Now that you know the secret to making options work is to pick the right underlying stock first, let’s move on to options themselves…
All About Options
What I’m going to do here is give you an understanding of options, then I’ll get into the difference between monthly and weekly options.
The first thing to understand is that an option is nothing more than the right, but not the obligation, to buy or sell a stock for a specified price on or before a specific date.
That’s all it is.
An option BUYER owns the RIGHT to buy or sell a stock at a fixed price until the option expires. An option buyer pays money to own those rights.
An option SELLER owns the OBLIGATION to buy or sell a stock at a fixed price until the option expires. An option seller receives money to take that obligation.
A Call option is the right to buy a stock at a specific price on or before a specific date.
A Put option is the right to sell a stock at a specific price on or before a specific date.
You can buy options and you can sell options.
You can also sell options you don’t own.
The trader that purchases an option, whether it is a Put or a Call, is the option “buyer.”
The trader that originally sells the Put or Call is the option “seller.”
Each option contract is equal to 100 shares of the underlying stock. There are basically two things you do with options, BUY them or SELL them.
When you buy an option, you are buying the “right” to buy or sell a stock, on or before a certain date, (called the expiration date), at a certain price, (called the strike price). When you sell (also known as “write”) an option, you are selling the “obligation” to buy or deliver a stock, on or before a certain date, (called the expiration date) at a certain price, (called the strike price).
There are four parts to an option.
- The TYPE – Put or Call.
- The UNDERLYING STOCK
- The EXPIRATION DATE
- The STRIKE PRICE
1st Part Of An Option – Type: Puts and Calls
Calls
When investors anticipate a stock’s price will be rising, they would buy Calls. When they buy a Call, they are buying the right to “call” the stock away from someone at a fixed price, (the strike price) for a fixed amount of time, until the expiration date (which is always the third Friday of the expiration month).
How Does A Call Work?
Let’s say ABCD is a stock trading at $87 per share on November 15 and an investor thinks it’s going to rise by year end. And let’s say that investor could purchase the ABCD Dec 90 Calls for $5 per contract (each contract is equal to 100 shares). The investor that buys any ABCD Call option owns the right to call the stock from the market at $90 per share until the third week of December.
In our example, December is the expiration month. That means that on the third Friday of December this option will expire. All the ABCD options with a December expiration will expire on the third Friday of December. If ABCD does rise, the price of the option will also rise.
If ABCD shoots up to $110 per share, then this option will likely rise to around 20. Think about it, this investor owns the right to buy ABCD at $90 and it’s trading at $110. He paid 500 bucks for the right to buy ABCD at $90 anytime he wants until the third week of December.
He can sell that option anytime he wants between the time he bought it and the time it expires. Once the third Friday of December rolls around, this option expires.
Almost all Call buyers sell their Call options rather that exercise them. If ABCD starts dropping, then the value of this option will also drop. If ABCD drops to $83 then there won’t be much value in owning the right to buy ABCD at $90 when you could buy ABCD in the market at $83.
This option will only be valuable if ABCD is trading over $90 come the third Friday of December. If ABCD is trading below $90 on the third Friday of December, then this option will expire worthless. Think about it, who would want to pay someone for the right to buy ABCD at $90 when they could buy ABCD for less than $90? That’s a Call option. There are only two kinds of options, calls and puts. Think “call up” and “put down”.
Now let’s move on to “Put” options.
Puts…
When investors or traders anticipate a stock’s price will be dropping, they would buy Puts. (But that’s not what this strategy is about.) When they buy a Put, they are buying the right to “put” the stock to someone at a fixed price, (the strike price) for a fixed amount of time, until the expiration date (which is always the third Friday of the expiration month).
When an investor or trader thinks a stock price will be staying the same or rising, he would sell Puts and receive money for selling someone the right to “put” stock to him at the strike price until the options expires.
How Does A Put Option Work?
Let’s say ABCD is trading at $87 per share on November 15 and an investor thinks it’s going to drop by year end. That investor could purchase the ABCD Dec 90 Puts for $5 per contract (each contract is equal to 100 shares). The investor that buys any ABCD Put option owns the right to “put” the stock to the market at 90 per share until the third week of December.
In our example, December is the expiration month. That means that on the third Friday of December this option will expire. All the ABCD options with a December expiration will expire on the third Friday of December.
If ABCD does drop, the price of the put option will rise. The investor can control 100 shares of ABCD by owning 1 ABCD Put contract.
In this case, the investor could control 100 shares of ABCD at a fixed price (the strike price) of 90 per share for $500 (5 per contract x 100 per contract = $500). If the stock price of ABCD drops, the value of this option will rise. If ABCD rises in value, this option will drop in price.
Why Does The Value Of The Put Rise If The Stock Drops?
Because the value in owning the right to sell ABCD at 90 becomes more valuable as the stock drops below 90. Imagine being able to sell a stock 23 points higher than it’s trading at. That’s what you would have if you owned the right to “put” ABCD at $90 if ABCD was trading at $67.
If ABCD drops down to $67 per share, then this option will likely rise to around 20. Think about it, this investor owns the right to sell ABCD at $90 and it’s trading at $67. He paid 500 bucks for the right to sell ABCD at $90 anytime he wants until the third week of December.
He can sell that option anytime he wants between the time he bought it and the time it expires. Once the third Friday of December rolls around, this option expires. Almost all Put buyers sell their Put options rather than exercise them. If ABCD starts rising, then the value of this Put option will drop. If ABCD rises to $110 then there won’t be much value in owning the right to sell ABCD at $90 when you could sell ABCD in the market at $110.
This option will only be valuable if ABCD is trading below $90 come the third Friday of December. If ABCD is trading above $90 on the third Friday of December, then this option will expire worthless. Think about it, who would want to pay someone for the right to sell ABCD at $90 when they could sell ABCD for more than $90?
Why Does The Value Of The Put Drop If The Stock Rises?
Because the value in owning the right to sell ABCD at $90 becomes less valuable as the stock rises above $90. Imagine owning the right to sell the stock at $90 when it rises to $100. There is no value in owning the right to sell a stock at $90 if the same stock is trading in the market at any price over $90. As that stock rises over $90, the value in owning the right to sell at $90 declines.
OK, that’s the first part, Type: Puts or Calls
2nd Part Of An Option – The Underlying Stock
Every option has an underlying stock as it’s root. In our example above, ABCD is the underlying stock. The price fluctuation of the underlying stock will cause a fluctuation in the price of the option.
3rd Part Of An Option – The Expiration Month
Options are only traded until a fixed date called the expiration date. In our ABCD Dec 90 Put example, the owner of this Put can sell ABCD at $90 anytime he wants to until expiration which is the third Friday of December.
4th Part Of An Option – The Strike Price
Strike prices are spaced 5 points apart on stocks below $200 per share. Over $200 the strike price increment changes to 10 points.
With Call options, the strike price is the price that the Call owner can buy the underlying stock at. In our ABCD Dec 90 Call example, the owner of this Call option can buy ABCD at 90 anytime he wants before expiration.
With Put options, the strike price is the price the Put owner could sell the stock at anytime he wants until expiration. There are strike prices in 5 point increments on every stock that is optionable. On the stock of ABCD for example, you can buy or sell Puts and Calls on ABCD with strike prices from as low as 20 to 120.
Here are a few more things you need to know about options…
“Premium”
The premium is the price of an option contract, as quoted by the exchange it trades on. It’s the price that the buyer (holder) of the option pays to the option seller (writer) for the rights conveyed by the option contract. In our ABCD example, the ABCD Dec. 90 Call contract is priced at 5. The premium is said to be 5, which is the same as the price. Options are said to be in-the-money, at-the-money or out-of-the-money depending on where the stock price is relative to the option’s strike price.
“In-The-Money”
A Call is in-the-money when the price of the underlying stock is greater than the option’s strike price. A Put is in-the-money when the price of the underlying stock is lower than the option’s strike price. In our example, the ABCD Dec. 90 Call is in-the-money anytime ABCD stock is trading at any price higher than 90. The ABCD Dec 90 Put is in-the-money anytime ABCD is trading at any price below 90.
“At-The-Money”
An option is at-the-money if the strike price of the option is equal to the market price of the underlying security. In our example, the ABCD Dec. 90 Call is “at-the-money” if ABCD is trading at 90 per share. The ABCD Dec. 90 Put is “at-the-money” if ABCD is trading at 90 per share.
“Out-Of-The-Money”
A Call option is out-of-the-money if the strike price is greater than the market price of the underlying stock. In our example, the ABCD Dec. 90 Call is out-of-the-money anytime ABCD is trading below 90. A Put option is out-of-the-money if the strike price is less than the market price of the underlying stock. In our example, the ABCD Dec. 90 Put is out-of-the-money anytime ABCD is trading above 90.
“Intrinsic Value Of An Option”
The intrinsic value of an option is the difference between an in-the-money option strike price and the current market price of a share of the underlying stock. In our Call example, the ABCD Dec. 90 Call would have an intrinsic value of 4 if ABCD was trading at 94. The ABCD Dec. 90 Call holder owns the right to buy the stock at 90 and ABCD is trading at 94 so the ABCD Dec. 90 Call has an intrinsic value of 4. In our Put example, the ABCD Dec. 90 Put would have an intrinsic value of 4 if ABCD was trading at 86. The ABCD Dec. 90 Put holder would have the right to sell ABCD at 90 and ABCD is trading at 86, so this ABCD Dec. 90 Put would have an intrinsic value of 4.
“Time Value Of An Option”
Time value of an option is the portion of the premium that is attributable to the amount of time remaining until the expiration of the option contract and to the fact that the underlying components that determine the value of the option may change during that time.
Time value is generally equal to the difference between the premium and the intrinsic value.
Three Things That Effect The Price Of An Option
- The price of the underlying stock relative to the strike price of the option. Options in-the-money are priced higher than options that are out-of-the-money.
- The time remaining until expiration of the option. The longer the time left in an option, the more value it will retain. As options get closer to expiration, the time decay erodes their value. We let this price erosion factor work to our benefit when we spread Puts in the current month.
- The volatility of the underlying stock, the higher the option’s premium will be.
Exercise Type
The option style, as specified in the contract, determines when, how, and under what circumstances, the option holder may exercise it. It is at the discretion of the owner whether (and in some circumstances when) to exercise it.
▪ European – European-style option contracts may only be exercised at the option’s expiration date. Thus they can never be worth more than an American-style option with the same underlying, strike price and expiration date.
▪ American – American-style option contracts can be exercised at any time up to the option’s expiration. Under certain circumstances (see below) early exercise may be advantageous to the option holder.
* Weekly options settle American Style, which means they can be exercised before expiration.
Exercise An Option
Exercising an option means you choose to exercise your rights to buy the underlying stock at a fixed price ( the strike price) on or before a certain date ( the expiration date ) if you are the buyer of call options.
Or it means you choose to exercise to sell the underlying stock at a fixed price ( the strike price) until a certain period of time, ( the expiration date ) if you are a buyer of put options.
In order to exercise and option the holder decides whether to enforce that right or not and that is known as to “exercise an option”. Once you decide to exercise your rights, you notify your broker, either thru your trading platform online or by calling your broker and notifying them you want to exercise your option.
Assignment
You exercise an option when you are the holder of an option and you choose to exercise the rights of the options that you own. When that happens the person who sells you the option receives an “assignment”.
Assignment occurs when an option holder exercises his option by notifying his broker, who then notifies the Options Clearing Corporation (OCC). The OCC fulfills the contract, then selects, randomly, a member firm who was short the same option contract. The OCC then notifies the firm. The firm then carries out its obligation, and then selects a customer, either randomly, first-in, first-out, or some other equitable method who was short the option, for assignment. That customer is assigned the exercise requiring him to fulfill the obligation that he agreed to when he wrote (sold) the option.
Exercise by Exception
In the U.S., for the convenience of brokers, who would otherwise have to request exercise of all in the money options, the Options Clearing Corporation will automatically exercise any option that is set to expire in the money by 1 cent or more. This is called “exercise by exception.” A broker or holder of such options may request that they not be exercised by exception. The price of the underlying security used to determine the need for exercise by exception is the price of the regular-hours trade reported last to the OCC at or before 4:01:30 pm ET on the day before expiration. This trade will have occurred during normal trading hours, i.e., before 4:00 pm. It can be any size and come from any participating exchange. The OCC reports this price tentatively at 4:15 pm, but, to allow time for exchanges to correct errors the OCC does not make the price official until 5:30 pm.
This next part is vital to your success because once you understand who uses options and why, then you’ll understand where we fit into the picture and how we profit.
Who Uses Options And Why…
Basically, in the option’s markets, it boils down to professionals and speculators. Professionals use options as a “hedge” against a current position. This “hedge” is mostly for protection.
Mutual funds, professional money managers, professional traders and institutions like large pension accounts use these kinds of hedges. This is the group that options were mostly designed for. However, it’s the power of leverage that hooks the speculators.
And that’s who we’ll profit from.
And now that weekly options have been invented and the volume has increased, the individual investor has the greatest trading opportunity sine the invention of the internet. So rather than having to wait a month or longer, we can now use the same strategies and use options that expire every week.
The differences between regular monthly options and weekly options are few. Monthly options are listed and traded for all months going several years down the road. All monthly options expire on the third Friday of their expiration month. Weekly options are listed every Thursday and expire 8 days later on the following Friday.
In 2010, weekly options were made available on some stocks and in 2011, the volume picked up to where it presented opportunities for the individual investor.
The Advantages Of Weekly Options…
The biggest advantage you can get with any option is to be an option seller. With monthly options, you have to wait 30- 45 – 60 days or longer to get paid. With weekly options, every Friday is pay day.
Being a seller lets you take advantage of time decay. The biggest decay in price occurs is in the last week of an option’s expiration. With weekly options, every week is expiration week.
The best advantage you can get…
If you add up the premium you could get for selling an option in 1 month, then compare that to the premium you’ll get doing it four times a month, you’ll see that you will at least double your income on covered calls and credits spreads with weekly options.
OK, let’s review…
At this point, you’ve learned the secret to success is in picking the right stock…
How to pick stocks for weekly options trades using technical analysis…
How to set up your charts…
And all about options.