option, the premium received is considered quick income if the underlying stock owned does not go in the opposite direction and it is not exercised by the buyer of the the contract. On the buyer side, the premium paid is money that is lost and connot be recovered unless when the underlying stock is exercised at a profit or the option contract is sold at a higher price.

Expiration

Options contracts have an expiration date, this date is always stated and the price of the option is significantly affected. An option that is not exercised at expiration date would turn into a worthless piece of paper. That is why it is very important to pay close attention on the expiration date as this significantly dictates the price of the option. If a contract is far away from expiration and the strike price is reached, the price of the option would be fair. A contract that is near or at its expiration date, and the strike price is not met, the option contract would be near worthless. If the underlying stock is trading at the strike price or higher with a far away expiration date, the price of the option would be reasonably high. If the same strike price is met or better, but the expiration date is near, the option will lose value a little bit. This value is caused by time deterioration where the price of the option contract is devoid of time value but instead, the price of the contract is now dictated by its intrinsic value because the option is at or in the money. When choosing which option to buy, it is important to pick the best expiration date based on the strategy a trader is intending to execute. 

At the money, In the money, out of the money

Monitoring an open option contract determines a successful trade from a failed one. Once an option order is initiated, the participant can't just sit back and relax due to the fact that the stock that it is based on fluctuates all the time. Since options move in conjuction with the stock market, it is very important to closely monitor an open contract to see whether you are breaking even, losing money or being profitable.

At the money
When the price of the underlying stock is the same as the strike price stated on the option, it is called at the money. Also, if the stock price is a few cents away from the strike price, it is also at the money.

In the money
In the money means that the strike price is inside the current market price of the underlying stock. An option is profitable if it is in the money or deep in the money. If the underlying stock is trading at $20 a share, a $15 strike price is in the money for a call option. This is profitable because if the option is exercised, the trader can buy the stock at $15 and sell it at the current market price of $20. For put options, if the underlying stock is currently trading at $20 a share, a $25 strike price is in the money. This means the trader can exercise a put option at $25 and buy it back at the current market price of $20 profiting $5 in the process.

Out of the money
Out of the money simply means that the strike price is outside the current market price of the underlying stock. Exercising options if it is out of the money delivers realized loses. For a call option, if the price of the underlying stock is at $20 a share, $25 is out of the money. If the call option is exercised, the trader buys the stock at $25 which is completely illogical. For a put option, a strike price of $15 if the underlying stock is trading at $20 a share is out of the money and unprofitable. This means, the buyer of the put can exercise it with a short position starting at $15 while the stock is trading at $20.

Exercising options

The term exercising options means performing the right to buy or sell the underlying asset at the strike price stated on the contract before the expiration date. The value of options rise and fall depending on the underlying stock's volatility. The constant fluctuation in price of options whether caused by time or or its intrinsic value means that the contracts themselves can be bought and sold at a profit or at a loss. However, if the ultimate purpose of the option holder is to purchase the stock before the contract expires, the holder is said to be exercising his options. When options are exercised, the option holder buys the stocks owned by the options writer at the strike price. For put options, the holder of the put exercises the option by assuming a short position starting at the strike price and buys back the stock to cover at a profit.

You may wonder why most traders would use options if their goal is to purchase the stock anyway, the reason is that they are using a relatively small amount of money to control a particular number of shares without risking more than they are willing to pay for the option. If they used limit orders instead, they are already committed to take losses should the stock go the opposite way because they already own the stock. Limit orders are only executed once the price stated by the client is met. For example, suppose Boeing is currently trading at $70 and a trader wants to take advantage of an upward momentum. The trader would place a limit order for Boeing at $71 hoping that the stock would go even higher to $75 and close the position. At 100 shares, it would cost her $7,100. If the stock goes higher, then its good for her but if the stock lost momentum and fell rapidly back to $66, she would have lost a total of $500. Now if she bought a call option instead, it would have saved her a lot of money. Suppose a $71 strike price for Boeing costs $1, it would only cost her $100 to buy a call option. If the stock goes higher to $75, she can just exercise her call option at the strike price of $71 and sell the stock at the current market price of $75 for a $400 profit. If the stock dropped down to $66 dollars, her capital is not fully exposed because she does not own the stock. At $66, she can just walk away from the contract and not exercise the call option, she only lost $100 which was the amount paid to buy the call option. That is way better than losing $400 more.

If a trader decides to exercise an option, he would have to notify his broker in advance. There are different rules on exercising options by region, American style options can be exercised at any time before its expiration date while European style options can only be exercised at expiration date. 

 Writers

If you buy a CALL option then you buy the right to purchase something. But who sells it to you? This other person does not have the RIGHT to sell it to you, she has the OBLIGATION of selling it to you if you want it. This person is called a writer. You can buy an option, but you can also WRITE an option (meaning you are now obligated to sell it).
If you write an option you will receive the premium that the buyer will pay. (Minus any brokerage and taxes).
Writers have a problem: They have limited profits (the margin they receive, when the strike price is not profitable for the buyer) but unlimited risk of loss when the strike price is profitable. That means for a call option, if the spot price is below the strike price, the buyer will not exercise the option, therefore you only get the premium. If the spot price is above, buyer will exercise and you pay the difference (but keep the margin).
Let's say you buy a CALL option of 100 INFY shares from me (Rs. 2200 strike price, Jan 07, Rs.20 premium per share). You pay me Rs. 2000 (Rs. 20 x 100 shares) as premium. If the price goes to Rs. 2,300 you will exercise the option and I will have to pay the Rs. 100 difference per share, totally Rs. 10,000. My loss is Rs. 8,000 because I got the 2,000 premium.
If the price goes down to Rs. 2,100, you will not exercise the option, and I will get only Rs. 2,000, which was the premium.
Why do I write options? Because most options go UN-exercised! Meaning, I can write an option today and it is quite likely that the market price will not be within the premium so I won't have to lose money! And after all, I can write a CALL option and BUY a future at the same time, ensuring that I make profits in the difference. (This is also hedging) 

Options strategy: covered calls

Covered call is an options strategy where the owner of a particular stock writes or sells a contract against the stocks owned in exchange for a premium. This strategy can deliver a steady income since the call writer receives the premium as soon as it is opened. It is also a safe strategy as long as the underlying stock does not fall in price far enough that it erodes the value of the premium received. When selling calls, writers benefit more if the stock they own does not get called away or exercised by the buyer of their call. This happens when the current market price of the stock does not reach the strike price stated on the contract. When their stock is not called away, the call writer can write another covered call option after the contract reached its expiration date.

Covered call is very effective on a sideways market where the price of the underlying stock does not fluctuate on a wider band. This is reversed and ineffective if the underlying stock is volatile so a covered call is only recommended on less volatile stocks. Since selling a call means giving up control of the stocks owned to the call buyer, the writer is helpless when the stock falls continually. In this scenario, the stocks owned by the writer would not be called away but he will suffer a significant loss due to the fact that he cannot sell the stocks until the contract expires. A way to avert this loss would require the writer to buy back the call he wrote at a slight loss to regain control of the stocks. Since the action taken is sell to open when the call is sold, buy to close is the action required to regain control of the stocks at the broker screen. If the writer chooses an out of money strike price, his gains are limited to the premium received and the profits generated by the underlying stock when it gets called away at a higher price.

Options strategy: Long calls

A long call simply means buying a call option to assume a long position on the stock or the option itself. A call buyer hopes that the price of the underlying stock would go up to realize profits. The loss potential of the call holder is limited to the premium paid to the call writer. A long call's profit potential is limitless as long as the price of the underlying stock keeps rising in price before expiration date. There are two ways to profit from buying calls, this is done by exercising at a higher strike price or selling back the option contract at a higher price.
Since options have an expiration date, gains generated from the continual rise of the underlying stock is limited by it. If the call buyer decides to roll over his option position, which involves the process of closing the existing contract and opening a new one with a higher strike price and a much longer expiration date, the call buyer would have to pay an extra premium for the new contract opened. By doing this, he still caps his loss potential to the premium paid but ends up paying more for the roll over as it involves opening another contract. However, if the call buyer is really sure that the stock would keep rising, he can avoid paying another premium from rolling over by just exercising the option. Exercising a long call means that the call buyer intends to purchase the underlying stock and hold it for a definite time period.
The risk involved in buying calls is when the underlying stock drops significantly in value, but since the call holder does not yet own the stock, he will not suffer losses from the price drop. The call buyer will not exercise the option because the strike price is at a level that will not generate profits. The price of the option will also drop in value to the point that selling it would incur losses for the call holder. 

Options strategy: long puts

Long puts is a strategy used in options to profit from a falling stock. The advantage of a put is that the put holder (buyer) can technically short a stock even if it is not sortable with the broker due to lack of available shares to lend. Another advantage is that since the trader does not own the stocks while assuming a bearish position, the trader's loss potential if the stock goes up in value is limited to the premium paid for the option. If the underlying stock drops in value enough that it hit the put buyer's strike price before expiration, the trader can either exercise the put option or sell the put option at a now much higher price.

A put that is exercised is different from an exercised call where the stocks are delivered to the investor at the call's strike price. Once a put option is exercised, the investor assumes a short position on the stock beginning at the strike price. If the underlying stock is deep in the money, the investor exercising the put option can continue with the short position or sell to cover at the current market price.

As an example, a trader is looking to short ABCD at $98, the current market price is $100. If the trader buys a put with a strike price of $98 and the option costs $1.00, the trader would have to pay a total premium of $100 for 1 contract of ABCD put. If the stock goes down to $96 a share, the trader can exercise the option assuming a short position at strike price and buying to cover at $96 for a profit of $200 minus the premium paid at $100. If the trader sellers the contract instead, the put option will now be worth more once it is sold. 

Options strategy: naked puts

A naked put is a strategy where the writer sells the put without assuming a short position on the stock. The advantage of using this strategy is once the underlying stock did not reach the strike price, the naked put writer gets to keep the premium received without risking significant capital to assume a short position on a particular stock. If the put was exercised by the put buyer, the naked put writer will be forced to buy the stock at the strike price.

To look at the advantage of using this strategy, lets say that an investor is looking to buy stocks of ABCD and its current market price is $100 a share, he is thinking of placing a limit order instead at $95 to take advantage of a possible dip. If the investor placed a limit order, he would have to wait until the price hit $90. However, if the investor sold naked puts on ABCD stock at $95 for $2.50 per contract, the investor would receive a $250 premium while waiting for the stock to drop to $95. Days passed and before expiration, the market price of ABCD fell to $93 and it was exercised by the put buyer, the writer would still have to buy the stock at the strike price of $95 even if the stock is trading at the current market price of $93. It is still better than buying the stock at market price when it was $100 or waiting several days for it to go down to $95.

Options strategy: covered puts

A covered put is the process of shorting a stock and write (sells) put option on it to receive a premium for income. Once the put is in place, the trader's profit is capped at the put's strike price and the premium received from the sale. A huge disadvantage when using this strategy is that once the stock moves higher, the losses incurred by the trader will be substantial. This strategy is rarely used as traders would just assume a naked put strategy instead of a covered put. 

Options strategy: straddles

A straddle is an options strategy used if the trader has no clue where the market is going next. Straddles are typically utilized on volatile underlying stocks that could potentially make a large move in either direction. These potentially huge price swings are governed by external factors like news about the company or a pending interest rate decision by a central bank.

Straddles are initiated by opening a long call and put with the same strike price, expiration date and underlying stock. Once the stock begins to move significantly in one direction or a leg, the losing leg would be closed out at a loss and the profitable leg would be sold at a profit. When buying straddles, it is important to select an underlying stock that is guaranteed to move significantly. If the underlying stock remains unchanged until the straddle reached its expiration date, the trader takes a loss from both long put and call options which at this stage has expired worthless.