Tuesday, April 28, 2015

Introduction to Options

What Is an Option?
Options are simply legally binding agreements – contracts – between two
people to buy and sell stock at a fixed price over a given time period.
There are two types of options: calls and puts. A call option gives the owner the
right, not the obligation, to buy stock at a specific price over a given period of time.
In other words, it gives you the right to “call” the stock away from another person.
A put option, on the other hand, gives the owner the right, not the obligation, to
sell stock at a specific price through an expiration date. It gives you the right to
“put” the stock back to the owner. Option buyers have rights to either buy stock
(with a call) or sell stock (with a put). That means it is the owner’s choice, or option,
to do so, and that’s where these assets get their name.
Now you’re probably thinking that this is sounding complicated already. But
options are used under different names every day by different industries. For
instance, we are willing to bet that you’ve used something very similar to a call
option before. Take a look at the following coupon:
 

 The way pizza coupons and call options work is very similar. This pizza coupon
gives the holder the right to buy one pizza. It is not an obligation. If you are in

 possession of this coupon, you are not required to use it. It only represents a right
to buy. There is also a fixed price of $10.00. No matter how high the price of pizzas
may rise, your purchase price is locked at $10.00 if you should decide to use it.
Last, there is a fixed time period, or expiration date, for which the coupon is good.
Now let’s go back to our definition of a call option and recall that it
represents:
1) Right to buy stock
2) At a fixed price
3) Over a given time period
You can see the similarities between a call option and pizza coupon. If you
understand how a simple pizza coupon works, you can understand how call
options work.
Now let’s take a look at a put option from a different perspective. Put options
can be thought of as an insurance policy. Think about your car insurance, for
example. When you buy an auto insurance policy, you really hope that you will not
wreck your car and that the policy will “expire worthless.” However, if you should
total your car, you can always “put” it back to the insurance company in exchange
for cash. Put options allow the holder to “put” stock back (sell it) to someone else
in exchange for cash. Remember, if you buy a put option, you have the:
 1) Right to sell stock
2) At a fixed price
3) Over a given time period
As you will discover, the mechanics of calls and puts are exactly the same; they
just work in the opposite direction. If you buy a call, you have the right to buy
stock. If you buy a put, you have the right to sell stock.
Option Sellers
We know that buyers of options have rights to either buy or sell. What
about sellers? Option sellers have obligations. If you sell an option, it is also called
“writing” the option, which is much like insurance companies “write” policies.
Buyers have rights; sellers have obligations. Sellers have an obligation to fulfill
 the contract if the buyer decides to use their option. It may sound like option
buyers get the better end of the deal since they are the ones who decide whether
or not to use the contract. It’s true that option buyers have a valuable right to
choose whether to buy or sell, but they must pay for that right. So while sellers
incur obligations, they do get paid for their responsibility since nobody will
accept an obligation for nothing.
There are some traders who will tell you to always be the buyer of options while
others will tell you that you’re better off being the seller. Hopefully, you already see
that neither statement can always be true, because there are pros and cons to either
side. Buyers get the benefit of “calling the shots,” but the drawback is they must pay
for that benefit. Sellers get the benefit of collecting cash but they have a drawback
in that there are potential obligations to meet. What are the sellers’ obligations?
That’s easy to figure out once you understand the rights of the buyers. The seller’s
obligation is exactly the opposite of the buyer’s rights. For example, if a call buyer
has the right to buy stock, the call seller must have the obligation to sell stock. If a
put buyer has the right to sell stock, the put seller has the obligation to buy stock.
These obligations are really potential obligations since the seller does not
know whether or not the buyer will use his option. For example, if you sell a
call option you may have to sell shares of stock, which is different from saying
that you will definitely sell shares of stock. A call seller will definitely have to sell
shares of stock if the call buyer decides to use his call option and buy shares of
stock. If you sell a put option, you may have to buy shares of stock. A put seller
definitely must buy shares of stock if the put buyer decides to use his put option
and sell shares of stock.
It’s important to understand that options only convey rights to buy or sell

 shares of stock. For example, if you own a call option, you do not get any of the
benefits that come with stock ownership such as dividends or voting privileges
(although you could acquire shares of stock by using your call option and thereby
get dividends or voting privileges). But by themselves, options convey nothing
other than an agreement between two people to buy and sell shares of stock.
Now that you have a basic understanding of call and put options, let’s add
some market terminology to our groundwork.
 The Long and Short of It
The financial markets are filled with colorful terminology.
And one of the biggest obstacles that new option investors face is
interpreting the jargon. Two common terms used by brokers and
traders are “long” and “short,” and it’s important to understand
these terms as applied to options.
If you buy any financial asset, you are “long” the position. For
example, if you buy 100 shares of IBM, using market terminology, you are long
100 shares of IBM. The term “long” just means you own it. Likewise, if you buy a
call option, you are “long” the call option.
If “long” means you bought it then “short” means you sold it, right? Not quite.
Some people will tell you that “short” just means you sold an asset, but that is an
incomplete definition. For example, if you are long 100 shares of IBM and then
sell 100 shares you are not short shares of IBM even though you sold 100 shares.
That’s because you bought the shares first and then sold them, which means you
have no shares left.
However, let’s say you bought 100 shares of IBM and then, by accident, entered
 an order online to sell 150 shares of IBM. The computer will execute the order
since it has no way of knowing how many shares you actually own. (Maybe you
have shares in a safe deposit box or with another broker.) But if you really owned
only 100 shares then you would be “short” 50 shares of IBM. In other words, you
sold 50 shares you don’t own. And that’s exactly what it means to be short shares of
stock. It means you sold shares you do not own. However, when we short shares in
the financial market, it’s not meant to be by mistake – it is done intentionally. How
can you intentionally sell shares you don’t own? You must borrow them. In order
to further understand what it means to be “short” and how that applies to options,
let’s take a quick detour to understand the basics of short selling.
Traders use short sales as a way to profit from falling stock prices. Assume IBM
is trading for $70 and you think its price is going to fall. If you are correct, you
could profit from this outlook by entering an order to “short” or “sell short” shares
of IBM. Let’s assume you decide to short 100 shares. Your broker will find 100
shares from another client and let you borrow these shares. Although this sounds
like a lengthy, complicated transaction it takes only seconds to execute.
 In terms of the mechanics, shorting shares is similar to making a purchase on
your credit card. Your bank finds loanable funds from somebody else’s account
to let you borrow and you then have an obligation to return those funds at some
time. How complicated is it to short shares of stock? About as complicated as it is
to swipe a credit card at a cash register.
Let’s assume you short 100 shares of IBM at $70. Once the order is executed,
you have $7,000 cash sitting in your account (sold 100 shares at $70 per share)
and your account shows that you are short 100 shares of IBM – you sold shares
that you do not own. Do you get to just take the $7,000 cash, close the account
and walk away? No, once you short the shares of stock, you incur an obligation to
replace those 100 shares at some time in the future. In other words, you must buy
100 shares at some time and return them to the broker. Obviously, your goal is to
purchase those 100 shares at a cheaper price.
Let’s assume that the price of IBM later drops by $5 to $65 and you decide to
buy back the shares. You could enter an order to buy 100 shares and spend $6,500
of the $7,000 cash you initially received from selling shares. Once you buy the 100
shares, your obligation to return the IBM shares is then satisfied and you are left
with an extra $500 in your account. In other words, you profited from a falling
stock price. This profit can also be found by multiplying the number of short
shares by the drop in price, or 100 shares * $5 fall in price = $500 profit. If you
have shorted 300 shares of IBM, you would have ended up with a 300 shares * $5
fall in price = $1,500 profit. Of course, if the price of IBM had risen at the time
you purchased them back, then you’d be left with a loss since you must spend more
than you received to return the shares. If short selling still sounds confusing, just
 realize that the short seller generates profits in the same way as a stock buyer but by
entering transactions in the opposite order. For instance, when you buy stock, you
want to buy low and sell high. When you short stock, you want to sell high and
buy low. If you short a stock and then buy it back at a higher price, you’re left with
a loss because you really bought high and sold low.
Short selling works because traders are obligated to return a fixed number of
shares and not a fixed dollar amount. In our example, you shorted 100 shares with
a value of $7,000. Your obligation is to return 100 shares of IBM and not $7,000
worth of IBM. If you can purchase the shares for less money than you received,
you will make a profit.
 This is not meant to be a course in shorting stocks but rather a way to understand
what the term “short” really means when applied to the stock or options market.
Shorting means you receive cash from selling an asset you don’t own and then incur some
type of obligation. In the case of shorting stocks, your obligation is that you must
buy back the shares at some time.
If you short an option, you have sold something you don’t own. You get
cash up front and then incur some type of obligation depending on whether
you sold a call or put. If you short a call, you get cash up front and have the
obligation to sell shares of stock. If you short a put, you get cash up front and
have the obligation to buy shares of stock. The cash is credited to your account
immediately and is yours to keep regardless of what happens to the option. That
is your compensation for accepting an obligation, much like the premiums you
pay to an insurance company.

 When you sell (short) an option you will receive cash, which is yours to keep
regardless of what happens in the future.
 Notice that the long and short positions are taking opposite sides of the
transaction. For instance, the long call (call buyer) must be matched with a short
call (call seller). The long call has a right while the short call has an obligation.
Rights and obligations are opposites. In addition, the long call gets to buy while the
short call is required to sell. Buying and selling are also opposites.
For put options, the long put (put buyer) must be matched with a short put
(put seller). As with call options, it is the long position that has the right while the
short position has the obligation (opposites). The long put, however, has the right
to sell while the short put is required to buy (opposites).

 This arrangement is required to make the options market work. Both parties
(the buyer and seller) cannot have rights. They can neither both buy nor both sell.
One side has the right to buy (or the right to sell), while the opposite side has the
obligation to complete the transaction.
This arrangement is often a source of confusion for new traders. They wonder
how the option market can work if everybody has a right to buy or sell. The answer
is that it is only the long position that has the rights. The short position has an
obligation. It is important to understand this relationship when going through this
book, especially when you get to strategies.
 Long options have rights. Short options have obligations.
 Getting Out of a Contract
We just learned that you can get into an option contract by either
buying or selling a call or put. But once you’re in the contract, is there a
way to get out of it at a later time? The answer is yes. All you have to do
is enter a closing transaction (also called a reversing trade). In other words, you can
always “escape” your obligations by simply doing the reverse set of actions that got
you into the contract in the first place.
For example, if you are short an option and decide at a later time you don’t want
the corresponding obligation, you can get out of it by simply buying the options
back. This is much like you do with shares of stock if you are short. However, just
because you can get out of the contract doesn’t mean that you can avoid any losses
that may have accrued. The price you pay to get out of the contract may be higher
and, in some cases, much higher than the price you originally received from selling
it – just as when shorting shares of stock. But the point is that you can get out of a
short option contract by simply buying it back.
If the idea of buying back a contract sounds confusing, think of the following
analogy. You probably have a cell phone are locked into some type of agreement such
as a one-year contract. Cell companies do this to prevent people from continually
shopping around and jumping to the hot promotion of the month. However, your
 cell provider will also have some type of “buy back” clause in the contract. That is,
if you wish to get out of the agreement, you must pay a fixed amount of money,
perhaps $200, and you can escape your remaining obligations. If you pay this fee,
the company cannot take you to court later and say that you didn’t fulfill your
obligations. The reason is that you bought the contract back – it no longer exists
between you and the company. That’s the fee they specified to end all obligations.
This is mathematically the same thing that happens when you buy back a
contract in the options market. Although it is not a fee to end the contract, what
you’re really doing is going long and short the same contract, thereby eliminating
all profits or losses beyond that point. If you’re long the contract and you’re short
the same contract, then you’ve effectively ended all obligations.
Likewise, you can get out of long call option by simply doing the reverse;
that is, selling the same contract that you own. Because of this possibility, most
option traders simply trade the contracts back and forth in the open market rather
than using them to buy or sell shares of stock. As we will later see, trading option
contracts is a big advantage because they cost a fraction of the stock price.
 You can always get out of an option contract at any time by simply entering
a reversing trade.
Let’s make sure you understand the concepts of long and short calls and puts
by using our pizza coupon and car insurance analogies. If you are in possession of
a pizza coupon, you are “long” the coupon and have the right, not the obligation,
to buy one pizza for a fixed price over a given time period. In the real world, you
do not buy pizza coupons; they are handed out for free. But that doesn’t put an
end to our analogy because the basic idea is still there. Since you are holding the
coupon, that means you posess the right to use it, and that’s the role of the long
position. The pizza storeowner would be “short” the coupon and has an obligation
to sell you the pizza if you choose to use your coupon. You have the right; he has
the obligation.
If you buy an auto insurance policy you are “long” the policy and have the
right to “put” your car back to the insurance company. The insurance company
is “short” the policy; it receives money in exchange for the potential obligation of
having to buy your car from you. Whether you make a claim or not, the insurance
 company keeps your premium just as you will when selling options. That’s its
compensation for accepting the risk.
In the real world of car insurance, you cannot just force the insurance company
to buy the car back for any reason. There are certain conditions that must be
met; for example, the car must be damaged or stolen. You can’t just obligate the
insurance company because you don’t like it anymore or because it has depreciated.
However, in the real world of put options, you can sell your stock at a fixed price
for any reason while your put option is still in effect. There are no restrictions. Of
course, you wouldn’t want to do that if the fixed price you’d receive is less than the
current market price. The main point is that if you are long a put option, you call
the shots. You have the rights. You have the “option” to decide. You have the right
to sell your stock for that fixed price at any time during the time your “policy” is
in effect.





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