Introductory Guide to Stock Options: Part 1

The purpose of this article is to provide you with a brief introduction to the world of stock options. We will go over the background theory, present real examples, and briefly explain why an investor might utilize options instead of buying stocks outright.

An option is a contract between a buyer and a seller (also known as the options writer), which grants the buyer the right, but not the obligation to either buy or sell a stock at an agreed upon price known as the “strike price” on or before a deadline known as the “expiration date.” An option is considered a derivative because its value is

from its underlying stock. An option trades in lots of 100 and does not trade on a stock exchange (such as the New York Stock Exchange) – it trades on a network known as an Options Exchange. The largest options exchange in the world is the Chicago Board Options Exchange (

). There are two unique kinds of options: call options and put options.

A call option grants the buyer the right, but not the obligation to

a stock at the strike price on or before the expiration date. To better understand this, let us take an example of an actual options quote, which is known as an options symbol. A standard option symbol looks like this:

2.80. Let us break this options symbol down: The first four letters in the symbol (

111022C35000 ) indicate the underlying equity, which in this case, represents the ticker for Apple

. The next two numbers (AAPL

1022C35000) indicate the year in which the options expire, which in this case, is 2011. The next two numbers (AAPL11

22C435000) indicate the month in which the options expire, which in this case, is October (10th month of the year). The next two numbers (AAPL1110

C35000) indicate the day of the month on which the options will expire. Options (unless weeklies) always expire on the third Friday of the month (technically expiring on Saturday, but Friday is the last day the options can be traded). In this case, the expiration date is the 22nd of October. The next letter in the chain (AAPL111022

35000) is either C or P to represent whether it is a call or put option. In this example, the C indicates it is a call option. The numerical value that follows (AAPL111022C

) represents the strike price ($350.00). The quote price of $2.80 represents 1 share. To purchase one lot (contract), the total cost will be 100 x $2.80 = $280.00 (otherwise known as the

).

The buyer of this call option has the

to buy 100 shares of AAPL at $350.00 regardless of the current market price. The buyer can do so at any point from the date of purchase, up until the close of market on October 22, 2011. In exchange for this right, the buyer of the call option will pay the seller a premium of $280.00. The seller of the option is

to sell the buyer of the contract 100 shares of AAPL at $350.00 if the buyer decides to exercise his/her right. One of three scenarios can occur: The price of AAPL stock will either fall below, rise above, or trade at the strike price. Let us explore all three of these scenarios

Assume AAPL is trading at $300.00. Because the stock is trading below the strike price of $350.00, the contract is considered to be “out of the money.” The market value of the contract is diminished, as the prospect of AAPL's stock price rising above $350.00 becomes less and less likely as the expiration date nears. The contract price is lower because investors are not willing to pay a premium to own shares at price higher than the current market value. Exercising the option is pointless considering the shares can be bought on the open market for cheaper than the $350.00 strike price. The buyer can still sell his options contract on the exchange to another investor to minimize the loss. The option writer will do nothing on his end since the option is out of the money.

If a call contract is out of the money, the buyer can lose only the premium paid. Under no circumstance, can the call buyer lose more than the initial $280.00. Likewise, the profit for the writer is limited to the premium received. Under no circumstance can the writer make more than the initial, one-time payment of $280.00.