There are only two types of options, CALLS and PUTS. All the other types of option strategies use the basic call or put in combination with other calls or puts. Knowing the basics gives you a good foundation for understanding the advanced strategies.

Call options are a bet that the price of the stock will rise.

An investor would buy a call option on XYZ stock if he expected the price of that stock to rise on stronger earnings or new products over the next several months. An easy way to remember this is "Call Up".

Put options are a bet that the price of the stock will fall.

An investor would buy a put option on XYZ stock if he expected the price of that stock to fall on weaker earnings, more competition or general market conditions over the next several months. An easy way to remember this is "Put Down".

Using the two types of options above investors can construct basic strategies using just one type or complex strategies using different combinations of each or both. These different strategies will be discussed in detail later.

LEAPS:

Leaps, "Long term Equity AnticiPation Securities" are nothing more than very long term CALL or PUT options. The maximum term on a leap is 2.5 years and they always expire in January. We will get into the various ways to invest with leaps later in this series.

Option Contracts

Options are traded by contract. A contract consists of the rights to control 100 shares of stock. The option premiums are based on a price per share times 100 shares per contract. If the price quoted for a call option was $2.00 then the actual cost of one contract would be $200. Sometimes as a result of a stock split or a merger with another company a contract can be for more than 100 shares but this is very rare. If you owned one option contract on a company that split its shares 2:1 you would immediately be given another contract for the new shares. The strike price would be cut in half as well. If you had one contract of a $100 call before the split you would have two contracts of $50 calls after the split. Where confusion abounds is when a company splits 3:2 or some other ratio that does not divide equally. In those cases your contract for 100 shares can become a contract for 150 shares. Consult your broker for details if you own options on a stock that splits or merges with another company in a stock swap deal.

Options Are a Fixed Time Investment

Options are the right to buy/sell a security for a fixed price over a fixed period of time. Options are cyclical in timing and generally expire four times per year. Some stocks may have options that expire in Jan/Apr/Jul/Oct like IBM while others may expire in Feb/May/Aug/Nov like Boeing. This may be confusing to new traders since this only applies to longer-term cycles.

Every stock has options in the current month (front month) and the next month regardless of the stocks cycle. As each month expires the market makers establish new symbols for the next month out. This way there are always multiple option strikes and expirations within 60 days for any stock. The cycle concept allows for shorter term investing without having to maintain symbols and prices for every strike and every month all year long.

75% of all options traded are traded in the current month and next month expiration cycle. For example if the current date was February 1st, 75% of all the option contracts traded would be for the February and March expiration cycles.

Strike Prices

Strike prices are the prices for which you can contract to buy or sell stock with an option. For instance a June $30 Call option on Cisco Systems would represent a "strike price" of $30.

For years strike prices begin at $5.00 and progressed in increments of $2.50 on stocks under $25.00. For stocks over $25.00 the increment is $5.00. For higher priced stocks the increment was $10.

With the advent of decimal pricing and the change in the option symbol format several years ago there is no limit to the number of strikes available. Some stocks have strikes for every $1 and some low dollar stocks even have 50 cent strikes. Typically the strike increment is based on the price of the stock and the volume and volatility. When you look at an options montage on your brokers trading platform it will show you the strike increment for the stock you are trading.

The option symbols changed several years ago to what was supposed to be a "common" format that everyone would use. Unfortunately the format was so cumbersome that most broker screens only show you a subset of the actual symbol to reduce confusion.

The actual symbol looks like this. I am going to describe it vertically and then put it together into its actual format.

MSFT - Stock symbol for the underlying security
15 - Two digit year (2015)
05 - Two digit month code (May)
15 - Two digit expiration day (May 15th)
C or P - Single character C for call, P for put
00050 - Five digit whole dollar strike price
000 - Three digits for decimal places

The symbol for a MSFT $50 May 2015 Call would look like this:

MSFT150515C00050000

For most people that long symbol is meaningless. This is why the brokers and the charting systems on the web break it down into a smaller chunk.

For instance Qcharts, a commonly used charting program, recognizes the same symbol in this format.

O:MSFT 15E50.00D15 The "O" means option symbol.
The "E" is the old month code signifying a May Call.
The D15 stands for Day 15, which is the expiration day in May.

Interquote.com symbols look like this:

MSFT1515E50 for 2015, day 15, E = May, 50 = $50.

A lot of systems still use the old month codes in place of the complicated symbol in the first example.

The month code specifies whether the symbol is a call or a put by using a different letter for the month. "A" is the month code for a January Call and "M" is the month code for a January Put.

Month Codes For Equity Options

Option Montages For Equity Options

The graphic below is from an OptionsXpress options montage. They don't even show the symbols. If you want to trade the option you just click on the "Trade" link for that strike.


The following montage is from the CBOE. They abbreviate the symbol but add another field to designate what exchange the quote is from. For instance the Microsoft $48.50 May strike is quoted on 12 different markets. You don't need to worry about the exchange codes. Your brokers trading platform will typically scan the exchanges when you enter an order and fill you at the exchange with the best price. Some brokers have trade relationships and they will always send your order to the same exchange unless you specify otherwise. Note that the bid/ask is currently the same for all the exchanges but the "last" is different because of the volume traded. If the exchange only processed 7 contracts early in the morning that trade may have been 53 cents where the exchanges with constant volume maintained a last that is close to the current bid/ask. You really don't need to worry about this. Your broker handles it automatically.


In The Money, At The Money, Out of The Money

You will see references to the above terms commonly used in publications when discussing options. Their abbreviations are ITM, ATM and OTM.

In The Money (ITM)

A call option is ITM if the strike price of the option is below where the stock price is currently trading. A $25 call would be ITM if the stock was trading above $25. For example $27.

A put option is ITM if the strike price of the option is above where the stock price is currently trading. A $25 put would be ITM if the stock was trading below $25. For example $23.

At The Money (ATM)

A call option is ATM if the strike price of the option is at or near the price where the stock is currently trading. A $25 call would be ATM if the stock was trading at or very near $25.

A put option is ATM if the strike price of the option is at or near the price where the stock is currently trading. A $25 put would be ATM if the stock was trading at or very near $25.

While a $25 call option for example would be technically ITM if the stock was trading at $25.50 it would commonly be referred to as ATM instead. ITM is normally reserved for strikes $2 or more away from the current stock price. The same is true for a put option trading fractionally ITM. It is technically ITM but commonly referred to as ATM.

Out of The Money (OTM)

A call option is OTM if the strike price is above the price where the stock is currently trading. A $30 call option would be OTM if the stock price was $25.

A put option is OTM if the strike price is below the price where the stock is currently trading. A $25 put option would be OTM if the stock price was $30.

Deep In/Out of The Money (DITM/DOTM)

An option is commonly referred to as DITM or DOTM if the strike price is more than $10 away from the price where the stock is currently trading. A $15 call would be DITM if the stock price was over $25. A $40 call would be DOTM if the stock price was under $30.

Intrinsic/Extrinsic Value

When discussing options there are multiple terms commonly used to represent implied value in an option price. Options are traded just like stock with a bid and ask. The values that make up the option price are "time value" and "stock value".

The price you pay for an option is called the option "premium". This premium consists of time value (extrinsic) and stock value (intrinsic).

Stock value is said to be "intrinsic" when the strike price of the option is ITM. A $25 call option has $5 of intrinsic value or stock value when the stock price is $30. The difference between the strike price and the stock price is intrinsic value.

The amount of the option price that is not intrinsic or stock value is called the extrinsic value. Using a $25 call option with the stock price at $30 the option premium could be $7.00.


Using the table above you can see the premium components based on a six month time period on a $25 call and a $30 stock price. Assuming the stock price does not change for the entire six months you can see the time value "decay" as the clock ticks down on the option.

In January the June call has $2 of time premium but that premium evaporates as time passes. When June arrives there is very little time premium because the clock has run out.

The time premium is said to decay as the clock progresses. The higher time value farther from the expiration point is based on the expectation that the stock "could" rise as time progresses. If the stock does not progress then the expectation falls and the amount that an investor buying that option is willing to pay decreases. This rate of time value decay is called "Theta".

The major factor, which influences the time value of an option, is volatility in either the stock price or the market or both. Increased volatility causes higher time values since traders are taking a greater risk when writing/buying options.

I will have more on definitions and how they impact your trading and profits next week.

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We have a lot of new traders reading the newsletter and I get a lot of questions. Over the next several weeks I am doing a multi part mini course on options. How do the strategies work? I will describe all the various strategies including calls, puts, spreads, covered calls, naked puts, straddles, strangles, definitions, etc. Stay tuned!

Jim Brown

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