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What Are Options, and Why Should We Care About Them?

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Editor's note: To help investors get their feet wet with options trading, Minyanville has launched this "6-Week Options Kickstarter," an educational series aimed at increasing understanding of the basic nuts and bolts of options. In this series, veteran options trader Steve Smith will take you through options fundamentals with an emphasis on real-world applications. Note: Intermediate or advanced-level traders may get more mileage out of Minyanville's 9 Weeks to Better Options Trading series. Or click here to learn more about our OptionSmith MV Premium newsletter.

Knowledge is good.
-- Emil Faber

Even as stock-trading activity continues to decline, the popularity of options is on the rise.

Average monthly trading volume in stocks was 6.5 billion shares through the first half of 2012 -- nearly 50% below the 12.2 million shares per month average seen in 2008. 

Meanwhile, options volume has increased by an average of 19% in the past six years, and with good reason.

The development of electronic trading platforms and the decimalization of options have greatly lowered the cost of entry for retail options traders. In addition, we have seen an ever-expanding choice of products, such as options on ETFs like the Spyder Trust (SPY), which only launched in 2005 due to licensing issues, and weekly options on names such as Google (GOOG) and Apple (AAPL) have provided an ever-expanding selection of options to trade. 

The increase in options trading volume has not gone unnoticed by the major online brokers. TD Ameritrade (AMTD), and Schwab (SCHW) have expanded their options platforms through their respective acquisitions of ThinkorSwim and OptionXpress, and offer a growing range of educational tools and resources. 

Brokerage firms reap multiple benefits from options. Options transactions are typically more expensive than stock trades and also carry better profit margins. Also, by educating retail investors about the proper use of options, the brokerage firms are creating smarter customers that will do more trading over the long term, thus creating a virtuous growth cycle.

So let’s start at the very beginning by learning what options are, and why we should care about them.

The Option Contract

We use the term “option contract” for a reason since an options transaction is literally a contract between the buyer and seller. Contracts come in two forms: puts and calls.  

A call option gives the buyer the right, but not the obligation, to buy shares in a security at a specified price (known as the strike price) within a given time frame that ends on a specific date (which we call the expiration date).

On the other side of the trade, the seller of the call option has the obligation to sell said security at the specified strike price within the time frame. In a standard option, each contract represents 100 shares of the underlying equity. 

For example, the buyer of an Apple September $600 call has the right to purchase 100 shares of Apple at $600 at anytime up to the September 22 expiration date, regardless of what price Apple shares are trading at the time.

The seller (also knows as the writer) of that September $600 call has the obligation to sell 100 shares of Apple at $600 at any point prior to the expiration date. 

If the call owner decides to purchase the underlying shares, we say that he is “exercising” his right to do so.  If the call writer is forced to sell shares, he is being “assigned” his obligation.

A put option gives the buyer the right to sell shares at a specified strike price prior to the expiration date.  And on the other side, the seller of a put option has the obligation to purchase shares at the strike price prior to the expiration date. 

At any given time, most equity and ETF options offer a multitude of strike prices, which are typically in $5 increments (though options in some smaller stocks trade in $1 or $2.50 increments), and at minimum, four expiration dates throughout the year that occur on the third Friday of the month. Also, many different expiration periods -- such as quarterly, monthly, and even weekly options -- have been added to popular issues in recent years.

Unlike stocks, where each one has a finite number of shares to be traded, the options market can create an unlimited number of contracts. And whereas all shareholders can make or lose money depending on the price of a stock, the option market is a zero-sum game. For every dollar made in the option market, there is a dollar lost.

Options Come with Premiums

The cost of an option is usually referred to as its “premium.” Back to our Apple September $600 call example: With shares of Apple at $605 on July 6, the call was priced at $35 per contract.

Given that the strike price is $5 below the current stock price, the call is said to have $5 of intrinsic value.

The other $30, which is comprised of time and implied volatility, is described as extrinsic value. 

Put options that have strikes that are above the current stock price have intrinsic value.  Those below the current price have only extrinsic value.

Options that have intrinsic value are said to be “in-the-money,” while those strikes above the current stock price and whose value is solely extrinsic are said to be “out-of-the-money.”  If an option expires out-of-the money, it is worthless and all rights and obligations cease. 

Insurance Analogy

It is interesting to note that quite a bit of options terminology overlaps with that of the insurance industry. An option’s price or value is referred to as its premium (like an insurance premium). The purchaser of an option has losses limited to the amount of the premium.  The seller of an option is regarded as a writer (like an insurance underwriter). And an option’s expiration date is analogous to a term insurance policy. 

The insurance analogy crosses over to options pricing.

It costs a lot of money to insure a house sitting on a fault line in San Francisco.   

The same is true for volatile stocks. Let’s take Arena Pharmaceuticals (ARNA), a biotech whose share price can double or get cut in half on an FDA ruling. Its options are dramatically more expensive than that of companies like ExxonMobil (XOM) or ConEdison (ED), which have much more stable businesses and stock prices.

In our next article, we’ll advance our discussion by exploring exactly how these premiums get valued.

Here is a complete schedule for the 6-Week Options Trading Kickstarter:

1. What Are Options, and Why Should We Care About Them?
2. Option Pricing: The Five Components
3. Meet the Greeks
4. How to use Options: Three Basic Principles
5. Covered Calls
6. Hedging, Portfolio Protection, and Avoiding Disaster

Twitter: @steve1smith23

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POSITION:  No positions in stocks mentioned.