Although often decried as highly speculative and risky  — an incorrect assessment in my opinion, stock options provide the trader with an important alternative to buying stocks that has the advantage of potentially higher returns on a dollar for dollar basis and a known-in-advance amount of maximum dollars at risk involved in any transaction.

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Part 1: Stock Options Basics

Options and leverage
A major advantage of trading options is their much lower cost compared with the price of the stock to which they apply. Because of this, the options buyer can control a number of shares whose market price might otherwise be too high to buy, thus the term leverage is appropriate to describe this attribute.

Definition and some basic option terms
A stock option is a contract that conveys the right to buy or sell a stock, usually referred to as the “underlying stock”, at a specified price, referred to as the “strike price”, for a specified period of time.

There are two categories of stock options, called Calls and Puts respectively. Each contract, whether a call or a put, represents the right to buy 100 shares of the underlying stock. Options traded on the North American stock exchanges do not have to be exercised and are often allowed to expire worthless without penalty on their pre-established expiration date.

Stock options can be bought or sold and are traded through a stockbroker in the same way as stocks, using the normal bid and asked system to establish their trading price, referred to the “premium”. The premium varies according to the chosen strike price and time remaining until expiration. The expiration dates for stock options listed on the north American exchanges occur on the third Saturday of the month, meaning, for practical trading purposes, the Friday preceding that Saturday, or the Thursday if there is a holiday on the Friday.

Not every month has an available expiration date for each individual stock. The stock’s options are assigned to a pre-set expiration cycle of which there are three, the January cycle, the February cycle and the March cycle.

For much more on options, check out the Chicago Board Options Exchange (CBOE) and especially useful on that site for a quick reference is the Glossary.

LEAPS the exception
It should be noted that there is a somewhat special category of long term options that do not follow that pattern of expiration dates but expire in January of any one of the following three years. LEAPS are important to learn about and will be dealt with separately. An earlier reference on this Stock Market Basics site can be found at When Working Capital is Limited, worth checking out to see what has happened in the interim.

Also, for practical purposes, options are not often exercised but are considered merely as a product to be traded in the same way as other trading. However, there is a major exception, they would frequently be exercised when they are employee options or any similar types of “privileged” options, sometimes available as a bonus or incentive in many companies.

Time value and intrinsic value
Time is an important component of an option and part of the premium relates to the time remaining until the option expires, therefore referred to as the “time value”. The remaining part of the premium is referred to as the “intrinsic value”. As each day passes, the time until expiration date becomes less and consequently the time value gradually diminishes at an accelerated rate the nearer it becomes to the actual expiration date. Time value is generally referred to as being a “decaying asset”.

The Strike Price
As mentioned above, when the option is purchased, the price at which it can be exercised, the strike price, is established and can be any of three possibilities,

  1. A future price that is lower than the existing stock price, referred to as “In the money”
  2. A future price that is the same as the existing stock price, referred to as “At the money”
  3. A future price that is higher than the existing stock price, referred to as “Out of the money”

There are many ways to trade options and they have practical uses in many situations other than merely as a vehicle to trade like stocks, however, at the level of this stock market basics site we will limit our references to a few of the simpler versions that meet our needs as beginners learning the stock options basics.

Forthcoming articles:

More on this topic will be covered in the next few posts to this website, Part 2 will provide an example of a winning options transaction and Part 3 will deal with the option strategy known as “Spread Trading”, another relatively simple alternative to buying stocks.

Related posts:

  1. Stock Options Explained – Part 2
  2. Buy the Stock or Buy the Option? Risks and Rewards in Trading Options
  3. Trading Options for the Beginner
  4. A Case for Buying Options Instead of Buying Stocks
  5. The Stock Chart and a Simulated Trade to Buy Shares and Options of AGCO
  6. Part 2, Starting With Small Capital
  7. Recap: Paper Trading Candidates, Part 2

Filed under: Stock Market Basics

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