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Futures And Options Basics

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An option is a traded security that is a derivative product.

By derivative product we mean that it is a product whose value is based upon or derived from the price of something else. Since we are talking about stocks, a stock option is based upon, among other things, the price of the underlying stock.

There are also options on other traded securities such as currencies, indexes and interest rates, but here we will limit our discussion to stock options, or options based on stocks.

A distinguishing factor of an option is that is a depreciating asset in the sense that it has a limited life, and has to be used before the date on which it expires. As time goes by, the option loses value as it moves closer to its expiration date

When we speak of options in terms of volume, we refer to contracts. Each stock option contract is equivalent to 100 shares of stock. When we talk about two contracts, we are talking about 200 shares, 10 contracts; we are talking about 1,000 shares, 75 contracts 7500 shares and so on.

Amount of Shares	Equivalent Amount of Option Contracts
100	1
200	2
1000	10
7500	75
15000	150
50000	500
100000	1000

NOTE: It is important to understand the dollar cost of options before actually trading them. When an option is quoted at $1.00 per contract, the investor must realize that the $1.00 represents a price of $1.00 per share, not per contract. Remember that each contract is worth 100 shares. This means that if you were to buy one option contract at a quoted price of $1.00, your total cost will be $100.00 (1 contract x $1.00 per share x 100 shares per contract). If you were to buy 10 contracts for $1.50 per contract, your total cost will be $1500.00. Use the formula below when calculating total dollar cost of the option.

Total Dollar Cost of Trade = Number of Contracts x Price per Contract x 100

Option contracts are literally a sales agreement between two parties. The two parties are the buyer (or holder) and the seller (or writer). When you buy an option contract you are considered to be long the option. When you sell an option contract, you are considered to be short the option. This, of course, is assuming you had no previous position in the said option.

In an option contract, although it seems as though the buyer and seller must be tied together, they are not. You see, the buyer doesn't really buy from the seller and the seller doesn't really sell to the buyer.

In reality, an organization called the OCC or Options Clearing Corporation steps in between the two sides. The OCC buys from the seller and sells to the buyer. This makes the OCC neutral, and it allows both the buyer and the seller to trade out of a position without involving the other party.

Futures And Options Basics

Strike Price

This is the price at which the buyer of a call option has the right to buy the underlying. For example if you bought BHP calls at a strike price of 30$ then you have the right to buy the stock at 30$ (no matter what the market value of the stock is). In the case of put options, the strike price is the price at which you have the right to sell the underlying. Following the example above, if you buy BHP puts at a strike price of 30$ you have the right to sell BHP stock for that price (again, no matter what the market value of the stock).

Exercise

If you are the owner of options you have the right to exercise them. So when you call in your order to exercise your call options the result is that you lose the options (and the premium you paid) and you buy the shares at the strike price, no matter what the price of the stock is at the time. For puts, you lose the put options and must deliver i.e. sell the stock at the strike price. This is stock you either own or have to purchase from the market.

Premium

The strike price is often confused with the premium. The premium is the price you pay to buy the option itself. So the premium buys you the right to either buy (calls) or sell (puts) a stock at the strike price. In the example above, the premium for the options i.e. the price you have to pay to acquire them would be somewhere around 3$. So, spending 3$ per share allows you to control stock that costs 10 times as much. This is leverage.

Expiry Month

Options always have a certain life span i.e. they expire. Whenever you buy an option you specify the strike price and the expiry month of the option. The further away in the future the expiry month is the more expensive the option will be (i.e. the premium will be higher). This is only logical because a longer life span means that you can enjoy control over the stock for a longer time.

Time Decay

When you buy an option you pay a premium. This premium is higher the further out the option expiry is. As you hold the option and it gets closer to expiry its time value diminishes. This is called option time decay. It causes options to lose value with time. And this decay increases the closer the option gets to expiry.

While the above might be off-putting on the first sight consider this: options at different strike prices have different time decay i.e. one option loses its value quicker than another one. This means that you can combine these options (buy one, sell another) to construct so-called spreads. And these actually increase in value as time progresses. Look for my next articles for more info on the subject.

And think about this: if a bought option loses money with time, what would happen to options that are sold?

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About Author

Both John Roney & Emil Emilov are contributors for EditorialToday. The above articles have been edited for relevancy and timeliness. All write-ups, reviews, tips and guides published by EditorialToday.com and its partners or affiliates are for informational purposes only. They should not be used for any legal or any other type of advice. We do not endorse any author, contributor, writer or article posted by our team.

John Roney has sinced written about articles on various topics from Finances, Finances and Options Trading. This Article Provided By The Options University: Options Trading Strategies For Safer Investing and Consistent Profits. Discover how to protect your investments with the leveraged power of options. Step-by-step video tutorials, articles, free and premium. John Roney's top article generates over 90500 views. Bookmark John Roney to your Favourites.

Emil Emilov has sinced written about articles on various topics from Alternative Medicine, Real Estate and Options Trading. I hope you enjoyed my article on options trading. If you want to see what I trade and how I pick my trades with all the gory details please visit my blog at http://blog.emilov.co. Emil Emilov's top article generates over 201000 views. Bookmark Emil Emilov to your Favourites.

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