OPTION BASICS

by Helmut Schmidhofer

This is a crash course in options theory. Hopefully, it is pitched correctly between being not too elementary, but also not requiring too much prior knowledge of options.

Options are bought and sold like any other commodity. The option buyer is often called the option taker and the option seller is often called the option writer.

There are two types of option: (i) a CALL option gives the taker the right to buy the underlying stock at an agreed exercise price; and (ii) a PUT option gives the taker the right to sell the underlying stock at an agreed exercise price. In each case, the writer is obliged to meet the other side of the trade when the option is exercised. "Exercise price" is also often called "strike price".

The first thing you must learn is to think in terms of profit/loss diagrams (PLDs). Do NOT touch an option strategy unless you can form a clear mental picture of its PLD.

The following diagrams show the PLDs for a long and short position in the underlying stock and call and put options. The break-even and profit or loss are easy to see.

All options strategies are constructed from a combination of these six basic PLDs. Before going onto the next lesson, you should practice a few of the combinations. Get some graph paper and a pencil and do the following:

1. You are simultaneously long and short in the underlying. Add the two PLDs. The result is a horizontal line above (profit) or below (loss) the zero line depending on the entry prices S.
2. Combine a short call with a long underlying, called "covered call writing". It results in a PLD similar to the short put and is therefore sometimes called "synthetic short put". Practice with several positions of the long underlying, S, relative to the exercise price of the option, E.
3. Combine a long put with a long call, both at the same exercise price E. This is called a "long straddle" and would be taken when a significant move is expected but the direction is uncertain.
4. The opposite is the short straddle, where you sell a call and a put. The position carries great risk but is highly profitable in a drifting market.

There are numerous other combinations of the basic six, such as horizontal spreads, vertical spreads, butterfly and condor spreads, box spreads, etc. These require an understanding of options pricing, which is covered in the next lesson.

A spread is the simultaneous purchase of one option and sale of another of the same type, where the options differ in time to expiration or in exercise price. It can do no harm to practice a few of these combinations and construct their PLDs. Just bear in mind the following basic properties:

1. An option with a longer time to expiration will be worth more than another with the same exercise price but a shorter time to expiration.
2. If two CALL options differ only in their exercise price, the option with the lower exercise price is worth more than the option with the higher exercise price.
3. If two PUT options differ only in their exercise price, the option with the higher exercise price is worth more than the option with the lower exercise price.
4. On expiry, an option is worth its intrinsic value, which is either zero or the amount by which the option is "in the money", i.e. S-E for calls and E-S for puts.

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