Option Investor
Educational Article

What You Need to Know About an Option

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So, you still want to be an option trader? Great. Thats encouraging. Eight columns and youre back for more. When you think about it, there arent a lot of people who follow through and are willing to make the effort to learn a skill let alone to learn it right.

So many people are spoiled. They have little, if any, patience. We live in a society in which people want it NOW!! We have fast cars, fast food, and even Fast Times At Ridgemont High. People look for shortcuts everywhere, sacrificing quality for the sake of speed.

Well, you can take shortcuts in learning about options, but I guarantee itll cost you. Its not Minute Rice. It will take time and perseverance. Thats why Im impressed that youre still here. OK, lets get to work.
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What You Need To Know
The first thing you need to do when considering trading an option is to determine which option you want to trade. There are a lot of choices on the menu (option chain). Just like a restaurant, some choices are good for you while others are not. There are puts and calls and many strike prices for each. We first want to establish where the underlying asset is trading in relation to the strike price of the option youre considering. This isnt particularly complicated, but it is an important concept.

ITM, ATM & OTM
I love acronyms. Some can be very funny while others can challenge the imagination. However, in the world of options, they dont make them too tough. ITM stands for in-the-money. ATM stands for at-the-money. OTM stands for out-of-the-money.

Using CALLS:
In-The-Money: A call option is considered to be in-the-money (ITM) if the asset is trading above the strike price of the option.
At-The-Money: A call option is considered to be at-the-money (ATM) if the asset is trading very close to, or at, the strike price of the option.
Out-Of-The-Money: A call option is considered to be out-of-the-money (OTM) if the asset is trading below the strike price of the option.

Using PUTS:
In-The-Money: A put option is considered to be in-the-money (ITM) if the asset is trading below the strike price of the option.
At-The-Money: A put option is considered to be at-the-money (ATM) if the asset is trading very close to, or at, the strike price of the option.
Out-Of-The-Money: A put option is considered to be out-of-the-money (OTM) if the asset is trading above the strike price of the option.

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Lets take a look at a few examples:
Example A:
ABC is trading at $28.60
Option: $27.50 call
Option strike is below where ABC is trading = in-the-money (ITM)
The $27.50 call is ITM by $1.10 ($28.60 - $27.50 call)

Example B:
ABC is trading at $28.60
Option: $25.00 call
Option strike is below where ABC is trading = in-the-money (ITM)
The $25.00 call is ITM by $3.60 ($28.60 - $25.00 call)

Example C:
ABC is trading at $28.60
Option: $30.00 call
Option strike is above where ABC is trading = out-of-the-money (OTM)
The $30.00 call is OTM by $1.40 ($28.60 - $30.00 call)

Example D:
ABC is trading at $28.60
Option: $27.50 put
Option strike is above where ABC is trading = out-of-the-money (OTM)
The $27.50 put is OTM by $1.10 ($28.60 - $27.50 put)

Example E:
ABC is trading at $28.60
Option: $25.00 PUT
Option strike is below where ABC is trading = out-of-the-money (OTM)
The $25.00 PUT is OTM by $3.60 ($28.60 - $25.00 put)

Example F:
ABC is trading at $28.60
Option: $30.00 put
Option strike is above where ABC is trading = in-the-money (ITM)
The $30.00 call is ITM by $1.40 ($28.60 - $30.00)

You may have noticed that the ATM (at-the-money) designation is conspicuous by its absence in our examples. Why? Because an option that is ATM is trading at, or near (within .20 or .30), the strike price. If ABC would have been trading at $25.25, one might consider it to be at-the-money for a $25 strike price option.

Practice Makes Perfect (lets hope so)
Heres a little practice for you. Calculate the answers below. These will likely be on one of our upcoming quizzes.

Stock XYZ is trading at $53.75. Fill in the blanks.

The $55.00 call is ________ ITM or OTM?

The $50.00 put is ________ ITM or OTM?

The $60.00 put is ________ ITM or OTM?

The $45.00 put is ________ ITM or OTM?

The $60.00 call is ________ ITM or OTM?

The $55.00 put is ________ ITM or OTM?

Ill publish the answers next week. Im not kidding. This stuff is important.

Choosing The Right Option
So, how do we select the right option to trade? There are more decisions to be made. They involve the delta of the options being considered, and, of course, a little TA (no, its not T&A, its TA = technical analysis). Well be getting into deltas, and a few other Greek letters, in a few weeks. Those are also important concepts to understand and important considerations when selecting an option to trade.

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This Is Good Stuff
Just a reminder that, if youre new to options, these basic articles are valuable. Print these articles out so you can reference them at your leisure. This is your bible for the options basics. Its information you need to know before you risk your hard earned dead presidents and it may very well become a collectors item. What better reasons can there be?

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Mike Parnos - A Little Knowledge Goes A Long Way
The outspoken Mike Parnos has been writing Option Investors very successful Couch Potato Trader column for over four years. Hes been trading and teaching options for over 15 years and knows what you NEED to know to trade options profitably.

Too many traders trade the more advanced option strategies without having a good understanding of options, how they work, and how they are meant to be used. The results? Say goodbye to your money. That is why there such a stigma attached to options. And thats a recipe for disaster. If you have more money than you know what to do with, losing $5,000 or $10,000 is no big deal.

However, if youve worked hard for your money, and you appreciate the value of a dollar, you should make every effort to learn everything you can about options before you put your money at risk.

Mike tells you like it IS, not how you hope it will be. As you read through the columns, feel free to send him your questions. The address is support@optioninvestor.com. Be sure to mention Options 101 in the subject line.

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