An option is a contract between a buyer and a seller. An option buyer buys the contract from the option seller. In the stock markets the buyer and the seller never meet. If you are the buyer you place an order with your broker to buy an option. You can give your broker a price, or buy at the market. There are two types of options: Calls and Puts

So the question becomes, "What exactly are you buying?" The stock option buyer obtains a contract that gives him the right to buy a stock at a given price, for a given amount of time. If the stock goes HIGHER than the stated price on the option contract (the strike price), the option is intrinsically worth money because you can buy the stock at the strike price and immediately sell the stock on the open market for a profit. Most people don't do this, because they can sell the option directly for MORE MONEY than they would make, if they EXERCISED their option rights. Whenever you buy an option, you can sell it as well, just like a regular stock, if you do so before the option expires.

A Call Call option gives the holder the right to buy 100 shares of a stock at the strike price of the option anytime before the expiration date. A Put option gives the holder the right to sell 100 shares of a stock at the strike price anytime before the expiration date. All options have a strike price and an expiration date.

Options are a zero sum game. Unlike stocks, if you make money buying and selling options, you will have taken money from some trader that sold you the options you bought, and bought the options you sold! All four examples of buying and selling options are discussed in the "Why Options" help section.

Options can be settled in 3 ways: you can offset the option, exercise it and take physical delivery or, in some cases, you can cash-settle the option. Offsetting an option involves reversing the original transaction prior to the exercise date. If you bought a call, you have to sell a call. If you sold a call, you have to buy a call. A physical delivery option, which typically applies to stocks, gives the owner the right to receive physical delivery (for a call) and to make physical delivery (for a put) of the underlying stock when the option is exercised. A cash-settled option, which typically applies to index options, gives the owner the right to receive a cash payment based on the difference between the value of the underlying index at the time the option is exercised and the fixed exercise price of the option.

Stocks and indices can all have options associated with them. An index option will give you the right to buy or sell the index at a specific price anytime before the expiration date of the option. The most popular index option is the OEX. The OEX options give you the right to buy or sell the S&P100 cash index at the strike price anytime between now and the expiration date. For example, if you bought an OEX 460 Call and the S&P 100 went to 480, you could exercise your option. This gives you the right to buy the index at 460. Since you can't easily buy the S&P100 index, you simply receive a profit when you exercise this cash-settled option. In this case you receive 20*100 = $2000. The trader who sold an OEX 460 Call will have to produce the $2000. Your net profit is the price you sold minus the price you bought the option minus brokerage fees. The S&P500 index also has options called SPX options. There are many others.

The futures option is the other type of option for which analysis is available on this web site. To get to the futures website, click futures login at http://platinum.optionetics.com. Futures tend to intimidate people, because everyone has heard stories about a futures trader who was wiped out due to margin calls. Futures contracts have high leverage and must to be managed very carefully. When you buy or sell a futures contract, you have assumed the risk of temporarily buying or selling a very large amount of a given commodity.

Let's assume a trader is bullish on Texas Instruments. It's Dec 10, 1999. The tech rally of 1999 is ongoing and there is a Jan 2000 options contract. The trader simply calls a stock option broker or uses an electronic web site stock option broker web page and makes the order : "Buy 1 Jan00 110 TXN call at the market." The broker eventually returns with the filled order and gives you the fill: 3.25.

TXN closes the day at 107. The multiplier for stocks is $100 dollars so the call option buyer paid $325. The option is out of the money. If TXN manages to stay at 107 until the option expires in Jan of 2000, the option value will decay in value and reach 0.0, i.e. worthless, at expiration. This is the complete risk assumed by the call option buyer. The most he can loose is the $325 he used to buy the option.

The TXN call option has given the purchaser the right to buy 100 shares of Texas Instruments stock at a price of 110. If TXN increases in value to above 110 before expiration, say at 115, the option becomes in the money because the option holder can exercise the option and make money. The buyer could physically get delivery of 100 shares of TXN at 110 then immediately sell TXN at 115 in the stock market. His profit on the stock would be $11500 - $11000 = $500. But he paid $325 for the option, so his net profit would be $500 - $325 = $175. The usual approach, in 95% of the cases, is the call buyer sells a call and closes out the option position without taking physical delivery. So the call option allows the holder to participate in stock movements at limited risk. Similarly, a put option buyer has the right to sell a stock at the strike price.

Let's assume the trader is bearish, but does not want to sell a stock short due to the unlimited risk. Instead the trader wishes to buy a put option. This will give the trader the right to sell 100 shares of TXN at a strike price. The trader can buy a January 110 put on TXN for 7.45. This means 7.45*100 = $745. The Jan 2000 put option expires on the "third Friday of Jan 2000 which in this case is Jan 21. This $745 allows the trader to wager that TXN will fall and stay below 110 during the next 42 days.

Suppose TXN does fall to 100. Then the put option is worth (110 - 100.0)*100 = $1000 at expiration. The put buyer could decide to go short 100 shares of TXN at the market value of 100 and take delivery of the short shares. Usually the put buyer offsets the put and sells a put at the same strike price and expiration to close out the option position. The net profit is 34%. Instead of using $10,700 dollars to short 100 shares of TXN on Dec 10 1999 and assuming the risk of a substantial upward movement in TXN, the trader spent $725 to buy the put. The $725 was the only money at risk.

Two other traders in the 2 trades above potentially assumed unlimited risk. The call seller received the $325 premium but assumed unlimited loss unless he also owned the 100 shares of TXN needed for delivery. Likewise, the put seller received the $725 premium but assumed the limited risk of buying TXN for a fixed price no matter what happened to the TXN price. The put seller risk is limited, because the stock can only go down to 0.0.

If the call seller owns the 100 shares, he is said to be a covered call option seller. If the call seller does not own the 100 shares, he is said to be selling naked calls. Brokerage houses require that naked call sellers provide margin to cover their position, and many do not even allow naked call sells. The margin requirements vary by institution. If the stock moves against the seller, the seller may receive a margin call from the brokerage firm. The margin call requires that the call seller come up with collateral or stock to cover the call. Intense stock buying and a run up in price occur when a stock is over sold, and short sellers must cover their positions to meet margin calls.

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