Basics of Trading Options

Options Basics

Trading options involves a contract which gives the holder (the "Buyer") the RIGHT, but not the OBLIGATION to either buy (a "call" options), or sell (a "put" options) a particular financial asset, at a specified price (the strike price) on or before a given date (expiration day). After this expiration day, the option no longer exists. Unlike the Holder, who has no obligation, the Seller IS obligated to either sell , if the option is a call, or buy, if the option is a put, should the holder decide to exercise the option. A call option gives the holder the right (but not the obligation) to buy a particular financial asset at the strike price, anytime prior to the expiration date. The writer (or seller) of the options has the obligation to sell the shares. A put option gives the holder the right (but not the obligation) to sell the asset at the strike price, anytime prior to the expiration date. The writer (or seller) of the options has the obligation to buy the shares.

The price that an option trades for is called the "premium". The buyer, or holder of the option can never lose any more money than the premium that was paid for. The writer, or seller, however, has unlimited potential loss if they are required to fulfill an option that did not go the way they had intended it to go.

The benefit of an option, to the buyer, is that it enables them to control a block of stock by paying only a small percentage of that block's actual market value. Many investors use options as sort of an "insurance policy", or hedge against market volatility by protecting stock that they actually hold from an unfavorable market move, while not giving up ownership of the stock. Think of this like buying Insurance, in a Blackjack game, if the dealer has an Ace showing..

The Expiration date for options is actually the last day that it may be exercised. If an option is allowed to expire without being exercised then it becomes worthless and the seller is released from all obligations under the contract.

Anatomy of Trading Option

An option has four basic parts:

1. The underlying security that is being bought or sold.
2. The option type: put or call.
3. The strike price.
4. The expiration date.

Let's walk through a sample scenario...

We want to purchase an October 50 call option of AAA. Now we have the four basic parts: AAA is the underlying security, October is the expiration month, and 50 is the strike price (sometimes referred to as the exercise price). Since the option is a call, the holder has the right, but not the obligation, to buy 100 shares of AAA at a strike price of $50.00.

Expiration Rule Warning!

When you buy an option, you need to know whether it is being sold under what's know as the European style, or the American style. The European style option cannot be exercised until the expiration date, while the American style can be exercised anytime before, or on, the expiration date. Most stock options are traded as American style, but there are still some that use the European style instead. If you are not sure, ask your broker before placing the order.

Who handles the transaction?

When trading equity options, in order to ensure that both parties keep up their end of the contract, an entity known as the The Options Clearing Corporation (OCC) is the "middleman" in all contracts.

The role of the OCC is to guarantee all exchange-traded contracts once the transaction is completed. It is the OCC's responsibility to see that both parties fulfill their obligation under the exercised contract. Let's examine this more closely using the October 50 AAA call option we went over earlier:

Suppose you want to exercise that AAA October 50 call option. The first step would be to notify your broker. Your Broker would then notify the OCC. The OCC would then randomly select a brokerage firm which is short one AAA October 50 call option and notify it that it has to produce 100 shares of AAA stock. The selected brokerage firm then notifies one of its clients, who has written an AAA October 50 call option, that he must produce 100 shares of AAA stock because his call has been exercised. The brokerage then transfers the shares to the buying brokerage and the OCC is notified that the transaction is complete.

This guide only scratches the surface of trading stock options. Learn more on through Options University. You need to arm yourself with as much information as possible to make sure that all of your trades leave you in the money!

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