How Options Work (Part 1)

Options are the most versatile and fun trading instruments ever invented. Many traders don’t realize it but options have been around since the 1800’s. Since options typically cost less than stock, they can provide a leveraged approach to trading that can significantly limit the overall risk of a trade or simply provide additional income. Basically, option buyers have rights and option sellers have obligations. Option buyers have the right, but not the obligation, to buy or sell the underlying stock at a specified price before 4:00 PM Eastern on the 3rd Friday of their expiration month. There are two kinds of options: calls and puts. Call options give you the right to buy a stock and put options give you the right to sell a stock. You do not want to mix these two up. It will cost you many headaches and lost trading capital if you do.Margin on options trades can sometimes be quite complicated especially in the area of naked option writing. For simple call and put buying, there are no margin requirements since your risk is limited to the price of the option. For those selling options to open a position, you will have an obligation to buy a stock (if you sold a naked put) or deliver a stock (if you sold a naked call). Since it is possible that you will be required to buy or sell a stock when selling naked options, you will have to have some margin available in your account to start the trade. Your brokerage firm will let you know the exact amounts.To trade options, you will be required to learn a few more trading terms above those associated with plain stock transactions. We will start with a strike price, expiration date and option premium. The strike price – This is the price at which you are agreeing to strike the deal at. In other word the price you are trying to buy or sell a stock. These strike prices are the same for almost every Optionable stock. They begin at 5.00 and trade in 2.50 increments up to 25.00. 5.00, 7.50, 10.00, 12.50, 15.00, 17.50, 20.00, 22.50, 25.00. Above 25.00 and they start trading in 5.00 increments. 25.00, 30.00, 35.00… All options have a set amount of time before they expire. This is known as the expiration date. A stock option expires when the markets close on the 3rd Friday of the expiration month. If you purchased an option that expires in February then it will expire at the market close on the 3rd Friday of February. If you purchased an option that expires in March, then it will expire at the market close on the 3rd Friday of March. All listed options have options available for the current month, known as the front month, and the next month, front month + 1. This means that if we are in the February options month, front month, we will always have March options available since it is the front month + 1. You may want to buy a longer term option and look to see if there are any April options available for a stock you are trading in. If there are no April options available then it is because all Optionable stocks are assigned a trading cycle. Each stock has a corresponding cycle of months that they offer options in. There are three fixed expiration cycles available. Each cycle has a four-month interval:
A.
January, April, July and October
B.
February, May, August and November
C.
March, June, September and December
If a stock you are trying to write options on is traded in cycle B you can get options quotes for any of the months listed in cycle B at any time. If you wanted to buy or sell options for the month of April you would have to wait until the 3rd Friday of February was gone. At that point we would be in the options month of March. The March options month would be the front month. Options are written for all Optionable stocks on the front month + 1 (March + 1 = April).