Market review - Options 101

When discussing options, look no further than an old rotary telephone (you young folks will have to look that up or ask a grown-up). When a call comes in, you pick UP the CALL. Conversely, when a call ends, you PUT the phone DOWN.

Calls – up

Puts – down

This is denoted on the long side (ownership) of the option position. On the short side, the opposite is true.

The buyer of an option contract (1-contact = 100 shares) on the long side believes that the underlying stock is either going up (calls) or down (puts) from the strike price. The strike price is usually set in 5-point increments of the current underlying stock price. Let’s look at an example:

CAT (Caterpillar)

Market price 267.97

Feb 270 call - $10.90 (premium)

1 Feb 270 call - $1,090.00

There are two factors that make up the “Premium.”

Intrinsic value – The value of the market price above the strike price

Time value – The time left in the contract (in this scenario, Feb)

As the price of CAT moves towards or exceeds 270, the cost or premium of the contract increases (intrinsic value plus remaining time value).

As the price of CAT moves downward, or away from the strike price (270), the premium declines accordingly.

Put contracts act the exact same way, but in the opposite direction. As the price of the underlying stock goes away from 270 (on the downside), the more intrinsic value the contract has, and thus increases in value.

On the third Friday following the third Saturday of February, the contract expires. Failure to act by either selling the contract on the open market, or exercising the contract “In the money”, the option expires worthless. This example is why there is such a high risk to taking positions in option contracts.