250percent.com - Stocks & Options 101

Stocks & Options 101

Let's start from the beginning. Of course, you know that owning a "stock" gives you a piece of ownership in a company. If there are a million shares, and you own 1 share, than you literally own one-millionth of the company. 100 shares is generally considered a "board lot" or "lot" for short. Trading an amount which isn't a multiple of 100 is called an "odd lot".

Unlike a stock, an "option" doesn't give you ownership in the company. Options have three basic properties. One, there is an "underlying stock". IE, every option directly relates to a stock traded on a major exchange. Two, there is a "strike price". The "strike price" is the price at which the underlying stock will change hands when the option is exercised. And three is the "expiry date". If you own an option, it will expire (IE, the option is worthless after that date) on the third Friday of the month of expiry. Expiry dates are usually expressed only by the month. Some long term options, sometimes called "LEAPS", also include the year (IE, expiry date of "May" is May 2002, and "Jan03" is January 2003). If you own an option, and would like to use it, that is called "exercising" that option.

Sometimes people will refer to options as "in the money", "out of the money", or "at the money". "In the money" means if the option were to expire today, at the current stock price, it could be exercised. "Out of the money" means that is the option were to expire today, at the current stock price, it could not be exercised. And "at the money" means the current stock price is close to the strike price.

There are two types of stock options - calls and puts. If you purchased one "call option", you are purchasing the right (but not the obligation) to buy 100 shares in the underlying stock, at a set price, any time between the day after you purchased it to the day of expiry. Conversely, a "put option" gives the holder the right (but not the obligation) to sell 100 shares at a set price between the day after purchase to the day of expiry. Once you buy an option, there are only three things that can happen. You can sell the option before expiry (on the open market), let the option expire, or exercise the option before expiry.

You can also choose to sell options, which is also called "writing an option". By selling an option, someone pays you a "premium" for the right to buy or sell 100 shares of stock. When you sell an option, the premium is deposited into your trading account and that money is yours to keep no matter what. Once you sell an option, there are only three things that can happen. You can purchase the option back before expiry (off the open market), let the option expire, or the option can be exercised on you.

Selling a put option by itself is called a "naked put", because you are promising to buy stock at a fixed price no matter what. If you sell a naked put with a strike price of $100, with the stock at $100, and the company announces a massive fraud that drives the stock price down to 1 cent, you would be legally obligated to buy shares at $100 each despite the fact that they're only worth 1 cent. So worse case scenario you can lose almost 100% (the number of options times 100 times the strike price, minus the premium you received). Best case scenario you get to keep the premium and the option expires worthless.

Selling a call option, or giving someone the right to buy the stock, when you don't own the stock, is called a "naked call". Naked calls are one of the riskiest plays in options, as you risk of loss is nearly infinite. That is, if you sell a naked call with a strike price of $10 with the stock currently at $10, and the company discovers a cure for cancer and the stock price shoots up to $10,000 a share, you are obligated to deliver 100 shares to someone for $10 each. But since you don't own those shares, you would have to buy them for $10,000 each for a loss of almost $1 million per naked call you sold. Worse case scenario, infinite loss (number of options times 100 times the current stock price, minus the premium you received). Best case scenario, you get to keep the premium and the option expires worthless.

If you sell a call option, but you do own enough of the underlying stock, it is called a "covered call", which is considered one of the safest plays in options trading. If the stock you own discovers a cure for cancer, you will have to deliver the shares at $10 each, but at least it doesn't drive you into bankruptcy. You'll miss out on the massive profits, but that's all... Worse case scenario, a small profit. Best case scenario, a decent profit. Properly executed covered calls mean a guaranteed profit either way.

"May 10 @ 4/5" refers to either a call or put option (it doesn't specify) that has a strike price of $10 per share, which will expire on the third Friday on May 2000, which has an option price of $ 4/5 or 80 cents per share. Purchasing 1 option of this will cost you $80 - 100 shares x 80 cents per share, as options are priced on a per share basis, and one option equates to 100 shares. Selling 1 option will put $80 into your account.

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