c12 JWBT016-Busby September 30, 2008 14:21 Printer: TBD
128 STRATEGIES TO WIN
someone buys an October 35 GE put, the buyer has the option to sell the
stock to the writer or seller of the put when the stock price reaches the
strike price.
Each equity option contract controls the right to 100 shares of the un-
derlying stock. Because options give ownership rights in another asset (i.e.,
stock), an option is a derivative. Derivatives have unique risk, and it is im-
portant to know these risks and fully understand them before trading the
product. Check with your broker and ask for written materials that specify
in detail all of the risks involved.
In order to buy an option, you must pay a premium. The premium is
the cost of the option, and that money goes to the seller of the option and
will not be returned to you. An option contract price is quoted in dollars
and cents. As noted above, most options contracts control 100 shares of
the underlying stock. If the price is $1.50, that amount is multiplied by 100.
The cost of the option in this example is $150. That is the premium received
by the seller of the option.
If the strike price established in the contract is reached or exceeded,
the option is said to be “in the money.” For example, if you have a
September 135 put on Apple, and Apple is trading at $134, the contract
is in the money.
The premium is the cost of the option, and it consists of intrinsic value
and time value. Intrinsic value is the amount of money a contract is “in
the money.” Intrinsic value is equal to the share price minus the strike
price. (This cannot be negative; if the strike price is higher than the share
price, the value will be zero.) Time value is the amount of money a con-
tract is “out of the money.” Time value is equal to the premium minus the
intrinsic value.
There are short-term and long-term options. Long-term equity anticipa-
tion securities (LEAPS) are long-term options and by definition have an ex-
piration date greater than nine months. Due to the length of time involved,
these options are affected less by time decay. Most options go out three or
four months, but LEAPS go out up to four years. LEAPS expire on the third
Friday in January of their expiration year. If LEAPS are held for more than
one year, profits from LEAPS are taxed as long-term capital gains.
In order to trade options, you must have a brokerage account and com-
plete an Options Account Agreement and sign a risk disclosure agreement.
Many brokers allow for options trading. One such broker is OptionsXpress.
If you want to learn more about trading options, check out their web site
at http://www.OptionsXpress.com. Once the application is complete and the risk
disclosure read, understood, and signed, the brokerage house will evalu-
ate the application to determine whether options trading will be allowed
with the account. If the broker believes that the application merits approval
for long positions with limited risk, that portion of the application may be