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Options Trading: Reviewing the Basics

By  Jan 27, 2011

Topics: Finance & Investing

The terminology of the options industry is probably the biggest inhibitor to traders becoming familiar with how options trading works. Mastering the basics helps to get over this hurdle and to make positive steps toward mastering options trading -- and also to understanding the broad range of risks involved from high-risk all the way to very conservative.

Options are intangible, and are contracts specifying a series of rights. For example, a call grants its buyer the right (but not the obligation) to buy 100 shares of a specified stock (the underlying security) at a specified price (the strike) on or before a specified date (expiration). A put is the opposite. It grants its owner the right to sell 100 shares of the underlying at the strike and by or before expiration.

The key advantage to buying options is that for only a fraction of the cost of buying shares, you get complete control. Every option controls 100 shares of the underlying stock. For buyers, a lot of flexibility is in play. When you buy an option, you have the right to close it at any time in the same way that you sell stock. You just enter a “sell to close” order. You are never at risk for any amount beyond the amount you pay (the premium) for the option.

You can also sell options. Unlike the more familiar long position involving the series buy-hold-sell when you short an option, the sequence is sell-hold-buy. A short call can be very risky or very conservative. It is risky to just short the call, since a stock’s price can rise indefinitely. So an uncovered call (also called a naked call) is very high-risk. For example, if you sell a call with a 30 strike (meaning the exercise occurs at $30 per share), but the stock price rises to $50 per share before expiration, you are on the hook for the difference between $30 and $50, or $2,000 (remember, every option relates to 100 shares). The main advantage of selling an option is that you get cash at the time you make the sale.

A much safer strategy is the covered call. This is when you sell a call and also own 100 shares of the underlying stock. In the event of exercise, your 100 shares are called away. You profit in three ways: First, you get a capital gain on the stock (assuming you were smart and sold an option with a strike higher than your original cost). Second, you earn all dividends while you own the stock. Third, you get to keep the option premium. If you select the option wisely for a covered call, you can earn double digit returns consistently and safely.

If you sell a put, you cannot really cover it unless you are short 100 shares of the underlying stock. A short uncovered put is less risky than the uncovered call. This is true because a stock’s price can only fall so far. Some think the maximum risk is zero, which occurs only if the stock becomes completely worthless. But the real risk is the difference between the put’s strike and the stock’s tangible book value per share, less the put premium. For example, for sell a put with a 30 strike and get 3 ($300). The stock’s tangible book value per share is $18. Your maximum risk in selling this uncovered put is the net difference between $30 and $18, ($12 per share), or $1,200 for 100 shares; minus the $300 you got for selling the put. So your risk is $900. However, if you think it is unlikely that this stock will drop to its tangible book value per share, the risk is lower.

The attributes of each option -– type (call or put), underlying security, strike price, and expiration date –- are collectively called the terms and all listed options contain these terms. The terms cannot be changed or replaced, making the market orderly and reliable. The basic terminology is a good starting point for understanding how options work. From here you need to step up to the more advanced terms, such as spreads and straddles, to truly appreciate this complex market.

Michael C. Thomsett is an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks.