There are only two types of options, CALLS
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, "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.
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
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:
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.
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
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
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
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
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.
If you like the options education you have been receiving and you are on a free trial then now is the time to subscribe. Don't wait until you miss a newsletter to decide you want to take the plunge.
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!
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