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Options 101 With TD Ameritrade's Shawn Cruz

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Options 101 With TD Ameritrade's Shawn Cruz

TD Ameritrade Holding Corp. (NASDAQ: AMTD) Trader Business Strategy Manager Shawn Cruz on May 29 presented an introduction to options at the virtual Benzinga Boot Camp.

Here's what Cruz says investors with little or no knowledge of options need to understand.

What Is An Option?

Investors who hold shares of a public company own a fraction of the company.

An option gives an investor the right to buy or sell a specified number of shares of a stock at a certain price — known as the strike price — before a certain date known as expiration. 

The cost of buying or selling an option is referred to as the premium.

The total cost to enter one option contract is equal to the price of the option (premium) multiplied by the options multiplier, which is almost always 100. One option contract represents the right to buy or sell 100 shares of the underlying stock.

An option is essentially a raincheck or coupon for a stock that can be redeemed up to a certain date regardless of the current market price, Cruz said. After the expiration date passes, the value of the option is "more or less null and void."

Options typically have one of three functions for an average investor, he said: 

Generate additional income.

Speculate on a stock's move.

Hedge against an existing position by minimizing the downside.

Call Vs. Put Options

Anyone who owns a call option holds the right to buy the underlying stock at a certain price. The price of the contract will gain in value when the underlying stock increases in value.

On the other hand, anyone who owns a put option holds the right to sell the underlying stock at a certain price. The price of the contract will gain in value when the underlying stock loses value.

It is important to note the owner of a contract has the right to buy or sell the underlying stock at an agreed price, but not the obligation to do so. On the other hand, the seller of a contract has the obligation to buy or sell the underlying stock at the agreed-upon price.

An options holder can also sell the contract itself in the options market at any point prior to expiration. If the option has no value because the trade went in the opposite direction, the contract will expire worthless and no action is required on the part of the investor.

What Determines The Value Of An Option

Finally, there are three factors that determine the price of an option, said Cruz:

  1. Price of the underlying stock: typically expensive stocks have more expensive option premiums.
  2. Time to maturity: a contract that expires in one week has less time to reach its target and is usually cheaper compared to an option that expires next month.
  3. Implied volatility: this refers to how much price movement is expected by the market before the contract expires.

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