Chris Butler, the founder of projectoption, offered viewers an in-depth presentation Friday on everything a new investor or trader needs to know about options at the Benzinga Boot Camp.
The Textbook Definition: Buying an option gives the holder the right (but not the obligation) to buy or sell an underlying asset at a fixed price (known as the strike price) on or before a predetermined date (known as expiration).
Investors can buy one of two kinds of options. The first is a call option that gives the holder the right (but not the obligation) to buy a stock. As a general rule, a call option increases in value as the stock price increases.
The second is a put option and gives the holder the right (but not the obligation) to sell a stock. Unlike a call option, the value of the put option will rise when the value of the stock falls.
It's important to note that the option price listed on a brokerage or trading platform must be multiplied by 100 because one option contract is used to buy or sell 100 shares of a stock. So, one could accurately say that a quoted option price is on a "per-share" basis, Butler said.
Investors and traders can sell their options in the open market to someone else. Or at any point through expiration, they can exercise the option — that is, convert the option into stock at the strike price.
But options traders rarely exercise the options they own to realize a profit.
Options range in duration, and it wouldn't be uncommon to find options that expire in one day and others that extend all the way through the end of 2022.
All options will cease to trade on the expiration date. If the value of the option has no value, it will automatically be removed and the investor's loss is 100% of the value.
Rationale For Buying Call Options: Investors and traders would typically buy a call option because of its uncapped upside potential and limited risk compared to owning the stock outright, Butler said at the Boot Camp.
Suppose someone buys a call option on a stock with a $100 strike price for $5. The total cost to enter the trade is $500 as opposed to buying the stock outright for $10,000 (100 shares at $100).
The option trade becomes profitable once the stock moves above $105 (remember, the trade cost $500) and the most that can be lost is the same at $500.
In some cases, the value of a call option can increase faster than the shares itself.
The one drawback of owning a call option is that it is essentially a race against time. Even if a stock trades above the strike price one day after expiration, the option will expire with no value.
Rationale For Buying Put Options: Similar to a call option, the holder of a put option can realize a theoretical unlimited gain and smaller losses compared to being active in the stock through a short position, Butler said.
One would buy a put option amid expectations for the stock to fall in value. Or, a long-term investor who believes their stock could fall in value in the near-term can protect their downside exposure.
The Math Behind An Option: All option prices are calculated based on two separate components, the intrinsic value and extrinsic value.
The intrinsic value refers to the "real" benefit of owning the option, or the price of the stock minus the strike price. The extrinsic value is thought of as the price associated with an option's potential to become more valuable prior to expiration.
As time passes and as expiration approaches, the extrinsic value "decays" out of the option's value. After all, it is more likely for Apple Inc. (NASDAQ: AAPL) to gain $100 per share over a one-year period, and this extra cost needs to be reflected in the option price.
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