How to Invest in Options 2 0f 5 Options Basics

Options Basics
Puts & Calls
Specifications
Value

Puts and Calls
Options come in two types, puts and calls. A call option gives the holder the right, not the obligation, to buy 100 shares of the underlying security at a fixed price for a fixed period of time. A put option gives the holder the right, not the obligation, to sell 100 shares of the underlying security for a fixed price for a fixed period of time. If the option is not exercised or sold by expiration, it becomes worthless.
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The Four Specifications of an Options Contract
There are four specifications that describe an options contract. They are: the type (put or call), the underlying security, the expiration date, and the striking price. As an example, and option referred to as an “XYZ Jan 40 call” is an option to buy 100 shares of XYZ stock for $40 per share. This option expires on the Saturday after the third Friday in January. The price is quoted on a per-share basis. This means that an option priced at $4 would cost the investor $400 (4 * 100) plus commissions.
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The Value of Options
An option is a derivative security. Its value is determined by the underlying stock and will fluctuate as the underlying stock rises and falls. As time passes the options price, the premium, erodes until it ultimately expires worthless. That is why options are referred to as a “wasting asset”. Fortunately, your option can be exercised, invoking the right expressed by the contract, or it can be sold to claim its value.
Options Relative to Price
There are three different terms for describing where an option is trading in relation to the price of the underlying stock. A call option is said to be out-of-the-money if the stock is selling below the strike price of the option. The call option would be in-the-money if the stock were trading above the strike price. An option is at-the-money if the stock price and the strike price are the same.
The intrinsic value of a call option is the amount by which the stock price exceeds the strike price. If the stock price is below the strike, there is no intrinsic value. The time value of an option is the amount by which the option premium itself exceeds the options intrinsic value. Intrinsic value plus time value = the options premium. As an example: Suppose the XYZ Jul 50 Calls are trading at 4 while XYZ is trading at 52. The options intrinsic value is 2 and the time value is 2. An investor is, in effect, paying 2 to see what happens between now and when the option expires in July.
An option normally has the largest amount of time value when the stock price is equal to the strike price. As an option gets further in or out-of-the-money the time value will erode.
Factors influencing the price of an option
There are four major factors that determine the price of an option, and two that contribute to a lesser amount:
1-The price of the underlying stock.
2-The strike price of the option itself.
3-The time remaining until expiration.
4-The volatility of the underlying stock.
And to a lesser extent:
The current risk free interest rate (usually the 90 day T-bill)
Dividend rate of the underlying stock.
Probably the most important influence on the options price is the stock price and its relation to the strike price. Options very far in or out-of-the-money may have markedly less time value and sell closer to their intrinsic value.
Another important determinant of an option’s premium is the time remaining until expiration. Option time value erodes dramatically as an option approaches its expiration. The rate of decay is related to the square root of the time remaining. Thus a 3-month option decays at twice the rate of a 9-month option (square root of 9=3).
The volatility of the underlying security is another important component of an options price. Volatile stocks make for higher options prices. There are two different kinds of volatility. There is historical volatility and there is implied volatility. Historical volatility estimates volatility based on past price activity. Implied volatility starts with the option price as a given and works backwards to ascertain the theoretical value of volatility equal to the market price minus any intrinsic value. It measures the amount of volatility the market is pricing into the option.
The dividend rate and the 90 day T-bill rate have to do with the cost to carry the contract.
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