Equity options are a useful cash flow tool you should be using. Read on for a quick look at what they are and how to profit from them.
The Basics On Equity Options
Options are another way investors and traders can profit from financial markets. An option is a contract that entitles the owner to either buy or sell stock at a set price. Most, but not all, stocks traded on the open market can be optioned. Speculators use them to capture short term movements of the market, investors can use them to generate additional cash flow and protect themselves from expected downturns.
Stock option – a contract giving the owner to right to buy or sell stock at a certain price, the strike price. Options are sold in contracts, each contract represents 100 shares of the underlying asset.
There are two basic kinds of options; Call Options and Put Options. Call options are used when the asset is expected to go up, put options are used when the asset is expected to go down. They are listed on the exchange and accessed through a broker. Options are listed for each underlying asset by expiration and strike price. The expiration is the date on which the options is no longer good, usually the third Friday of each month and can be listed for several months or even years. The strike price is the price at which the contract guarantees the underlying asset can be bought or sold.
There are two important factors involved in pricing options, intrinsic value and time value. Intrinsic value is the difference between the price of the option and the price of the asset. In the case of a call, if the price of the underlying is above the strike price the difference is what the option would be worth if it expired today. If the price of the asset is below the strike price there is no intrinsic value. The remaining value is time value and is the price, or premium, an investor pays to own the option. Time value can and does slip away. Each day the passes the option will lose a small percent until all the time value has been eaten away. This is measured by a metric called Theta. Options that are at the money or out of the money have no intrinsic value, only time value.
Three terms to understand when talking about options is In The Money, At The Money and Out Of The Money. At the money means the price of the underlying asset is the same or nearly the same as the strike price of the option. This is true for both calls and puts. Out of the money means the option has no intrinsic value. A call option is out of the money if the price of the underlying is below the strike price. A put option is out of the money if the price of the asset is above the strike price. In the money means the options has intrinsic value. For call options this means that the asset price is above the strike price, for puts it means the opposite.
If, at expiration, an options expires at the money or out of the money it has no time value and no intrinsic value so expires worthless. The owner no longer has rights associated with the underlying stock and the seller is free to sell another option on the same stock. If on the other hand an option expires in the money it will be left with intrinsic value and can be closed for a profit. The deeper in the money an option is the more intrinsic value it has.