InvestingTrading Options - The Basics (Part Three)
Options have unique properties. These make options quite interesting trading vehicles and sometimes difficult to understand. Before explaining how to trade them and the different strategies let's first examine the options fundamentals.
Strike Price
This is the price at which the buyer of a call option has the right to buy the underlying. For example if you bought BHP calls at a strike price of 30$ then you have the right to buy the stock at 30$ (no matter what the market value of the stock is). In the case of put options, the strike price is the price at which you have the right to sell the underlying. Following the example above, if you buy BHP puts at a strike price of 30$ you have the right to sell BHP stock for that price (again, no matter what the market value of the stock).
Exercise
If you are the owner of options you have the right to exercise them. So when you call in your order to exercise your call options the result is that you lose the options (and the premium you paid) and you buy the shares at the strike price, no matter what the price of the stock is at the time. For puts, you lose the put options and must deliver i.e. sell the stock at the strike price. This is stock you either own or have to purchase from the market.
Premium
The strike price is often confused with the premium. The premium is the price you pay to buy the option itself. So the premium buys you the right to either buy (calls) or sell (puts) a stock at the strike price. In the example above, the premium for the options i.e. the price you have to pay to acquire them would be somewhere around 3$. So, spending 3$ per share allows you to control stock that costs 10 times as much. This is leverage.
Expiry Month
Options always have a certain life span i.e. they expire. Whenever you buy an option you specify the strike price and the expiry month of the option. The further away in the future the expiry month is the more expensive the option will be (i.e. the premium will be higher). This is only logical because a longer life span means that you can enjoy control over the stock for a longer time.
Time Decay
When you buy an option you pay a premium. This premium is higher the further out the option expiry is. As you hold the option and it gets closer to expiry its time value diminishes. This is called option time decay. It causes options to lose value with time. And this decay increases the closer the option gets to expiry.
While the above might be off-putting on the first sight consider this: options at different strike prices have different time decay i.e. one option loses its value quicker than another one. This means that you can combine these options (buy one, sell another) to construct so-called spreads. And these actually increase in value as time progresses. Look for my next articles for more info on the subject.
And think about this: if a bought option loses money with time, what would happen to options that are sold?