Tuesday, January 16, 2007

Option Education Program Lesson 1: Buying CALLS

I want to preface this and all subsequent lessons by stating that I am not a self-professed option expert with decades of option trading experience and professional floor trading experience and that what I say is the law. My experience, however, has been mostly self-taught through trial and error coupled with theoretical learning extracted from "self-professed" option trading experts that I think can be helpful.

The sole intention and objective of these following lessons is to provide a foundation to understanding options as a viable investment vehicle.

Part of understanding any subject well is understanding the vernacular, you know, the parlance, the terminology, the language and so forth. The option industry is no exception. It has all kinds of terms that can make one quickly confused and frustrated. These lessons will hopefully help you interpret the option language without feeling left out.

I also want to add that one of the multi-faceted purposes of this and subsequent lessons on options is to help you realize that you can find plenty of free and credible information and resources about options on the web. The point being that you need not spend incredible amounts of capital getting educated and prepared to trade options.

Having said that, I am sensitive to those readers out there who have already spent options education "tuition". I certainly don't want to mislead readers into thinking that this is an option education program "bash". There are quality option educators out there that meet and have met the needs of many an option trader at any level.

I just think that given the exponential growth of option trading both on a retail and institutional level, the advancements in internet capability and access, and the fact that more and more people are becoming more aware of options as a viable investment vehicle, more efficient and effective ways of educating people about options are also growing.

I believe that with the advent of the user-generated content mechanisms that are now so easily, readibly and inexpensively available to anyone who is now remotely used to a computer and the internet that it only makes sense that option education ought to be free and equally accessible.

Now the question for option education is, what should be taught and who should teach it? In other words, should any person out there post option education blogs and if so should there be some sort of validation or regulation. As to what should be taught, I believe that there should be an emphasis on certain elements of options that everyone should know. As to who should teach, I believe that those who have actually traded and have traded options on a regular basis whether professionally or individually ought to be able to teach others.

As to validation of the content being taught, I believe that is where the community of readers such as the Option Jungle "swingers" (aka: readers/commentators) can play an important role. I think that in order for any free exchange of ideas to be effective, the participants need to question the sources and justifications of a writer even that of an option trader blogger.

That is why I will refer any and all optionateurs (my fancy way of saying interested option parties) to two sources of option education to validate any option educator. The first is 888Options.com run by the Option Industry Council (OIC) in conjunction with the Option Clearing Corporation (OCC). The second is the CBOE. You can also find a plethora of option specific information at Investopedia that I've found to be informative and educational as well.

Alright. Enough long-winded formal speak. It's time to dive into the material for this lesson 1.

LESSON 1.

The Basics:

What is an option? There are basically several types of options. The most common are equity options (equity in this regard means stocks or "equity" participation in a publicly-traded company that is typically traded and listed on the U.S. stock exchanges such as the NYSE and the Nasdaq).

Other types of options can consist of index options (you know, Dow Jones Industrial Average, S&P 500, Nasdaq Composite, etc.), and real estate option contracts (these are agreements that a buyer and a seller of a real property use). Because most option traders focus on equity (stocks) options I will talk primarily about these types of options.

An equity option is actually a contract. It does not convey any ownership at all of any company's stock. It really only conveys a "right" to its owner to buy or sell the underlying asset which in this case is the actual stock.

Option contracts are considered a "security" which basically means that it trades just like a stock on any exchange that lists equity options such as the Chicago Board Options Exchange (CBOE), the American Stock Exchange (AMEX), the Boston Options Exchange (BOX), the NYSE Arca (formerly the Pacific Exchange), the Philadelphia Stock Exchange (PHLX), and the International Securities Exchange (ISE) as primary U.S. exchanges.

You may or may not have heard of an option contract as being a "derivative". This term implies that the value of the contract is in part based on, or "derived" from, the value of a particular underlying stock.

Basic Terms:

Alright now that you understand that there are different types of options let's get more specific about the terminology of options, specifically equity options.

Remember, an equity option is a contract much like a standard legal binding contract that one would see in all kinds of daily business transactions. In order for the contract to be valid, there must be certain material items included such as the agreed upon price of the underlying asset and since time is material to the existence and essence of the contract a date must be pre-determined whereby the contract becomes worthless. There must also include an opportunity for the buyer of the option contract to exercise his/her right to buy or sell the underlying asset. There must also be a binding obligation to the seller of the underlying asset to sell that asset upon the buyer's right to it being exercised. Finally, there is a cost for entering this contract called a premium. This basically means that there is a monetary value of that contract right that needs to be agreed upon by both the buying and selling parties to the contract.

I've basically just bored you to death at this point with a legal example of an option contract which outlines the similar guts of an equity option contract; exercise price of the underlying asset, expiration date, and premium for the contract.

An equity option investor can basically do two things with the option. You can either buy the option or sell the option. An investor who buys an option is essentially buying a right to either own or sell the underlying stock.

There are two types of standard equity options:

1. CALLS
2. PUTS

In this lesson we will only cover CALL Options.

CALLS

The most common and simplest method of investing using options is to "buy" calls. This means an investor is buying (paying a premium-a transaction whereby funds will be debited from your brokerage account) the "right" (that is exercisable) but not the obligation to "buy" (own) the underlying stock (100 shares per contract) anytime on or up to a date (expiration) at a specific price per share (exercise price aka strike price).

One common reason an investor will buy a call is because they believe that the price of the underlying stock will rise and in so doing hope that the value of their option contract premium will also rise. In Wall Street terms anticipating a stock price to rise is called being "bullish". "I'm bullish on Microsoft stock" means that you think that the price of Microsoft's common stock will go higher.

So when an investor tells you that they just bought 1 MSFT JUL 07 30 Call option contract for $1.00 per share you have all the information that is needed to know about that option contract.

1. How many contracts are being bought? 1 contract which is equivalent to potentially owning 100 shares of Microsoft stock in this example.
2. What stock can the investor exercise if desired? MSFT is the common stock symbol for Microsoft Corporation.
3. At what price can the buyer of this option exercise his/her right to buy 100 shares of MSFT? $30.00 per share.
4. What is the cost or premium for owning this contract? $1.00 per share x 100 shares = $100. This cost is what a seller of that particular call option contract was willing to sell it for.
5. When can the buyer or holder of this call option contract exercise his/her right to buy 100 shares of MSFT for $30.00/share? This investor has until the close of the third Friday of July 2007 to exercise. Technically, it is the third Saturday but because the option markets close on Friday after 4pm ET that is the trading expiration date.
6. Is this call option buyer/holder obligated to exercise his/her right to own MSFT stock? No.

Let's review key terms of a call option contract.

Buy Call =Buy the Right to Buy 100 Shares/contract
Contract=100 shares of the underlying stock
Exercise/Strike Price=agreed upon price at which buyer/holder of the option can exercise his/her right to buy the underlying stock
Expiration date=always referred to as the 3rd Friday of the month in which the option will expire
Premium=market value of the contract that both buyers and sellers agree upon
Underlying Stock=the actual stock and its market price that the option contract is tied to
Debit=money taken out of your brokerage account to pay for the premium of the contract

Alrighty then. If this is new to you then let it soak in because it does take time to absorb all of this and besides, you'll need to be clear on this before I explain puts. If this is not new to you then just stay tuned for the next lesson on PUTS.

Grab a vine and feel free to add or question this lesson.

10 comments:

Reno said...

I have a question about options... I first "buy to open" a call, and when I "sell to close" to close out my options position I don't need to have cash to buy the stock right? ie. if I bought a MSFT call option with a strike price of $50 with a premium of $1, and it's now trading at $60 and the premium is now $3 - I don't need the full exercise contract value ($50 x 100 = $500) in my account do I to "sell to close"? The only thing that makes a difference really is the premium amount and the strike price doesn't matter? In this case I would make $200 (($3 - $1) x 100)?

Thanks!

Terence said...

Reno,

Your question leads into the next lesson about basic opening and closing of option positions. The quick answer is YES. If you paid $100 (1.00 x 100) for the 50 MSFT strike and you sold to close that position for $300 (3.00 x 100), you would not need to have that amount in your account to close it. The proceeds from selling the 50 strike option would be credited to your account thus netting you a nice $200 profit before commissions. What you did was basically sold the 50 strike call option back to the option market before expiration without exercising that right to buy MSFT for $50. I'll go over in more detail this process as well as the selling to open process. Great question Reno and one that is a common point of confusion to new traders.

Reno said...

Ok thanks for clearing that up. That one had been bothering me for a while and even my broker couldn't give me a clear and consise answer about it -- I don't think he understood how options really worked. Maybe he was new on the job :)

Terence said...

No problem, Reno. I'll be posting the next lessons soon so feel free to ask any further questions. I think it helps everyone.

Anonymous said...

hi, i have one question.. tat's how to exercise our option... because usually, i only buy option and sell option back?? how to distinguish between those two??

Terence said...

If you buy an equity call option and you plan on exercising your right to buy the underlying stock of that option you typically have to notify your brokerage before the close of the expiration day which is typically every third Friday of each month. Options exchanges have a cut-off time of 4:30pm CST for receiving an exercise notice. However, most brokerage firms have an earlier cut-off time that should be determined in advance since it may affect when you receive delivery of the stock. Now this assumes also that this is an American-style option vs. a European-style otion (most index options). This means that with an American option you can exercise your right to buy or sell the stock depending on whether you bought a call or a put anytime prior to expiration Friday of that option. The Euro exercise means that you can only exercise your contract on the last trading day before expiration (typically the Thursday for most Index options). Remember, however, that you can still close out your option position in the secondary market any day prior to expiration and you are never obligated to exercise that option. Once you have given notice to your broker to exercise your option you'll be buying the stock at the strike price and you can sell those shares immediately after giving instructions to exercise (most online brokers allow you to auto exercise and auto sell at opening prices of the stock the next trading day after exercise). Also, it's important to know that all in-the-money options will automatically exercise if not closed out before expiration Friday so be sure to review your broker's procedure policy on exercising. Now this explanation to exercising refers only to long calls or puts not spread positions or covered calls so go to www.cboe.com to learn more details about those strategies and exercising etc. Just know that anytime you are short a call or a put and you are not hedged sufficiently or at all, you always bear the risk of being assigned the stock. That is part of the exercise process that one can never predict if you will be assigned. I'll talk about assignment in later lessons especially when talking about short selling options. I hope that this is not too confusing or overwhelming and that this answers your original question. If not, feel free to reiterate your question and I'll try to do a better job of helping with a solution. Thanks for your question nevertheless.

Anonymous said...

hi, do u know anything about tax on option trading? is there any tax imposed if i trade outside US? usually how much is the tax?

Terence said...

Thanks for your question. I'm certainly no tax expert and would definitely defer your question to your tax professional. It depends on your type of account that you are trading options such as IRA's etc, and also whether it is an individual or corporate account etc. Generally speaking, shorter term options less than a year out are taxed at capital gains tax rates. Again, I'd consult your tax advisor on these sorts of questions. You may ask your advisor about LEAP option capital gains for lower capital gains rates.

Anonymous said...

hi, what happen to the option that is bought when it expired? will it disappear and leave no money around? or it will automatically sell it on the day at whatever price?

thank

tmk0427 said...

If the option is in the money and is tied to a stock or etf, the call option will automatically exercise and the owner will receive the underlying stock at the exercise price of the call. If it is an index contract it will exercise into cash according to the strike price. If the call is out of the money it will be worthless to the owner and will disappear automatically from the account. See www.occ.com for more details about $0.25 in premium automatic exercise rules. This is a general explanation to your question. There are always other things to consider when exercising such as dividends, mergers or acquisitions, or taxable reasons to exercise. Always consult with your advisor or brokerage when deciding on exercising. Hope that helps.