Ho To Invest In Options 1 of 5 Introduction

Course IV -- How To Invest In Options
Introduction
An option is a derivative security. Its value is determined by the underlying issue, which for our purposes, we’ll assume is either common stock or an index (a widely followed basket of stocks).
Benefits of Exchange-traded Options
Although the history of options extends several centuries, it was not until 1973 that standardized, exchange-listed and government-regulated options became available. In only a few years, these options virtually displaced the limited trading in over-the-counter options and became an indispensable tool for the securities industry.
Orderly, efficient and liquid markets
Standardized option contracts provide orderly, efficient, and liquid option markets. Except under special circumstances, all stock option contracts are for 100 shares of the underlying security. The strike price of an option is the specified share price at which the shares of stock will be bought or sold if the holder exercises his option. Strike prices are listed in increments of 2 ½, 5, or 10 points, depending on the market price of the underlying security, and only strike prices a few levels above and below the current market price are traded. At any given time a particular option can be bought with one of four expiration dates. As a result of this standardization, option prices can be obtained quickly and easily at any time during trading hours. Additionally, closing option prices (premiums) for exchange-traded options are published daily in IBD as well as many other newspapers. Option prices are set by buyers and sellers on the exchange floor where all trading is conducted in the open, competitive manner of an auction market.
Flexibility
Options are an extremely versatile investment tool. Because of their unique risk/reward structure, options can be used in many combinations with other option contracts and/or other financial instruments to create either a hedged or speculative position. Some basic strategies will be described in options strategies.
Leverage
A stock option allows you to fix the price, for a specific period of time, at which you can purchase or sell 100 shares of stock for a premium, which is only a percentage of what you would pay to own the stock outright. That leverage means that by using options you may be able to increase your potential benefit from a stock’s price movements.
For example, to own 100 shares of a stock trading at $50 per share would cost $5000. On the other hand, owning a $5 call option with a strike price of 50 would give you the right to buy 100 shares of the same stock at any time during the life of the option and would cost only $500. Remember that premiums are quoted on a per share basis; thus a $5 premium represents a premium of $5 * 100, or $500, per option contract. Let’s assume that one month after the option was purchased, the stock price has risen to $55. The gain on the stock investment is $500, or 10%. However, for the same $5 increase in the stock price, the call option premium might increase to $7, for a return of $200, or 40%. Although the dollar amount gained on the stock investment is greater that the option investment, the percentage return is much greater with options than with stock. Leverage also has downside implications. If the stock does not rise as anticipated or falls during the life of the option, leverage will magnify the investment’s percentage loss. For instance, if in the above example the stock had instead fallen to $40, the loss on the stock investment would be $1000 or (20%). For this 10% decrease in stock price, the call option premium might decrease to $2 resulting in a loss of $300 (60%). You should take note, however, that as an option buyer, the most you can lose is the premium amount you paid for the option.
Limited Risk for Buyer
Unlike other investments where risks may have no limit, options offer a known risk to buyers. An option buyer absolutely cannot lose more than the price of the option, the premium. Because the right to buy or sell the underlying security at a specific price expires worthless if the conditions for profitable exercise or sale of the contract are not met by the expiration date. An uncovered option seller, on the other hand, may face unlimited risk.
Guaranteed Contract Performance
The Options Clearing Corporation (OCC) guarantees that the terms of an option contract will be honored.
Prior to the existence of options exchanges and OCC, an option holder who wanted to exercise an option depended on the ethical and financial integrity of the writer or his brokerage firm for performance. Furthermore, there was no convenient means of closing out one’s position prior to the expiration of the contract.
OCC, as the common clearing entity for all SEC-regulated option transactions, resolves these difficulties. Once OCC is satisfied that there are matching orders from a buyer and seller, it severs the link between the parties. In effect, OCC becomes the buyer to the seller and the seller to the buyer, thereby guaranteeing contract performance. As a result, the seller can buy back the same option he has written, closing out the initial transaction and terminating his obligation to deliver the underlying stock or exercise value of the option to the OCC, and this will in no way affect the right of the original buyer to sell, hold or exercise his option. All premium and settlement payments are made to and paid by the OCC.
Further details of Options Trading
Options expire on the Saturday following the third Friday of the expiration month, although the third Friday is the last day of trading.
Option trades have a one-day settlement. The trade settles on the next business day after the trade. Purchases must be paid for in full, and the proceeds from sales are credited to accounts on the settlement day. Some brokerage firms require settlement on the same day as the trade, when trade occurs on the last trading day of an expiration series.
Options are opened for trading in rotation. When the underlying stock opens for trading on any exchange, regional or national, the options on that stock then go into opening rotation on the corresponding option exchange. The rotation system also applies if the underlying stock halts trading and then reopens during a trading day; options on that stock reopen via a rotation.
When the underlying stock splits or pays a stock dividend, terms of its options are adjusted. Such an adjustment may result in fractional striking prices and in options for other than 100 shares per contract.