Options

 

Option is a financial instrument that represents a contract between a option writer and a option holder.

 

An option holder has the right, but not an obligation, to buy or sell a financial security at a predetermined price for a specific period of time or a specific date. An option holder may choose not to buy or sell this financial security(eg:stock).

 

An option writer has an obligation to fulfill the terms of the options contract in the event options holder chooses to exercise the right to buy or sell the financial security. An options writer doesn't have a choice and must sell or buy this financial security (eg:stock)

 

For any option, an option holder needs to pay a premium which is the price of this option or right and an option writer gets a premium to sell this option or right. In trading an option generally a broker or online company/broker charges a transaction fees to both options writer and options holder for this trade.

 

There are two types of options calls and puts

-A call option is the contract where the option holder has a right to buy a financial security at a predetermined price for a specific period of time or a specific date. The options writer must sell this financial security to the options holder in the event options holder chooses to buy it.

-A put option is the contract where the option holder has a right to sell a financial security at a predetermined price for a specific period of time or a specific date. The options writer must buy this financial security drom the options holder in the event options holder chooses to sell it.

 

Options are very powerful instruments to make money but you need to understand them and know exactly how they work. You can make money in options either by writing options (writer) or by holding options (holder)

Suppose you have 100 stocks of a company say P&G which is at $65 today in the market in October 2008. You think that the price of this stock might go up to $67 in january, 09 but unlikely to cross $70. Than you can write and sell a call option with strike price of $70 at a premium of $2 per share. So you make a total of $2x100=$200 (minus any transaction fees).In january, 09 two things can happen either price of the stock will be $70 (or more) or still remains under $70. Let us examine what will happen in these two situations.

If the price becomes $70 or more, the holder will exercise the right. But how much you earn? In addition to $200 of option premium you earn (70-65)x100 = $500. So in total you earn $700(minus transaction fees).

If the price remains under $70, the option which you wrote expires worthless and your profit remains at $200. Do you stop here ? NO. keep writing the options and keep earning the premium. So an investment of $6500 (65x100) keeps producing steady income.

Keep in mind you can not sell your stocks when you write options till the exercise date and only if the holder doesn't exercise his right on the exercise date. Now i have been asked this question multiple times even though the answer is obvious "If the price of the stock is under $70, is there a chance the holder might exercise his right to buy my stock and i won't have any stocks anymore?" The answer is NO for the obvious reason that if anyone wants to buy a share they will buy it at a lower price from the market.

 

Suppose you are interested in option of P&G Why? because you think the price of the stock might be in the range of $72-75 range. You want to maximize your profit with investment you have than instead of buying stock you buy options. Taking the same example from above if P&G is at $65 today in the market in October 2008, you purcahse 1 option of P&G (1 option is generally 100 shares) at price of $2 premium/share x 100 = $200. So your investment is $200 Now again in january, 09 two things can happen either price of the stock will be $70 (or more) or still remains under $70. Let us examine what will happen in these two situations for a option holder.

If the price becomes say $75. You have right to buy 100 shares at $70. Now do you need need to bring $7000 or more from somewhere to buy these shares before you can sell it and make money. Absolutely not, you don't need to (unless of course you want to) You can sell your option even before that date and keep the difference of $(75-70)x100=$500. Your total income is $500-$200(premium)= $300 (minus transaction fees).

If the price remains $70 or under, your option expires worthless and you loose $200 of premium which you paid.

Keep in mind you can sell your option anytime you want but you can't exercise your right till the exercise date.