Once you have gained an understanding of a few stock market basics it is now time to try understanding options.
In a nutshell, an option is a financial instrument just like your typical share of stock. It is also a legally binding contract. Ownership of an option gives the holder the right to buy or sell shares of stock at a certain price (strike price) on, or before, a certain date (expiration date). This holder is not obligated to buy or sell the financial asset and will usually only do so when it it financially beneficial to do so.
Options are defined as derivatives because their value is derived from the value of the underlying asset. For example, an Intel option is a derivative since its value is dependent upon the price of Intels common stock. It is derived from the price of the stock. Options can be based on stocks, futures, and commodities. In fact, commodity options trading is actually where the concept of options actually begin.
Understanding options begins by understanding the two basic types of options.
1. Put Option Put options give the holder the right to sell a stock at a certain price on, or before, a certain date. This method is much more risky and speculative than selling covered calls. When you purchase a put option you are expecting the underlying value of the stock to actually decrease. In a bear market you can really make a lot of money with this investing technique.
Like I mentioned previously, this method is much more risky and will not be focused on much on this site.
2. Call Option Call options give the holder the right to buy a stock at a certain price on, or before, a certain date. When you buy a call option you are expecting the price of the underlying stock to increase in value between the day you purchased it and the day the option expires.
Since covered call strategies involve ONLY the use of call options, this is where we will be spending the majority of our time.
The cool thing about trading options is that they trade in exactly the same way as your basics stocks do. At any given time, there are people who want to buy options and there are people who want to sell options.
Basic Terminology That You Need to Understand
The key to understanding options is sometimes just a matter of learning the investing jargon.
Long Positions When you have an overall buy position in a stock or option you are said to be long. Purchasing 200 shares of KO would make you long 200 KO shares.
Short Positions If you were to have an overall sell position you are said to be short. Selling 3 KO December 2010 $60 calls (where you do not own any shares of the underlying stock) means you are short 3 December 2010 $60 calls.
Opening Transactions This concept is really rather simple. Anytime you establish a new position (or increase an existing position) it is known as an opening transaction. Another commonly used term is buying to open. If, for example, you buy 5 December 2010 $30 calls, you are said to be buying to open. If you sold 1 of these same calls (and did not own any of the underlying stock) you would be said to be selling to open. Basically, these concepts just mean that you are opening new transactions; whether buying or selling.
In The Money, Out of the Money, and At the Money For some reason, these concepts seems to confuse more beginners than anything else. I do not really understand why because it is pretty simple if you break each concept down individually.
In the Money options are options that have intrinsic value right now. Basically, the holder of these options could exercise the right to buy the stock right now at a profit. For example, if you own a $20 call option, anytime the value of the underlying stock is greater than $20, it is said to be In the Money.
In much the same way, Out of the Money options have no intrinsic value. Continuing the example from above, any time the value of the underlying stock for your $20 call falls below $20 it is said to be Out of the Money.
Finally, At the Money options are just that. When the underlying stock is trading at exactly the same value as the call option it is said to be At the Money.
Understanding options does not have to be difficult. The key thing you need to do break down each concept individually. Once you have mastered the basics it is now time to begin selling covered calls.