Financial Zip

The words that come to most peoples minds when they hear the word options is speculative, risky, and complex. So far; true, true, true, IF and that is a big IF you don’t understand them. Most people who get into these have no idea how the work. Therefore they shoot themselves in the foot when the start to into live trades. They also get their perception of options from stock options given to employees of the dotcom companies in the late 90’s which ended up worthless. These are not the stock options we will be discussing in this article.

History of Options

We will be discussing equity options. So let’s go through a little history of the modern stock option. It really starts with the CBOE (The Chicago Board Options Exchange) on April 26, 1973. The CBOE’s first home was actually a smoker’s lounge at the Chicago Board of Trade. They started out with selling just 16 options contracts. As the number of underlying stocks with listed options doubled to 32, exchange membership doubled from 284 to 567. About the same time, new laws opened the door for banks and insurance companies to include options in their portfolios. For these reasons, option volume continued to grow. By the end of 1974, average daily volume exceeded 200,000 contracts. As the decades passed the volume and popularity of options have increased so that many people are now involved in trading options.

As testimony to the popularity of options trading, options are available today on over 2,300 underlying securities and 60 indices. In 2000, a record volume of over 670 million equity option contracts was traded across the five exchanges, a 51-percent increase over 1999’s record volume. This was the ninth consecutive year of increasing volume, according to the OIC.

What are Options?

As you can see it is a very popular form of securities trading. So what is an option and what are they good for? A call option is wanting to see the value of the asset increase. A put option is wanting to see the option decrease in value.

Let’s use an everyday of how an option works. You are out house shopping and you see the house that is perfect for you right now. Its $200,000 but you don’t have the money right then to buy the house. Instead you talk to the owner and work a deal so that you’ll put $3000 to buy the house in 3 months for $200,000. The following month they find a gold deposit under neath the home. The value of the home is now upwards of 2 million dollars. 3 months later you buy the home that is worth 2 million for the agreed upon price of $200,000. You just made 1.8 million dollars. What an investment!

The opposite is true if they found a toxic waste dump under the home rendering it worthless instead of being out $200,000 if you bought the home, you are only out the $3000 for the option to buy the home.

The same concept works with options. You can see the value rise dramatically or if the value of a stock really starts to take a nosedive you are limited in your loss with the option.

Leverage is the name of the game with options. Anytime you are buying an option you buy them in contracts. A contract is equal to 100 shares. So you are able to buy 100 shares at a lower price then if you bought 100 shares of normal stock.

Example: ABX stock is trading at $10 so you buy 100 shares you are going to pay $1000 for that stock.

The ABX stock option is trading at $3 you buy one contract so you spend $300 to control the $100 worth of stock.

As you can see options allow you to play the stock market without having to invest a lot for the stock. Leverage again, is the name of the game.

I addressed this earlier as to what calls and puts were I will just go over them again.
When you trade options you have four different players:
1. People who buy calls.
2. People who sell calls.
3. People who Buy puts.
4. People who sell puts.

Selling an option is a complicated process and can be very risky so for know we’’ stick with learning how options are bought.

Buying a call option- When you buy a call you buy a stock that you want to see the value go up.

Buying a put option – When you buy a put you want to see the value of the stock go down.

Anytime you are buying a put or call you are called the holder of that option. Holders have the right but not the obligation to buy the stock.

In my next article we will discuss some of the language of options and how they work exactly and where to go find options. Just understand that Options are about leverage and about limiting risk and that when you are buying options you have the right not the obligation to buy.

Next: Options 101: Language of Options