An option is the right to buy or to sell an "underlying instrument" at a specified, fixed price and by a specified date in the future. The "underlying instrument" could be a stock, a stock index, or a futures contract. The two types of options are calls and puts. You can buy or sell a call and buy or sell a put.

Options are derivative contracts. Options provide a trader with many ways to realize a market expectation that would otherwise not be possible. For example, Texas Instruments is making new highs but has recently consolidated. Therefore, a trader decides that it's not going any higher in the next 4 weeks. This becomes the trader's market expectation: "Texas Instruments will not go any higher for one month."

Simply selling Texas Instruments short does not realize this expectation. If Texas Instruments goes sideways in the next month, no profit will be made. Options allow you to make money with many types of market views. If the trader sold an "at the money" TXN call this market view WOULD be realized, and the trader would make money if the market went down OR sideways.

Some possible market views that can be realized with options are as follows:

• I'm bullish, but want limited risk
• I'm bearish, but want limited risk
• I have no idea which direction the stock is going. I just know it will move big!
• I have no idea which direction the stock is going. I predict it will get more volatile.
• I have no idea which direction the stock is going. I predict it will get less volatile.
• I predict the stock is not going anywhere.
• I predict the stock is going no higher.
• I predict the stock is going no lower.

You can manage your existing stock or index positions with options and use them conservatively to reduce risk. This type of option trade is a Covered Call. You can also use options as a high risk leverage tool to control large amounts of underlying instrument with little initial cash outlay. Hollywood movies (Orange Juice futures in "Trading Places") and Hillary Clinton (cattle futures) have dealt in options and its more risky attributes.

The Basic Stock or Index Call Option is the right to buy 100 shares of a stock or index at a fixed price per share any time between the purchase of the call and the future stock or index call option expiration date. This right to buy has value and represents the price of the option itself. An index option quote for a call appears as follows:

Lets say a trader bought the TXN index option in December and the current price for the TXN is 107. The option value is composed of two parts: an intrinsic value and a time value. In our case, the intrinsic value is 107-110 = -3. This means the option has no intrinsic value. If TXN would stay at 107, then just before option expiration we could exercise the call and receive 100 shares of Texas Instruments at 110 and immediately sell it at 107 for a net loss of $300 dollars (minus brokerage commissions). We would not do this and instead let the option expire worthless.

At the time we bought the call, the option consisted of all time value: $325 dollars. This time value is a wasting asset since it must go to 0 at expiration. Obviously, we exercise the option only if we can make a profit, which would require that TXN be above 113.25. We could also sell the option before expiration to recover whatever time value remains and/or whatever intrinsic value the option has gained.

Option time value is the key to this web site. A way to measure time value is through the option's "Implied Volatility" or IV for short. IV's can be used to compare option value between different stocks, between different option strike prices for the same stock and between different option expiration dates. IV's can be used to decide if an option is historically expensive or cheap. IV's can also be used to increase a trader's probability of making money on an option trade. More option discussions continue in the "Explain Options" Help section of Chapter 1.

The TXN trading example and graphic of buying a call is shown by clicking on the above link. The call option in the example had an IV of 50.4% and a statistical volatility of 52.8%. In Optionetics Platinum, the Create An Option Trade Risk Graph Analyzer and Create A Search web pages use option strategy tables. Each option strategy in the strategy table is linked to a help file which explains what the strategy means. The above link is the strategy table "buy call" help web page.

The basic stock or index put option is the right to sell 100 shares of the stock or index at a fixed price per share any time between the purchase of the put and the future expiration date. The put option is used when it is thought that a stock or index is overvalued or you own shares of the stock or index that have a profit and want protection against market corrections. You don't want to sell the shares, because you are a long-term bull. Still, you want to protect your profits, because you are uncertain about the outlook for the stock or index in the near future.

Buying a put option gives you protection from a falling stock or index prices during the period the put option has not expired and will still allow you to participate in a rising stock market. Since you pay a fixed fee for the put your profits will be lower but unlimited to the upside. Rather than exercising the put option, sell the option if it is profitable or let it expire worthless if it is not.

A TXN trading example and graphic of buying a put is shown by clicking on the above link.

By selling a call you grant the buyer the right to buy 100 shares of the underlying stock or index at the strike price anytime prior to expiration. You receive the option premium from the call buyer and the brokerage house takes its cut from both of you. The actions that may occur include: you later sell the option, or the option expires and you keep the premium, or the buyer exercises the call and you must provide the shares.

You own 100 shares of a stock or index. Using TXN in the prior example, you decide you would not mind selling it at an option Strike price of 110. Your desired strike price is 110. You sell a TXN Jan00 call at 110. Owning the stock and selling a call is an example of a covered call option trade.

In this covered call option trade you receive 3.25*$100 = $325 dollars into your account (minus brokerage commissions). The Jan00 110 call, on Dec 10 199, has no intrinsic value hence the $325 is all time value.

If the buyer of the call never exercises it before expiration, you get to keep the $325 dollars, the option premium, and your TXN shares. If the buyer of the call exercises it, you sell your TXN index shares at 110 to the buyer and again keep the $325 premium. You might wonder how does a covered call loose money. The call buyer exercised the option probably because TXN rose above the 110 strike price. The call seller does not participate in price movement above 110 and also looses the 100 shares of the stock.

An uncovered call is a trade where the trader sells option calls without owning the underlying stock or index. An uncovered call has unlimited loss and limited gain and is a risky strategy.

A TXN trading example and graphic of selling a call is shown by clicking on the above link.

The last example is selling a put. You grant the put buyer the right to sell 100 shares of stock or the index to you at the strike price anytime prior to expiration of the option. The put buyer pays you a premium for this right, which you keep. Lets assume you are interested in buying 100 shares of Texas Instruments stock. The current price of 107 is slightly high in your opinion, but you would buy at 100. You could put in a limit order of buy TXN at 100 on your favorite electronic trading web site and wait to see if it fills. This will cost you $10,000.

Another way is to sell a TXN Jan00 100 put. Suppose you do so and receive a premium of 8 or $8100 = $800 dollars. The option value is all time value, since the current stock value of 107 is higher than the put strike value of 100. If nothing changes the put expires worthless, but you keep the $800. If TXN never falls to or below your strike value or does so, but the buyer does not exercise the put before expiration, (the buyer usually thinks it will go even lower and sometimes misses his chance to sell), you keep the premium, but you do not own the stock. If the buyer exercises the put you again keep the premium but now own 100 shares of the TXN. You paid $100/share.

A TXN trading example and graphic of selling a put is shown by clicking on the above link.

The examples above involved exercising the option and dealing with the underlying instrument. Many option traders simply buy and sell the option itself taking profit and losses from differences in the option value at the time of the trade prior to expiration.

Many index options are only cash-settled options and can only be settled by exchanging cash and not the underlying between the buyers and sellers.