Papale on Options Basics

I have written my share of cover letters over the years but I ran across possibly the greatest one ever the other day on Yahoo.  This person was looking for a summer internship on Wall Street and was no doubt going up against some tough competition.   Here’s a snippet – “I won’t waste your time inflating my credentials…or feeding you a line of crap.  The truth is I have no unbelievably special skills or genius.  I have interned at Merrill Lynch and taken an investment banking class for whatever that is worth.”  The trading desk should hire him.

Last week we introduced calls and puts.  As a review, calls are the right but not the obligation to buy an underlying at a specific price within a defined time period.  For example, with AAPL around $500 I might own the AAPL Mar 475 call.  This give me right to buy AAPL at $475 (known as the strike price) up until they expire in March.  All options have an expiration date.  This particular option expires in March.  Options traditionally expire on the third Friday of each month and can be traded several months to a year or more ahead of expiration.  So today AAPL has options listed for January, February, March, April, Jun and beyond.  This give the investor or trader the opportunity to place his bet as far ahead of time as he would like.  In addition the range of strikes goes from far under the current price (known as deep in the money) to far above the current price (known as out of the money).  With the stock trading at $500 the strike price of $500 is known as at the money.  At the money is always closest to the price of the stock or underlying.

 

Puts are pretty much the opposite of calls.  Let’s  stick with AAPL.  If you remember from last week, puts give the holder the right but not the obligation to SELL the underlying at a specific price over a defined period of time.  So if I own AAPL Feb 500 put that give me the right to SELL AAPL at $500  anytime between now and February expiration – the third Friday of February.  So you can imagine if AAPL goes down the value of my puts will go up  since I have the right to sell AAPL at $500.  Strikes above the current price for puts are known as “ in the money” since they are more valuable because the holder can sell the stock higher than the current price.  Strikes lower than the current price are known as “ out of the money” as the holder would not exercise his right to sell at that strike price since he could do better by selling the stock in the open market.

Finally for today, one option represents 100 shares of stock.  Probably something good to know before starting to trade.  Next week –  pricing.

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