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Option 101: What is option? – Part I

An option is the contract that gives the buyer the
right” but not the “obligation” to trade the underlying at
a specific price called stike price within a specified period of time called expire dateThis right
implies a choice
: the buyer can use the option if the buyer wants but the
buyer doesn’t have to.  An option
is not an obligation.
 

There are two kinds of options: call and put:
 

l          A call
option gives the buyer the right, but not the obligation, to buy the underlying
instrument to the seller of the option at a definite price within a specified
period of time.  Calls are purchased by those who think the underlying
instrument may go up in price.

 

l          A put
option gives the buyer the right, but not the obligation, to sell the
underlying instrument to the seller of the option at a definite price within a
specified period of time.  Puts are purchased by those who think the
underlying instrument may go down in price.

Just like you can go long (buy) or short (sell)
the underlying instrument, you can go long or short options. Options can be
complex because we have four choices.  See the “Potential Underlying
Position” table below. 

 

Long (buy)

Short (sell)

Calls

Has the right to go long

May be obligated to go Short

Puts

Has the right to go short

May be obligated to go Long

Table 1: Potential Underlying Position

 [@more@]

So, have I confused you yet?  Laughing  Don’t worry;
let’s go over some options trading examples to help you understand options
better.

 

Example 1:

 

Let’s say I speculate the stock price of MannKind
Corp. (MNKD) is going to go up to $12
sometime before 9/21/2007 and I have $25K and want to open a position with MNKD,
what can I do?

 

I.                  
I
can just go long in MNKD stock at the today’s price, $8.98/share (8/30/2007).  With $25K, I can control ~2783 shares.  Say the price per share go up to $12 before
9/21/2007 and I close the position, I will have a realized gain of (3.02 *
2783) = $8404.66, an approximately ~34% in return.

II.               
Or
I can trade options, I can buy in-the-money MNKD Jan 08 $7.50 call (MWUAU.X) today
(8/30/2007).  The premium of the call is $2.25
per share (on 8/30/2007) or $225 ($1.30/share * 100 share/contract) per contract.  With $25K, I can purchase total of ~111
contract and with 111 contract, I have the right
and not the obligation
to go long and buy 11,100 shares of MNKD
1 at the price of $7.50.  Again, say the price goes up to $12 before
9/21/2007 and I exercise my MNKD Jan 08 $7.50 call which gives me the right to
buy 11,100 shares at price of $7.50!  And
most likely, I will turn around and sell these shares right back to market at
$12 per shares so at the end of all these, I will have a realized gain of ($12 -$7.50)
* 11,100 – (111 * 225) (cost of the call option) = $24,975, an approximately ~99%
in return!

Note:  

1. In stock, listed options are all for 100 shares of the particular underlying asset, 111 call contracts gives the buyer of the call the right to buy 11,100 shares of the underlying stock.

 

Example 2:

 

Say, I speculate the stock price of CIENA Corp. (CIEN)
is going to drop to $33.00 sometime
before Christmas of 2007 and with $25K; I want to trade CIEN accord to my own
market view.  So, what can I do?

 

I.                  
I
can short the stock at today’s price, $37.20 (8/30/07) and with $25K, I can short
~672 shares of CIEN and if share price of CIEN go down to $33.00 sometime
before Christmas of this year and I close the position, I will have realized
gain of $2822.40, an approximately ~11% in return.

II.               
I
can long in-the-money Jan 08 $30.00 (EUQMF.X) put @ $1.20 per share.  With $25K, I can buy ~208 contracts of EUQMF.X
put which gives me the right but not the
obligation
to short shares of CIEN @ $30.00 per share.  So, when price drops to $33.00 sometime
before Christmas of this year and I close the position, my realized gain would
be ($33.00 – $30.00) * 20800 – ( 208 * $120) = $
37,440.00 an approximately ~149% in return!

 

Both examples above, I choice to excerise the options but in the real world there are 3 possibilites for an option holder:

  1. Exercise the option, like I did in the examples above
  2. Just let the option expire
  3. Sell the option back to the market 

On the other side, as the option writer, the possibilites are more limted.  An option writer can:

  1. Hold the option to expire (and hope not to be assigned).
  2. Close the position and eliminate teh obligation  by buing the option contract back from the market.

I really hope the two examples above can help you
understand the basics of options trading. 
If you think not and still need more and detailed information on options
trading, Chicago Board Options Exchange (CBOE) has a terrific online tutorial
on options trading, the url of the online tutorial is: http://www.cboe.com/LearnCenter/.  Or, feel free to comment you questions on
this post below and I will try to answer your questions the best I can!


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