Options Essentials

5/17/2016 What Are Options?
- Motley Fool Options
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What Are Options?
Options Essentials
Follow the series of lessons to work your way through the course, or jump to a topic you're interested in:
Course Overview
1. What Are Options?
2. Getting Permission
3. Nuts & Bolts: Puts & Calls
4. Buying Options
5. Writing Options
6. Cracking the Code
7. Pricing
8. Exercise and Assignment
Download all 8 lessons in a PDF file
Lesson 1: A simple way to understand options as an investment tool.
Approximate Time Required to Read: 10 minutes
An option is a contract between two people setting forth terms to buy or sell 100 shares of a stock at
a set price (the strike price) by a set date (the expiration date). By opening the contract, you're
making a prediction on how the stock's price will move in the future — and you profit if the stock
moves in your favor.
The person who owns the option (bought it, is "long") has the right to buy or sell the stock; the other
person, who sold the option ("wrote" it, is "short"), has the obligation to buy or sell the stock
depending on the decision of the owner of the option. One of these people is referred to as the party,
while the other person is the counterparty.
When the option is opened, the buyer pays to the seller some money, called the premium, which the
seller keeps regardless of what happens with the option. Expanding on this just a bit: The buyer is
buying something of value (the right to exercise the option, forcing the seller to do something) and
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5/17/2016 What Are Options? - Motley Fool Options
the seller is selling that something of value, so the premium is paid right away, when the option is
opened, and the seller keeps the premium no matter what.
All option prices, by convention, are referenced on a per share basis. For the entire contract, multiply
by 100. For example, if an option is sold for $1.35, then the seller receives $135 dollars in premium.
We'll get into the details of what all this means and how to use it to your advantage as we progress
through the lessons.
Two Options, Many Possibilities
There are only two types of options, each of which you can buy or sell, which means there are four
possible positions.
Calls
A call option is a contract that represents the right to buy a stock at a set price by a set date
You Receive ... ... in Exchange For
Buy Calls Right to buy shares Premium payment
Sell Calls Premium payment Obligation to sell your shares
If you think a stock will increase, you can buy calls, giving you the right to buy shares at the
strike price even if the actual share price is higher.
If you think a stock will decline, you can sell (or "write") calls, giving you an initial payment but
also the obligation to sell your shares if the stock rises to the strike price — which you're
predicting won't happen.
Puts
A put option is a contract that represents the right to sell a stock at a set price by a set date
You Receive ... ... in Exchange For
Buy Puts Right to sell your shares Premium payment
Sell Puts Premium payment Obligation to buy shares
If you think a stock will decrease, you can buy puts, giving you the right to sell shares at the
strike price even if the actual share price is lower.
If you think a stock will increase, you can sell (or "write") puts, giving you an initial payment but
also the obligation to buy shares if the stock falls to the strike price — which you're predicting
won't happen
Lifetimes More Like Mayflies
Lifetimes More Like Mayflies
An option contract only exists between the time the contract is opened and it is either closed,
exercised, or expires at the expiration date.
If you close the position before the expiration date, then you pocket the gain or loss you made
between opening it and closing it and you have no further right or obligation to do anything.
If you let the option expire instead, then a couple of different things can happen, depending on the
option type, the strike price, and the share price.
Calls at Expiration
If the share price closes at less than the strike price on the last trading day before expiration,
then the option expires worthless. The call owner will not exercise the right to buy the shares
(after all, shares could be bought for a lower price on the open market), and the call seller keeps
the premium.
If the share price closes at more than the strike price on the last trading day before expiration,
the option will be exercised, usually automatically by the broker. (The act of matching the two
parties involved is called assignment.) The call owner will pay the call seller the amount
necessary to buy the shares at the strike price (the call seller must sell the shares), and the call
seller keeps the premium. A helpful mnemonic is "shares are called away from the seller."
Puts at Expiration
If the share price closes at more than the strike price on the last trading day before expiration,
then the option expires worthless. The put owner will not exercise the right to sell the shares
(after all, they could be sold for a higher price on the open market), and the put seller keeps the
premium.
If the share price closes at less than the strike price on the last trading day before expiration, the
option will be exercised, usually automatically by the broker. The put owner will sell the shares
to the put seller at the strike price receiving the amount promised (the put seller must buy the
shares), and the put seller keeps the premium. A helpful mnemonic is "shares are put to the
seller."
You may notice that puts and calls are kind of mirror images of each other and opposite things
happen depending on where the share price is relative to the strike price at expiration.
The two types of options and these strategies — on their own and combined into more complex
trades — will be your tools for successfully making options part of your portfolio. As you continue
through Options U, you'll learn how to put it all into action.
← Course Overview Lesson 2: Getting Permission →
Options Essentials
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Getting Permission
Options Essentials
Course Overview
4. Buying Options
5. Writing Options
7. Pricing
Lesson 2: Before you can trade options, you'll need to fill out forms
Before you make your first options trade, you'll need to have a brokerage account and get approved
for options investing. This can take a few days, so it's worth starting the process before you want to
start trading.
Applying for options trading permission with your broker involves filling out a form that they'll give you
when you ask. Simply say, "I'd like to apply for full options trading permission, please." You'll need to
answer questions about your investing experience, your assets, and a bit more. It can take a week or
longer to get approved. If you plan to follow along with our options trades, you'll want to apply for full
permission right away.
With most brokers, you can buy options even if you have very little money, say $5,000 or $10,000.
The advantage of buying an option contract or two is that you can "control" many shares of the
underlying stock for, typically, just a few hundred dollars. If the stock rises, you'll earn strong higher
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5/17/2016 Getting Permission - Motley Fool Options
returns on your money. However, to make options worthwhile after spreads and commissions, we
suggest you have at least $10,000 in your account.
With most brokers, you can buy options even if you have very little money, say $5,000 or
$10,000. To sell — or write — options, you should have a higher account balance.
To sell — or write — options, you should have a higher account balance. Typically, a
brokerage firm may require about $25,000 before you can sell put options, less if you wish to sell
covered calls (there, you only need to own the underlying stock). If you're not ready or able to sell
puts yet, that's perfectly fine. Writing covered calls is similar to writing puts, and can work in much the
same way. Meanwhile, buying options always requires less capital, and as your account balance
grows and you gain more experience, you can start to use more involved options strategies.
When writing any options, the brokerage terminology used to start the position is "sell to open." To
later close the position, you would use "buy to close." Writing options — putwriting, specifically —
requires ample buying power in your account. Be sure to review your cash and margin buying power
before writing a put option. Meanwhile, buying options is not unlike buying stocks. You can buy
options with cash or partly on margin, but margin is certainly not recommended.
Step by Step
Choose a broker: If you already have a brokerage account, you should be able to
continue trading there. If you're looking for a broker, we recommend using a discount
broker so trading costs don't eat into your gains. You can compare features, fees, and
reviews on our brokerage wiki page.
Get permission: Trading options requires special permission from your broker. You'll
have to answer a few questions about your trading experience, and we recommend
applying for the highest or secondhighest level of options trading permission (Level 2 to
Level 4; it varies by broker). Try to get optionswriting permission. If you receive Level 1 to
start, don't fret. We'll have plenty of trades for you, too, and as you gain experience, you can reapply
for higher permission.
Set aside cash: You'll need some money to buy options — ideally, you'll have $10,000 or
more in your account to start.
Questions about setting up your account? Ask us at the Help Desk.
← What Are Options? Lesson 3: Nuts & Bolts →
Options Essentials
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5/17/2016 Nuts & Bolts: Puts & Calls - Motley Fool Options
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Nuts & Bolts: Puts & Calls
Options Essentials
Course Overview
4. Buying Options
5. Writing Options
7. Pricing
Lesson 3: These two elements are the key to everything you can do with options
Approximate Time Required to Read / Complete Quiz: 30 minutes
There are only two types of options: calls and puts. A call appreciates when the underlying stock
rises, so you buy a call if you are bullish on that company. A put appreciates when a stock declines.
You buy a put if you believe a stock will fall or to hedge a stock that you already own. One way to
remember this is: "call up; put down" (as in, call something up, or put something down).
Next, let's walk through some of the most common options trades: buying calls, buying puts, selling
covered calls, and selling puts.
Strategy Why
Buy Calls (buy to When you believe a stock will rise significantly over time and you want to
open) leverage your returns or minimize capital at risk
Buy Puts (buy to To short a position, or to hedge or protect a current long holding
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open)
Sell Covered Calls To earn income on shares you already own while waiting for your desired
(sell to open) sell price
Sell Puts (sell to To get paid while waiting for a lower share price (your desired buy price) on
open) a stock you would be happy to buy
Buying Calls
Investors often buy call options rather than buying a stock outright to obtain leverage and potentially
increase returns severalfold. Call options work as "controlled" leverage, enhancing your possible
returns while limiting your potential losses to only what you invest (which is usually a much smaller
amount than a stock purchase would be). Because each option contract represents 100 shares of
stock, an investor can control — and benefit from — many shares of stock without putting a lot of
capital at risk. When you make the right, er, call, you'll enjoy higher returns than you would have if
you had used that money to buy the actual shares.
Let's look at an example. Imagine that a stock that you know well has been hit hard and now trades
at $27 per share. You believe the shares will rebound in the coming months or year. The market
offers $30 call options on the stock that expire in 18 months for $1.50 per share. Therefore, 10
contracts, representing 1,000 shares of the stock, will cost you $1,500 plus commissions. This option
contract gives you, its owner, the right to buy 1,000 shares of the stock at $30 any time before
expiration.
If your stock starts to rise again, your options will increase in value, too. Suppose the stock
recovers all the way to $32 after a few months. Your option's value would likely at least
double to $3 or higher per contract. You've made 100% in a few months. If you had simply
bought the stock, you'd only be up 18.5%.
Of course, there is a flip side. Suppose your stock continues its decline to the abyss. Even
18 months later, the stock price is less than $30, so your options expire worthless —
though in this scenario, hopefully you sold them at some point along the way to recoup
part of your investment.
At Motley Fool Options, we typically buy longerterm call options on wellvalued stocks that we
believe will reward you handsomely over the coming months or years. It's a way to take more
meaningful positions in stocks we believe in, without risking mounds of capital. This is useful if you're
lacking capital or just don't feel like risking it all in a stock.
We typically buy longerterm call options on wellvalued stocks that we believe will reward
you handsomely over the coming months or years. It's a way to take more meaningful
positions in stocks we believe in, without risking mounds of capital.
As with any investment, you should only invest what you can afford to lose, since a stock can easily
work against you in a set amount of time and make your call worthless. Where real opportunity can
be lost is when your timing is wrong. Your options might expire before the stock rebounds, causing
you to lose your option money and miss the stock's eventual rebound. Thus, we aim to buy longer
term calls in positions in which we have high confidence and that have nearterm catalysts.
Buying Puts
Next up, the antithesis to call options: puts.
We buy put options when we believe that the underlying stock will decline in value. Buying puts is an
excellent tool for betting against highly priced or troubled stocks, or even entire sectors! With put
buying, your risk is again limited to the amount that you invest in stark comparison to traditional short
selling, where your potential losses are unlimited. Ouch!
Aside from betting against a position with puts, we may also buy puts to protect an important position
in our portfolio, one that we don't want to sell yet for any number of reasons. When a stock being
protected — or hedged — in this way declines for a while, the puts will increase in value, smoothing
out returns.
We will recommend buying puts on stocks that we believe are due to decline over the
coming months or even years. We may also use puts to hedge long positions, or to short
sectors and indexes.
We will recommend buying puts on stocks that we believe are due to decline over the coming months
or even years. We may also use puts to hedge long positions, or to short sectors and indexes. We'll
almost always buy puts rather than short something outright to limit your risk.
Selling Covered Calls
Now our overview moves from the act of buying options to, instead, selling them to others.
Any qualified investor can "sell to open" an option contract. When you do so, you don't pay the
premium; instead, as the contract writer, you get paid. All cash generated from your option selling is
paid immediately and is yours to keep.
Do we have your attention? We thought so!
The call options that we write (or sell) are almost always covered calls. "Covered" simply means that
we own the underlying stock at the same time. Writing covered calls is one of the most conservative
options strategies available. In fact, most retirement accounts allow you to write covered calls.
They're generally used to generate income on stock positions while waiting for a higher share price
at which to sell the stock.
Here's an example of a covered call. Suppose you own 1,000 shares of a stable, bluechip stock. It's
trading at $56, but you think it is fairly valued around $60 and you would be happy to sell at that
price. So you write $60 call options on the stock expiring a few months ahead, and you get paid up
front to do so.
If the stock does not exceed $60 by your option's expiration, you keep your shares and
you've made money on the call options. You could then write more calls if you wanted to.

If the stock is above $60 by expiration and you haven't closed out your call option
contract, you'd sell your stock at $60 via the options. Your actual proceeds on the sale
would include the option premium you were paid. So you sold your shares at the price
you wanted to and received some extra cash for doing so. That's pretty sweet.
So, write covered calls when:
You would sell a stock that you own at a higher price, and you're not worried about it declining
too much in the meantime. Write calls at your desired sell price, collect the dough, and then kick
back and wait. Rinse and repeat, month after month, when you can.
You believe a stock you own is going to stagnate for a while, but you don't want to sell it right
now. Write calls to make the stagnation more profitable.
You want to cushion a stock that is in decline, but that you're not ready to sell yet. Tread
carefully here so you don't get sold out at too low a price.
When you write covered calls, you must be prepared to give up your shares at the strike price.
Approximately 80% to 90% of options are not exercised until expiration, but they can be exercised
early, so the call writer has to be prepared to deliver the shares at any moment.
When you write covered calls, you must be prepared to give up your shares at the strike
price. ... Even though covered calls are lowrisk, we'll still use them only on stocks we
know well.
That means that if the $56 stock in the example above suddenly soars to $70, you'd still have to sell
at $60. This is the biggest downside to covered calls — lost potential if a stock price rises. The other
risk is that a stock may fall sharply after hovering around your desired sell price for a while, forcing
you to wait longer for your sell price.
Even though covered calls are lowrisk, we'll still use them only on stocks we know well. We may
even set up some covered callonly positions — buying a stock just to write calls on it.
Selling Puts
Note: To sell puts, you must have a margin account. You won't actually need to use margin — which
entails high risk — but you must be marginapproved, have ample buying power (cash, in our
marginfree strategy), and have full options permission from your broker.
Selling puts — also referred to as selling naked puts — is a favorite strategy of ours to seed a
portfolio. There may be plenty of stocks that we'd like to buy at the start, but we'd prefer to snag them
at lower prices. Put options are an excellent way to potentially buy a stock at your desired, lower
share price and get paid an option premium while waiting for that price, whether it arrives or not.
Let's turn to an example: A toprated stock we found on CAPS and researched thoroughly is trading
at $39, but our analysis suggests that we shouldn't buy it above $35. The $35 put options expiring
four months out are paying $3 per share. We "sell to open" the put contracts and get paid $3 per
share to make the trade, giving us a potential net purchase price of $32 before commissions. A few
things could happen here.
Scenario 1: The stock could stay above our $35 strike price; the options we sold
would expire. We didn't get to buy the stock at the price we wanted, but at least we made
money on the options we sold.
Scenario 2: The stock could fall below $35 by expiration. In this situation, our broker
would automatically buy the stock for our account, giving us a start price of $32 before
commissions — even lower than our $35 desired buy price!
Scenario 3: The stock may tank to $29 soon after we sell the puts, but then climb
back above $35 by expiration. In this case, we most likely would not have had the
shares sold to us during this brief decline because about 80% of options are exercised
only at expiration, not before. So we won't own the shares, and we'll have missed our buy
price and the stock's rebound — but we did get paid the premium, at least, and can try again.
Scenario 4: The company's CEO flees to Bermuda and the stock is only at $16 by
our option's expiration. We didn't have the heart to close our losing option position, and
we still have hope, so we wait and the shares are "put" to our account at $35 (minus our
option premium) upon expiration. This is the worstcase scenario — we're down 50% to
start. But we own the stock now and can hope it rebounds. Of course, assuming that we
would have bought the stock outright when it hit our $35 buy price, as we had considered, we would
be down even more than we would be with this strategy, thanks to the $3 premium received for
selling the option.
We will most often recommend selling puts when a stock we follow closely and want to own (or own
more of) is, alas, above our desired buy price. We'll sell puts on it at lower strike prices, prices that
we believe are great levels at which to buy. Either we'll eventually get to buy the stock at our desired
price via the puts, or we'll keep writing puts if the situation merits it. We may also sell puts when a
stock we already hold a partial position in is above the price where we'd like to buy more. We'll write
puts as we wait to average in at lower prices. This is a great tool for allocation and averaging into a
position.
Writing puts on stocks you know well and want to own at lower prices can be an excellent
tool for income and for securing lower buy prices, but you must be prepared to buy the
stock should it fall below your strike price.
Writing puts on stocks you know well and want to own at lower prices can be an excellent tool for
income and for securing lower buy prices, but you must be prepared to buy the stock should it fall
below your strike price. At all times, you must maintain the cash or margin (for us it's always cash
and we recommend you follow that rule, too) to buy shares if they are put to you.
It's important that you only write puts on stocks that you understand well and will be happy and ready
to buy at the prices you're targeting. The risks of writing puts include the fact that the stock could
soar away without you. In many cases, it's better to just buy a great stock once you've found it. The
other risk, of course, is that a stock falls sharply and you're stuck owning it. The biggest risk with
selling puts, as with all options, is when investors rely on margin instead of cash. That can quickly
wipe out a portfolio.
Call Option Put Option
Option The right, but not the obligation, to buy a The right, but not the obligation, to sell a

buyer stock at a set price (the strike price); calls stock at a set price (the strike price); puts
appreciate as the stock rises (remember: appreciate as the stock falls (remember:
"call up") "put down")
Option The obligation to sell a stock at the strike The obligation to buy a stock at the strike

writer price; must hold the stock in the account. price; must have the buying power at the
(or This is called a "covered" position. ready (preferably in cash) in case the stock
seller) declines
Option Believes the underlying stock will rise Believes the underlying stock will fall

buyer
Option If the stock rises, is ready to sell existing If the stock falls, is ready to buy shares at

writer shares at the strike price, keeping the the strike price, keeping the premium
(or premium paid for writing the option received for writing the option
seller)
Check your progress take our quick quiz on puts and calls!
← Getting Permission Lesson 4: Buying Options
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Buying Options
Options Essentials
Course Overview
4. Buying Options
5. Writing Options
7. Pricing
Lesson 4: Boost your returns while limiting your risk
At first, most investors are compelled to buy options rather than write them. They're lured by the
prospect of large percentage returns and the small investment needed to earn them. But this is an
unfortunate introduction to options because the odds are stacked against the option buyer, and it's
easy to lose the whole investment on a trade. And once that happens, many new investors abandon
options entirely, forsaking them as too risky without ever learning about their benefits. That's partly
why we started with a focus on writing options: You have more chances to ultimately be right thanks
to the strategic involvement of the underlying stock, and the option premium and expiration work in
your favor rather than being hurdles to overcome.
So, now that you have a better understanding of writing options, you can consider the pure leverage
that comes with buying them — but use this leverage in moderation. What's more, in many cases,
you'll be able to write options to offset the cost of buying them. Smart.
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[When you write options], you have more chances to ultimately be right thanks to the
strategic involvement of the underlying stock, and the option premium and expiration work
in your favor rather than being hurdles to overcome.
Buying Pros and Cons
The plusses of buying options are many:
Your potential profits are unlimited, while your losses are always limited to what you invest.
Buying options usually requires little capital; many cost only a dollar or two, so you can risk a
total of just $100 to $200.
You control 100 shares of stock with every contract, so you have tremendous leverage.
Buying puts allows you to protect stocks you own or profit on any stock if it declines while
limiting your risk (unlike just shorting a stock).
If a trade goes in your favor, you can quickly earn 50%, 100%, or more. (Fools who followed one
of our alternate trades on Western Union (NYSE: WU) and bought calls were up about 75% in
a few weeks; some who bought calls on Perfect World (Nasdaq: PWRD) rapidly more than
doubled their money. Although keep in mind that the market has been strong recently.)
But there are numerous drawbacks to buying options, too:
If the stock moves against you, it's easy for your investment to lose most — and ultimately, all —
of its value.
You're buying a wasting asset. The "time value" of any option decays over time, and rapidly as
expiration approaches.
You pay the premium when you buy an option, so you're starting in a hole.
In many cases, when you buy an option, you have little recourse if the trade works against you.
Give Yourself the Edge
Now that you've made it this far, here's some excellent
news: There are several ways to tilt the odds in your favor
when buying options. Want to Speculate?
For instance, you can write options and use the premium Buying far "outofthe money"
you collect to help buy options, offsetting your cost and options (strike price is far from
lowering your starting capital at risk. When you buy the current share price; the
options using spreads — as with Jim's eBay (Nasdaq: option only has time value) for
EBAY) and FormFactor (Nasdaq: FORM) bull call very little cost per contract is a
spreads — much of the cost of the options is covered for speculative, exciting — and
you. Plus, your potential losses are limited, and although sometimes, reasonable — use
your possible gains are capped, you still face a large of options. We'll do this later on.
potential return. Another favorite bullish strategy is a If the stock moves enough, you
synthetic long: You write puts to buy calls on the same multiply your money.
stock, usually setting up your trade for little or no cost. If Remember: Only use money
the stock increases, both the puts and calls provide profits. you can afford to lose.
Other ways to give yourself the advantage when buying
options include:
Buy deep "inthemoney" calls (strike price is well below the stock price): Say you're
bullish on a stock trading at $26. You can buy calls with a strike price around, say, $20, and
participate in gains as the stock goes up. If it doesn't, as long as shares are above $20, your
calls will have value at expiration. Then, you can exercise them, buy the stock, and hold it for
appreciation. Inthemoney options give you better odds for a second chance with the stock.
Buy deep "inthemoney" puts (strike price is above the stock price): The argument above
applies here, too. Plus, if you want to protect a stock you own, you can write covered calls and
use the premium to buy puts — this is called a costless protective collar.
Buy LEAPS: The new LEAPS options roll out in September, October, and November each year,
with expirations dated three Januaries from then (e.g. in the fall of 2014, the January 2017
LEAPS rolled out). A LEAPS option has 2+ years until expiration when it first becomes
available. They actually cost less (on an annualized basis) than nearerterm options. As the
option buyer, you have more time to be correct with LEAPS.
With these strategies (and more that you'll learn in upcoming Options U. guides), you have more
reasonable — you might say more conservative — ways to buy options. You'll still be able to earn
large or unlimited potential returns, but you'll risk less capital, have more room for error, or get a
second chance on the investment.
Bottom Line on Buying Options
Buying options opens a new world to investors, one fraught with excitement and big reward — but
also with high risk if used in an undisciplined manner. When you buy, the clock is ticking, and you
need to be right before expiration. However, there are many ways to give yourself extra advantages,
and we'll be using all of them.
← Lesson 3: Nuts & Bolts Lesson 5: Writing Options →
Options Essentials
5/17/2016 Writing Options - Motley Fool Options
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Writing Options
Options Essentials
Course Overview
4. Buying Options
5. Writing Options
7. Pricing
Lesson 5: Get paid while you wait for the market to work its magic
Writing options (a.k.a. selling options) is one of our favorite options strategies, and we recommend it
often. The combination of writing options and owning superior stocks provides the best of both
investing worlds: nearterm option income and longterm stock profits.
The Wall Street Journal reports that about 30% of all options expire unexercised — and as option
writers, that's usually what we want. This results in consistent, repeatable profits. But over the years,
we've found that careful option writers can do much better than 30%, generating income on these
strategies a vast majority of the time.
There are plenty of other benefits to being an option writer:
You collect cash right away.
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You have time on your side: Options steadily lose time value as they near expiration.
You choose your desired buy price (writing puts) or sell price (writing covered calls) on the
underlying stock, so there are no surprises if the option is exercised.
You usually have plenty of leeway with your strategy — the stock can move meaningfully, and
you still earn a profit.
It's a disciplined approach: You can earn better, safer returns on stocks you know well, build
your portfolio, hedge it, or sell positions higher.
You almost always have recourse: If you write puts and the stock falls, you end up owning the
stock and can wait for a rebound. If you write covered calls and the stock soars, at least your
position still results in a profit, even if you miss additional upside.
These strategies are easy to repeat. You can profit the same way again and again and ...
Don't Overwrite Yourself
The main drawback to writing options is that missed
upside. The maximum profit you can earn (from the option
itself) is what you're paid at the start, so you need to write 7 Writing Lessons
options regularly if you're going to grow your portfolio
1. The trade command,
meaningfully. These small, repeatable gains can add up —
whether writing a covered
especially when combined with a portfolio of strong stocks.
call or a put, is usually "sell
But it can be tempting to overstretch yourself to land larger
to open," "sell," "write," or
gains. Therefore, it's important to stay disciplined and only
"short."
write options to the extent you can easily fulfill the potential
2. You're paid for writing the
obligation.
option on day one. You
keep this money no matter
That's right; every option you write is really
what.
3. Until the option expires,
a potential obligation:
you have a potential
For every put you write, you're agreeing to buy 100 obligation to either buy
shares of the underlying stock at the option's strike stock (when writing puts)
price if it declines and stays below the strike price by or sell stock (when writing
expiration. covered calls).
For every covered call you write, you're agreeing to 4. Much like a short, the
sell 100 shares of the underlying stock at the option's option's current value
strike price if it goes and stays above the call's strike shows in your account as a
price. So, you need to own the stock. negative number.
5. As the option falls in price,
If you write many more puts than your account can handle,
you capture the gains you
a price slide in the stock could — just like heavy margin
were paid upfront until the
use — wipe you out if your puts are exercised and you
option expires and
need to purchase buckets of shares. (This is why it's
disappears from your
harder to get permission to write options than to buy
them.) Or, if you write naked calls (in which you don't own account.
the underlying stock), your losses are potentially limitless. 6. You can always "buy to
close" an option you wrote
Therefore, don't get suckered into feeling that writing
before it expires, paying
options is "free money."
the going market price —
either for a loss or gain
But Buying Isn't Bad
depending on that price.
In contrast to the benefits enjoyed by the option writer, 7. Your obligation ends when
option buyers: you buy to close early or
when the option expires.
Pay money upfront to make the trade and have time
working against them from the start.
Need to see a meaningful move in the stock (before
the option expires), and in the right direction, to make the trade profitable.
Have no recourse if their options expire outofthe money; the whole investment is lost.
That's not to say buying options doesn't have many advantages. You can risk very little money and
leverage your investment to earn outsized gains when you're right. But you need to be right — and
right in time. When we do step up to buy options, our confidence level in the trade is high, and we
expect great things before expiration.
← Buying Options Lesson 6: Cracking the Code →
Options Essentials
5/17/2016 Cracking the Code - Motley Fool Options
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Cracking the Code
Options Essentials
Course Overview
4. Buying Options
5. Writing Options
7. Pricing
Lesson 6: Decipher the 21 digits of an options symbol
Deciphering option tickers used to be a lot harder (with special letter codes depending on which
monthly cycle each option was on), but with the introduction of "weekly" options and a simplified
labeling system, deciphering option ticker symbols has become a lot easier. Further, many sites are
now just showing the list of option strikes available for any given expiration date so investors rarely
run across these "long form" option symbols. However, for those times when you do, here is how to
crack the code.
As you're no doubt aware by now, there are often hundreds of options for any given ticker symbol.
Keeping track of expiration dates, strike prices, and option type (call or put) can get confusing, but it's
really pretty simple once you know the rules. Let's take a quick look at how these codes are built,
using the following CocaCola (NYSE: KO) January 2017 $35 strike call option as our example:
Call
http://newsletters.fool.com/50/optionsu/cracking-the-code.aspx 1/3
Ticker Expiration or Strike Price Dollars Strike Price

Put Decimals
Always six characters 2digit C Always five characters; Always three

total; add spaces if year, or P precede with zeros if characters; add zeros
necessary month, necessary if necessary
day
KO 170120 C 00035 000
To review: ticker + expiration + put or call + strike price + decimals equals (mind the spaces):
KO 170120C00035000.
Occasionally, for highpriced underlying stocks (e.g. Apple (NASDAQ: AAPL) before it's 7for1 split),
the exchanges offered "mini" option contracts, where each contract was for 10 shares instead of the
normal 100 shares. These had a "7" inserted immediately after the ticker symbol, so "AAPL7" would
be for a minicontract, while "AAPL" would be for the regular contract.
Clear as a bell, no? Don't worry — we'll continue to refer to our trades by their month and strike price,
as in the "CocaCola January 2017 $35 calls." With most brokers, all you'll need to do is quote the
underlying stock, then click to get its options. From there, choose the strike and month you want,
calls or puts, and make the trade.
Before moving on, here's one note of interest. Beginning in February 2015, the official expiration date
for monthly options (the only ones we'll likely use in the service) changes from "the Saturday after the
third Friday" of the month to simply "the close of market on the third Friday" of the month. This won't
change anyone's behavior, as we couldn't open or close option positions for that Saturday expiration
after trading closed on the third Friday, anyway. This just brings up a relatively archaic choice of
expiration dates into the modern world.
In the quote, there are three prices shown.
"Last Price" is simply what it says it is — the last traded price of the option. However, this last
price could be anywhere from a few seconds to many days old, so don't pay too much attention
to it.
Like any security, the "bid" price is what the counterparty is willing to buy the security for, so if
you enter a market order to sell (instead of a limit order), this is the price you will likely receive.
The "ask" price is what the counterparty is willing to sell for. If you enter a market order to buy
(instead of a limit order), this is the price you will likely pay.
With options, there is often substantially less liquidity in the market compared to shares.
Consequently, you definitely need to watch the bidask spread!
Stocks with a greater option volume and more liquid trading generally have a narrower spread.
Those $35 January 2017 KO calls currently have a spread of 3.5% between bid and ask. In
comparison, the stock currently has its bid and ask only $0.01 apart, meaning the bidask spread
there is only 0.02%. And CocaCola has some decently tight bidask spreads. Options on smaller
companies can have positively murderous spreads — 8%, 10% or even more. Thus, in Motley Fool
Options, we'll generally recommend using strict price limit orders, so as not to have the bidask
spreads overwhelm us.
Further note that call prices decline, and put prices rise, as the option's strike price
increases. This is as it should be.
Further note that call prices decline, and put prices rise, as the option's strike price increases. This is
as it should be. If HewlettPackard (NYSE: HPQ) trades at $42, which call option would you
anticipate as more valuable? The one letting you buy shares at $40 (which you could immediately
turn around and sell in the market for a $2 profit), or the one letting you buy shares at $45 (which is
greater than $3 more than what you would pay on the open market today)? Invoking the old "birdin
thehand" idiom, you'd happily pay more for the one that comes with the builtin profit.
Finally, know that options are sold in contracts for 100 shares each. In buying one KO January 2017
$35 call, you're buying the right to buy 100 shares of CocaCola for $35 per share any time before
close of trading on the third Friday in January 2017, and paying about $880 (the current ask price of
$8.80 multiplied by 100 shares per contract) for the privilege.
Next, peer closer into how options pricing works.
← Writing Options Lesson 7: Pricing →
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5/17/2016 Options Pricing - Motley Fool Options
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Options Pricing
Options Essentials
4. Buying Options
5. Writing Options
7. Pricing
Lesson 7: Go in and out of the money to see what an option is really worth
Approximate Time Required to Read / Complete Quiz: 30 minutes
Before you begin using option strategies as part of your portfolio, you need to know how to find and
understand how they're priced. Let's say Cisco (Nasdaq: CSCO) is selling for $22. You like the
company. You like the price. In fact, you really like the price. In addition to buying shares outright, you
decide to augment your potential gains by buying some call options. If you're right, the price of the
shares will rise and the value of the options will soar along with it. But before you can use options to
boost those returns, you need to know how to find the right option trade at the right price.
Pricing: How Much Is That Option in the Window?
An option's price is the sum of two components: intrinsic value, or IV, and time value, or TV.
Intrinsic value is the difference between the stock price and the option's strike price. IV cannot be
less than zero, since the option holder wouldn't exercise a call with a strike price of $30 if the same
stock is trading in the market at $25. (If you know people who would, please email me their contact
information privately – I'll be happy to sell them as many shares as they want!) IV is calculated solely
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based on how the underlying stock price moves in relation to the option strike price:
Stock Price < Strike Price Stock Price = Strike Price Stock Price > Strike Price
Call $0 $0 Stock Price Strike Price
Put Strike Price Stock Price $0 $0
Time value is simply the premium that people are willing to pay for the potential upside of the option
until expiration. Options are "wasting assets" – that is, as time passes and expiration approaches, TV
gets progressively smaller until you're out of time, and TV equals zero. The corollary is that at
expiration, the option's value is simply IV. Prior to expiration, TV is always positive, even though it
may be very small, such as when the stock price is far above or far below the option's strike price, or
expiration is imminent.
Consider the following CocaCola (NYSE: KO) calls, a stock which currently (Nov. 18, 2014) sells for
$42.85:
Call Strike Price Price Expiration Date IV TV
$42 $1.05 Nov. 22, 2014 $0.85 $0.20
$42 $1.63 Feb. 20, 2015 $0.85 $0.78
$42 $2.07 May 15, 2015 $0.85 $1.22
$45 $0.12 Nov. 22, 2014 $0 $0.12
$45 $0.45 Feb. 20, 2015 $0 $0.45
$45 $0.82 May 15, 2015 $0 $0.82
There are three key observations from this table:
1. Anytime the strike price is greater than or equal to the current
stock price, IV is zero. In such cases, the option value is solely Video Extra:
attributable to TV, and the expectation (hope?) is that the stock The Value of Time
price will meander back above the strike price by expiration.
2. The less time remaining until expiration, the lower the TV.
(Presumably, this is intuitive.)
3. For options with a common expiration date, TV is maximized
when the strike price and the stock price are equal. As the stock
price moves in either direction, TV falls. Jim goes to the tape to explain
the ins and outs — and
We're In the Money! importance — of time value, a
key factor in determining the
You'll hear phrases like "inthemoney" or "outofthemoney"
bandied about (often abbreviated ITM and OTM, respectively). This worth of an options trade. Click
is just a fancy way of denoting whether an option has intrinsic value here to watch!
or not. If IV is positive, the option is said to be inthemoney. If IV is
zero, it's termed outofthemoney.
It is also shorthand to describe where the stock price is relative to the strike price. ITM for a call
means the stock price is greater than the strike price; for a put it means the stock price is less than
the strike price (see the table, above). OTM, of course, is the opposite.
Expressing options as the sum of IV and TV also leads to the conclusion that early exercise of
options generally doesn't make sense (though there are, as always, exceptions to the rule). The
thinking goes like this (from the point of view of the option owner):
1. An option is worth IV + TV.
2. I can exercise it now and receive IV, or
3. I can sell the option and receive IV + TV.
4. IV + TV is more than IV. Therefore, selling an option rather than exercising early is the superior
choice.
To illustrate, if Starbucks (Nasdaq: SBUX) trades for $17.70 in August, and you own $16 October
calls selling for $2.40, you'd not bother to exercise early to collect the $1.70 spread ($17.70$16) –
you'd sell the calls on the open market for $2.40.
Hungry for more? Jim dives deep into time value in an Options Weekly from April 2014! Click
here to read >>
Check your progress take our quick quiz on options pricing!
← Cracking the Code Lesson 8: Exercise and Assignment →
Options Essentials
5/17/2016 Exercise and Assignment - Motley Fool Options
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Exercise and Assignment
Options Essentials
Course Overview
4. Buying Options
5. Writing Options
7. Pricing
Lesson 8: See what happens to your trade when an option reaches its end
Exercising an option simply means that the buyer of the call or put invokes their right to buy or sell
the underlying stock at the strike price. When the option buyer (or holder) decides to exercise, the
writer of the option is assigned an obligation to fulfill the terms of the contract. The hypothetical writer
of a $20 October Intel put must buy 100 shares, paying $2,000 in return.
The mechanics of matching an exercising option holder with an assigned option writer is handled
behind the scenes by the options clearing corporation. Given that there is usually more than one
contract open for a given option strike and expiration, the pairing to match the option owner to an
option seller (picking the person who is assigned) is done randomly.
Once assigned, the writer must fulfill his or her end of the bargain, either delivering shares already
owned, buying shares on the open market, or shorting shares and delivering those in fulfillment of
the contract. (Of course, in the latter situation, that person then has the obligation to go back at some
http://newsletters.fool.com/50/optionsu/exercise-and-assignment.aspx 1/2
5/17/2016 Exercise and Assignment - Motley Fool Options
point and cover the short.)
At expiration, all options that are in the money by $0.01 or more will be automatically exercised. If, as
the option seller, you do not want to fulfill your obligation, you must "buy to close" the option before
the end of trading on expiration Friday (which, for the options we recommend, is the third Friday of
the month). Exercise at expiration is generally automatic and handled by the Options Clearing
Corporation.
Expired options will be automatically removed from your account while the results of exercised
options will be posted to your account, by open of trading on the following market trading day (which
usually means the following Monday).
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5/17/2016 What Are Options?

- Motley Fool Options

Buy Calls Right to buy shares Premium payment

Sell Calls Premium payment Obligation to sell your shares

Buy Puts Right to sell your shares Premium payment

Sell Puts Premium payment Obligation to buy shares

Option The right, but not the obligation, to buy a The right, but not the obligation, to sell a

Option The obligation to sell a stock at the strike The obligation to buy a stock at the strike

Option Believes the underlying stock will rise Believes the underlying stock will fall

Option If the stock rises, is ready to sell existing If the stock falls, is ready to buy shares at

Ticker Expiration or Strike Price Dollars Strike Price

Always six characters 2digit C Always five characters; Always three

KO 170120 C 00035 000

Stock Price < Strike Price Stock Price = Strike Price Stock Price > Strike Price

Call Strike Price Price Expiration Date IV TV

$42 $1.05 Nov. 22, 2014 $0.85 $0.20

$42 $1.63 Feb. 20, 2015 $0.85 $0.78

$42 $2.07 May 15, 2015 $0.85 $1.22

$45 $0.12 Nov. 22, 2014 $0 $0.12

$45 $0.45 Feb. 20, 2015 $0 $0.45

$45 $0.82 May 15, 2015 $0 $0.82

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Options Essentials

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Original Title

Copyright

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Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

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5/17/2016 What Are Options?

- Motley Fool Options

Buy Calls Right to buy shares Premium payment

Sell Calls Premium payment Obligation to sell your shares

Buy Puts Right to sell your shares Premium payment

Sell Puts Premium payment Obligation to buy shares

Option The right, but not the obligation, to buy a The right, but not the obligation, to sell a

Option The obligation to sell a stock at the strike The obligation to buy a stock at the strike

Option Believes the underlying stock will rise Believes the underlying stock will fall

Option If the stock rises, is ready to sell existing If the stock falls, is ready to buy shares at

Ticker Expiration or Strike Price Dollars Strike Price

Always six characters 2­digit C Always five characters; Always three

KO 170120 C 00035 000

Stock Price < Strike Price Stock Price = Strike Price Stock Price > Strike Price

Call Strike Price Price Expiration Date IV TV

$42 $1.05 Nov. 22, 2014 $0.85 $0.20

$42 $1.63 Feb. 20, 2015 $0.85 $0.78

$42 $2.07 May 15, 2015 $0.85 $1.22

$45 $0.12 Nov. 22, 2014 $0 $0.12

$45 $0.45 Feb. 20, 2015 $0 $0.45

$45 $0.82 May 15, 2015 $0 $0.82

You might also like

Always six characters 2digit C Always five characters; Always three