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502-Introduction to Options
  The large sums of money that can be won or lost over a fairly short period
  with options make them both intriguing and frightening to many investors.
  Because of the broad array of esoteric terms and unfamiliar concepts
  associated with them, options can be a difficult subject for investors to
  understand. Frankly, we don't think options are for everyone. In fact, many
  investors have had quite successful investing careers without ever considering
  them.
  
  Even if you never end up buying or selling an option, it's a large enough part
  of the equities market to merit being aware of. You will probably be tempted
  at some point in your investing career to "take the next step" and leverage
  your ideas. This lesson will teach you the basics so you know what you may be
  getting into.
  
  
  Call and Put Options on Stocks
  
  
  At the heart of all the spreads and strategies discussed about options is the
  call and put. A call gives its owner the option to buy a stock at a specific
  price, known as the strike price, over a given period of time. A put provides
  the owner the option to sell a stock at a specific price (also called the
  strike price), over a given period of time. Let's look at how options are
  typically represented for a particular stock:
  
  JUN07 50c
  This refers to a call option with a strike price of $50 that expires in June
  2007. The owner of this call would have the option to purchase the stock for
  $50 anytime before the option expires in June 2007.
  
  AUG08 75p
  This refers to a put option with a strike price of $75 that expires in August
  2008. The owner of this put would have the option to sell the stock for $75
  anytime before the option expires in August 2008.
  
  
  What Is an Option Contract?
  
  
  Options are traded in units called contracts. Each contract entitles the
  option buyer/owner to 100 shares of the underlying stock upon expiration.
  Thus, if you purchase seven call option contracts, you are acquiring the right
  to purchase 700 shares.
  
  For every buyer of an option contract, there is a seller (also referred to as
  the writer of the option). In exchange for the cash received upon creating the
  option, the option writer gives up the right to buy or sell the underlying
  stock to someone else for the duration of the option. For instance, if the
  owner of a call option exercises his or her right to buy the stock at a
  particular price, the option writer must deliver the stock at that price.
  
  
  Understanding Option Pricing
  
  
  Two key phrases from our definitions for a call and put are "option to buy"
  and "option to sell." The owner of a call or put is not obligated to take any
  action. Thus, a call or put never has a value less than $0 before it expires.
  Consider the following example:
  
  You own a call that gives you the right to buy a stock for $50. However, at
  expiration, the stock is priced at $45. Why would you exercise your right to
  purchase the stock for $50 when you can buy it for less in the stock market?
  You wouldn't. So, your call is worth $0 anytime the stock finishes below your
  strike price, which is $50 in this example.
  
  When talking about option prices, people often refer to intrinsic value and
  premium to intrinsic value. (This intrinsic value has nothing to do with the
  intrinsic value we refer to when talking about the discounted cash flow of a
  company.) An option's intrinsic value is the difference between its strike
  price and the underlying stock price, when it favors the owner of the option.
  People often refer to intrinsic value as the amount that the option is "in the
  money." Let's look at three examples, assuming we are in 2006:
  
  1. FEB07 60c when the stock is trading at $75
  
  In this case, you own a call option that allows you to purchase the stock for
  $60 when it is trading for $75. We would say this call option has an intrinsic
  value of $15 because it gives you the right to purchase the stock for $15 less
  than you could purchase it for in the stock market.
  
  2. OCT08 80p when the stock is trading at $50
  
  In this case, you own a put option that allows you to sell the stock for $80
  when it is trading for $50. We would say this put option has an intrinsic
  value of $30 because it gives you the right to sell the stock for $30 more
  than you could sell it for in the stock market.
  
  3. JUL07 50c when the stock is trading for $40
  
  In this case, you own a call option that allows you to buy the stock for $50
  when it is trading for $40. This option has no intrinsic value. It is
  considered "out of the money."
  
  Let's take a closer look at the third example above. Although it has no
  intrinsic value, we discover that the option is trading for about $2 in the
  marketplace. Why is that? Although the option isn't in the money now, there is
  still some time left (before expiration) for the stock to move such that it
  could place the option in the money. This is referred to as time value or
  option value.
  
  In the case of the second example, the option may be trading for $32 even
  though the intrinsic value is only $30. In this case the option is trading at
  a $2 premium to its intrinsic value. This premium is also known as the time
  value.
  
  
  Drivers of Option Value
  
  
  There are several key factors that influence the value of an option. First,
  the level of volatility in the underlying stock plays a key role. The higher
  the stock's volatility, the greater the value of the option. If the underlying
  stock is more volatile, it means the option has a greater chance of trading in
  the money before the option expires.
  
  Second, the amount of time left until the option expires influences the
  option's value. The more time left until expiration, the greater the value of
  the option. Again, the longer until expiration, the more time for an option to
  trade or finish in the money.
  
  Finally, the direction the underlying stock trades will affect the value of
  the option. If a stock appreciates, it will positively affect call options and
  negatively impact put options. If a stock falls, it will have the opposite
  effect.
  
  
  Basic Option Strategy--Leaps
  
  
  There are literally scores of option strategies. Straddles, strangles, and
  butterflies are just some of the main types of strategies where an investor
  can use options (or sets of options) to bet on any number of stock and market
  movements. Most of these are beyond the scope of this lesson, so we will just
  focus on two strategies most often used by value investors.
  
  First, leaps are options with relatively long time horizons, typically lasting
  for a year or two. (The term "leaps" is an acronym for "long-term equity
  anticipation securities.") Some value-oriented investors like call option
  leaps because they have such long time horizons and typically require less
  capital than buying the underlying stock.
  
  For example, a stock may be trading for about $60, but the call options with
  two years to expiration and a $70 strike price may trade for $10. If an
  investor thinks the stock is worth $100 and will appreciate to that price
  before the leap expires, he or she could find the leap very attractive. Rather
  than spending $6,000 to purchase 100 shares of the stock, he or she could buy
  one leap contract for $1,000 (1 contract x $10 x 100). If the stock closes at
  $100 at expiration two years from now, the leap position would return $2,000
  (1 contract x ($30 – $10) x 100). This would mark a $2,000 profit on a $1,000
  investment (200%). However, if he or she had just purchased the stock, it
  would have marked a $4,000 profit on a $6,000 investment (67%).
  
  As we see above, leaps can offer investors better returns. However, this
  bigger bang for the buck does not come without some additional risks. If the
  stock had finished at $70, the leap investor would have lost his/her $1,000
  while the stock investor would have made $1,000. Also, the leap investor
  doesn't get to collect dividends, unlike the stock investor.
  
  Let's also consider a case where this stock trades at $70 at the leap's
  expiration, but then goes up to $110 soon after expiration. The owner of the
  stock enjoys the appreciation to $110, but the option holder in our example is
  out of luck.
  
  This latest example highlights perhaps the reason why options are a tough nut
  to crack for most investors. To be successful with options, you not only have
  to be correct about the direction of a stock's movement, you also have to be
  correct about the timing and magnitude of that movement. Deciding whether or
  not a company's stock is undervalued is difficult enough, and betting on when
  "Mr. Market" is going to be in one mood or the other adds great complexity.
  
  
  Another Strategy--Baby Puts
  
  
  "Baby puts" refer to put options that are far out of the money, and therefore
  trade cheaply. Investors will sell these baby puts on stocks that they are
  comfortable purchasing at a specific price, which will be the strike price of
  the put they are selling. Typically, this is the price that builds in a margin
  of safety to their estimate of the stock's fair value.
  
  For example, say an investor would be happy to purchase Coca-Cola KO for $35
  per share, but the stock is trading at $45. It's currently January, and the
  investor notices that the May $35 put options are trading for $1. The investor
  decides to sell (write) the May $35 put options for $1. This means the
  investor collects $1 for selling the right to someone else to sell the
  investor the stock for $35 anytime before the option's May expiration date.
  So, if Coca-Cola stock doesn't fall below $35 by the May expiration, the
  investor pockets the $1. However, if the stock falls below $35 before May, the
  investor will probably be required to purchase Coca-Cola stock for $35,
  because the person to whom he or she sold the put option will exercise his or
  her right to sell the stock for $35.
  
  Value investors might be willing to partake in this strategy because they
  decided in advance that $35 was a good price to purchase Coca-Cola stock. And,
  if the stock doesn't fall below $35, they get to collect $1 (by selling the
  baby put) as they wait for Coke's stock to trade cheaper.
  
  This strategy is not without some fairly large risks. If the investor doesn't
  have enough cash in his or her account to purchase the stock, the investor's
  broker may require additional funds be deposited. We'd recommend considering
  this strategy only if an investor has plenty of cash on hand. Also, a fresh
  piece of news could surface (between the time the investor sells the put and
  the put expires) that might change the investor's opinion of the fair value of
  the stock.
  
  
  The Bottom Line
  
  
  Some investors like options because they require less capital and thereby
  offer potentially greater returns. Others like to use them to execute
  strategies like the "baby put" example above. However, options also possess
  risks that will repel many investors, and rightfully so, in our opinion. Like
  we mentioned earlier, one can have a very successful investing career without
  spending a moment thinking about options.