Options strategies are among the most intriguing tools available. You can use options to be highly speculative or very conservative, or even personalize a plan of anywhere in between. Options are not only for traders but they can be used for investors with longer investment horizons to hedge or leverage positions, and even generate cash flow.
An option is simply a contract that provides you with the right to buy or sell a lot of 100 shares of a particular stock at a fixed price for a specific time period. When you have an open option position, you do not have any equity or debt position in the stock. You only have a contractual right to buy or sell 100 shares of a stock at a predetermined price. There are two forms of options. There are calls, which give you the right to buy shares a fixed price and, puts, which gives you the right to sell shares at a fixed price.
An option can be compared to a coupon, which will gives you the right to buy at a product for a certain price until it expires. Take for example, a coupon you receive in the mail for buying a pizza at $9.99 until it expires a month from now.
A primary reason options are popular is because they offer leverage to stocks and you can take advantage of price movements among hundreds or thousands of shares with only a fraction for the money. For example, you can own a $5 option of XYZ company that trades for $50 and still take advantage of an almost dollar for dollar price movement with only a fraction of the money down.
Although, an option gives the owner the right to buy or sell stock at a specified price most investors do not exercise this right, but rather buy or sell the option itself which increase or decrease in price along with the underlying stock.
Valuation of options may seem complicated at first, but it is actually quite simple once you understand the principle. Consider the price movement to be either a plus or minus depending on whether you are planning on buying or selling, and whether you plan to utilize calls or puts. The table indicates how price movements in the underlying security effect the option.
The value of options is made up of two components â intrinsic value and time value. Intrinsic value is the part of the optionâs premium equal to the number of point above or below its strike price. For example, a call that is three points above its strike price has an intrinsic value of three points and any price premium above that is known as time value. However, time value will diminish as the option approaches its expiration date.
When the market value of a stock is above the strike price of a call option the option is âin the moneyâ and the owner has the right to exercise it. The opposite is true for a put option. When an option is âin the moneyâ a dollar for dollar price movement versus the underlying stock occurs. A call option is âout of the moneyâ when the underlying stockâs price is below its striking price, and vice versa is true for a put option. Options that have a strike price equal to its stocks market value are âat the moneyâ.
Price movements for options will not always be identical, because as the expiration nears the time factor also affects the optionâs value. The value of options also depends on the volatility of the stock, and the volume of shares traded.
Chart of in the money and out of the moneyThere are four basic options strategies, buying calls, selling calls, buying puts and selling puts. But these four strategies can be combined into numerous strategies to adjust risk in both long and short positions.
An investor can construct a wide variety of strategies with only these four basic options that contain both high risks and low risk with both short and long investment horizons. These strategies can be used to generate cash flow, used as an in insurance policy against a correction, or used to leverage a position.