Options can be very confusing for a beginner. There are terms that are foreign to many investors who are only familiar with stocks – such as call and puts, beta, theta, gamma, strike, covered call, etc.
Let's start from the beginning. I think one of the easiest way to start learning is go to the Finance section of www.yahoo.com and let's use Microsoft Corporation (Ticker Symbol: MSFT) as a guide to our options education.
On the left hand menu, select Options. Now you should see the option page for Call Options and Put Options. Call Options is defined as the right, but not the obligation, to buy the stock at the strike price prior to expiration. Put Options is defined as the right, but not the obligation, to sell the stock at the strike price prior to expiration.
Now we have to define “Strike Price”. A strike price is the price that you can exercise the stock irregardless of the current market price. Say for example the current market value of a Microsoft stock is $30.00. You purchase one call option at a strike price of $35 with an expiration date of September 2007 which is two months away. Let's say for example the stock price of Microsoft rose to $40 after one month. Now you are ready to profit from the call option you purchased one month ago. Your call option gives you the right to buy the Microsoft stock at $35.00 and turn it around to sell the stock at the market value of $40.00, which gives you a profit of $5 per stock (not taking into account fees incurred).
So in a nutshell, when you buy a call option, there is another person out there who is selling that call option. So if the call option increase in value due to the rise of the stock price, you would exercise that call option by one of 2 ways to profit –
1. Exercise the call option by purchasing the shares from the seller at the strike price and turn around and sell it to the market at the market price, thus pocketing the difference,
2. Sell the call options itself, not the stock. The intrinsic value of the options has risen up due to the rise in the stock price. This way you do not need to come up with funds to purchase the stocks from the seller. All you need to do is sell the call options contract using the same brokerage firm that you bought the call options contract.
Of course, the example provided above are just simplistic scenario. Many other factors can come into play to affect the profitability and loss of investing in options, such as volatility, and greeks such as beta, gamma, theta, etc. I will provide more education on these other factors but today, you just learned the ABCs of options.
