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Let's review some terms:
- Option: "A contract permitting its owner to buy or to sell an asset at a fixed price until a specified date."
- Call: "An option permitting the holder the right (but not the obligation) to buy a specific asset at a pre-determined price until a certain date."
- Put: "An option permitting the holder the right to sell a specific asset at a pre-determined price until a certain date. Calls and Puts are distinct from each other, buying and selling of one has nothing to do with the other." (Discussions about Put Option strategies will be covered later)
- Strike (Exercise) Price: "The price at which the owner of an option can purchase or sell the underlying stock."
- Write a Call: "Sell a call option. The term write is synonymous with sell in options parlance. The seller then becomes the writer."
- Contract Size: "Options are only purchased in contracts, each contract representing 100 shares of the stock."
- Premium: "The price paid to the writer (the person who owns the stock) for the rights of the option. It is entirely a nonrefundable payment in full and not a down-payment on the stock."
- Optionable Stock: "All stocks are not optionable. Very simply, if the options market is buying and selling options on the stock, then that stock is optionable. To find if a stock is optionable, go to the Home Page of CBOE (Chicago Board Options Exchange) www.cboe.com, select Delayed Quoted from DIRECT LINKS, enter a ticker for the stock and hit Submit. This will give you a delayed quote and list of options for the stock if the stock is optionable. For instance, choosing Fore Systems Inc. (FORE) on 1/15/99 I get 55 different Call options to consider. If the stock we select is not optionable, we will get a SIGNAL NOT FOUND message."
We will spend our time this week and next discussing the conservative strategy of "selling" call options on stocks we own (writing covered calls). This is the safest play with options and one that should be mastered first!
An option is an agreement between two parties, a seller and a buyer. The seller agrees, for a price, to let the buyer exercise some action on an asset if the buyer chooses.
Example:You own a stock (the seller of the option). I (the buyer of the option) pay you for the RIGHT to buy the underlying stock at a fixed price anytime until some fixed date in the future. I have paid my money for this right, but I am not obligated to exercise the option.
You have taken my money, you MUST sell me the stock if I exercise my right, anytime before the fixed date. You are obligated.... Seller (writer) Buyer >Reward Receive an immediate premium (cash) for giving up temporary control of the stock. He still owns the stock, up to the time if and when the option is exercised (as owner of the stock, he will continue to receive any dividends paid). Buy the stock at a premium price if the stock price increases above the agreed upon "Strike Price." He has an unlimited profit potential if the stock price rises above this value (strike price). Risk The stock price may go above the strike price. He would sacrifice what might have been gained by selling at the new higher price. The stock price may stay the same or go down, in which case there would be no value in exercising the option. He could lose all the money paid to the seller for the option.
The seller's risk is limited to unrealized potential gains as the stock price rises above the strike. If the option is exercised, he will still get the profit selling the stock at the strike price. If the option is not exercised, he will still own the stock for further action. In either case he will pocket the premium paid for the call on the front end.
Which risk would you rather have, that of the seller or the buyer?
Why Does it Work?
We have talked about two parties in an options contract, the seller (writer) and the buyer. If I want to buy an option on say Intel (INTC), a very popular optionable stock, it may be difficult to find someone who owns the stock willing to sell the option. Enter the third party, the Options Clearing Corporation (OCC). This is a clearing house created by the options exchanges through which all options transactions are cleared.
So, rather than try to find a seller, I submit a request, through a broker, to the OCC where market-makers risk their own capital to bring us together making the options market an easy way to trade. I will get a current quote on a selected stock for a particular option, as with (FORE), which will include bid and ask values, set by the market-makers based on supply and demand, and if we agree, I will buy the option. I will never know from whom I bought the option, only that someone at this point in time offered to sell. The market-maker is the backbone of this trading system, a great example of a free-market enterprise at work.
How Do We Make Money?
A small aside to understand the terminology:
We saw the Reward/Risk comparisons between the buyer and seller of the Call option. In our example above, the seller owned, had possession of, the stock on which he "wrote" the option. There is another high-leverage way a Call can be sold, with certain agreements with a broker, that is, selling a Call without owning the stock. What that means is that I might write a call and then only buy the stock if I get called out, that is, if the option is exercised. This is a high-leverage play since I might receive the premium for the call with no outlay (if not called out). My return would be dramatic! Money in, no money out! "Might" is the operative word in this scenario. The risk for the seller goes up dramatically, however. He may have to pay market price for the stock to honor the call. Market price could be above the strike price. If called out he is obligated to sell at the strike price.
More terms:
- Called Out: "If the buyer of a call exercises the option, the writer is said to be Called Out. He must sell the call to fulfill his obligation."
- Covered: "If the writer of a Call owns the stock, he is said to be covered and the option is termed a Covered Call."
- Naked: "If the writer of a Call does not own the stock, he is said to be Naked, and the option would be a Naked Call."
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