Options Trading Basics

We have been getting a lot of questions lately about options trading because of our new options trading service, so I wanted to use this week's article to explain the basics of trading options. There is a lot more to consider when trading options and a lot more terminology you need to know then when trading stocks. Here are the most important things you need to know about options:

An option is a derivative, meaning its price is based on an underlying asset. These underlying assets can either be stocks, ETFs or Indexes. Buying an option gives you the right, but not the obligation to purchase the asset at a specific price (called the strike price).

There are two types of options, Calls and Puts. The value of Call options increase as the value of its underlying asset increases. Traders buy Calls when they think the price of the asset is going to go up. The value of Put options work the opposite way, they increase as the underlying asset decreases.

For Call options, if the price of the underlying asset is below the strike price of the option then it is "out of the money," when the price of the asset crosses above the strike price it is called, "in the money." This too works the opposite way for Put options. The price of the option has the greatest percentage moves when it crosses from out of the money to in the money but out of the money options also have the most risk.

Options are not issued by companies like stocks are. All options that exist are "written" or sold by another trader somewhere. So in a way, you are directly betting against that person if you buy an option.

All options have an expiration month. The option will expire at the close of trading on the third Friday of that month. If you are still holding the options at that time they will expire and be worthless.

When you trade options you are buying or selling options contracts. Each options contract controls a block of 100 options on 100 units of the underlying asset. So if the price of a stock option is $2.00 and you want to buy 4 contracts you will pay $800.00 (2*4*100) and you will have the right to purchase 400 shares of the stock.

There are a variety of different trading strategies that options can be used for. The most basic and probably the most common is simply buying Puts and Calls. More strategies include selling options, and using sets of options for calendar spreads, straddles, strangles and butterflies.

For example, on March 7 we bought GBZCS (BBH Mar 2006 195 Call) at a price of $1.50. "GBZCS" is the options symbol. "BBH" is the underlying asset, which in this case is a Biotech exchange traded fund. "Mar" stands for March, so this option will expire on the third Friday of March 2006, which is next week. The "195" is the strike price. At the time this options position was purchased, the underlying asset was about $191.10, well below the strike price. The next day, on March 8th, BBH went all the way up to $196.50 so it crossed over the strike price and the price of the option went from $1.50 to $2.75, which is over an 80% gain.

There is much more involved with trading options, but these are some of the most basic concepts to help you get started.