Options trading involves trading the option to buy or sell a stock, at a fixed price (strike price), until the option expires. With commodities, this is also known as futures trading. Options expire on the third Friday of each month. Options with expirations of more than one year are called LEAPS, which stands for Long Term Equity Anticipation Securities. Option premiums (the cost to purchase the option) can start as low as $0.05, depending on the underlying share price. The most common price range for premiums is around $2.50 – $5.00. When you buy an option, you are buying the option to buy 100 shares. So if you buy 5 options with a premium of $5, then you will spend $500 on your 5 options ($5 x 100 shares).

There are two basic options: call and put. A call is the option to buy a share at the strike price. The object of a call is to make the stock price go up. Your option is considered out of the money if the stock price falls and never rises above your strike price before expiration, then you will lose your premium, the amount you paid to purchase the option. Your option is in the money if the stock trades above its strike price.

A put is just the opposite of a call. The object of buying a put option is to lower the price of the underlying stock. A put option is the option to sell a share at the exercise price. A put option is in-the-money if the underlying stock is trading below its strike price, and a put is out-of-the-money if the stock’s price is trading above its strike price.

An option can still have a premium if it is out of the money. This is considered time value. The premium for an option is determined by two factors: asset value and intrinsic value. The intrinsic value is how much the option is in the money.

Operations with more advanced options

You can also sell calls and puts. Selling (or underwriting) a call while holding the current shares is called a covered call. Covered calls are widely used and are a way for an investor to make extra money during a stagnant or downtrend market. If you sell a call option without owning the underlying shares, this is called a naked call option. Naked calls are very risky because the price of the shares can go up infinitely and when the calls are exercised you are obligated to give the buyer the shares at the exercise price but have to buy them at the market price (you lose the difference between the price exercise price and the price on the free market).

Buying a put option while holding the underlying stock is called a matched put option. An investor buys the put option to protect himself or to ensure that the stock price falls. A matched put option is like an insurance policy: a sale price for your shares is guaranteed until expiration.

Selling (or writing) a covered put means you have the cash secured in your margin account to cover the cost of buying back the shares at the buyer’s strike price if the shares are offered to you. If you do not have the cash secured by selling the put, this is called a naked put. You are responsible for the cost of all shares at the exercise price if the put option is exercised (offered to you).

A straddle is buying both a call and a put option at the same time. The object of a straddle is for the investor to believe that the stock will move significantly up or down. If the stock price rises above your buy price or falls below your ask price, then you are in the money. A straddle is used when the stock is very volatile and is expected to move, but you are not sure which way.

A short straddle is the opposite of a straddle. A short straddle involves selling a call option and a put option at the same time. The investor believes that the underlying shares will not move, allowing the options to expire worthless and the investor to benefit from the premiums from the sale of the options.

A spread is the buying and selling of the same type of option (call or put) at the same time. A credit spread is when a higher premium option is sold and a lower premium option is bought. The investor is credited more than he is debited (the money earned from selling the options is more than it cost him to buy his options). A debit spread is the opposite: more money is spent buying options than selling options.

A calendar (or horizontal) spread is when the expiration dates on the long and short leg of the option differ. A vertical spread is when the strike prices of the long and short leg differ, not the expiration date.