a. US Option's Cheat Sheet

A Beginner's Guide to Options

Options are financial contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific time period. They are powerful financial instruments that can be used for speculation, income generation, and risk management.

The Fundamentals of Options

At their core, options are contracts between two parties. Let's break down their key components:

Basic Structure of an Option Contract

An option contract has several essential elements:

1. Underlying Asset: This is what the option is based on. It could be shares, ETFs, indices, commodities, currencies, or even other derivatives.
2. Strike Price: Also called the exercise price, this is the predetermined price at which the option holder can buy or sell the underlying asset.
3. Expiration Date: Every option has a limited lifespan. After this date, the contract ceases to exist.
4. Premium: This is the price paid by the buyer to the seller (writer) of the option. It represents the market value of the option contract.
5. Contract Size: Each option contract typically controls a specific amount of the underlying asset. For share options, one contract usually represents 100 shares.

Types of Options

There are two fundamental types of options:

Call Options

A call option gives the holder the right to buy the underlying asset at the strike price before the expiration date. Investors buy calls when they believe the price of the underlying asset will increase.

For example, if you buy a call option on Microsoft shares with a strike price of $300 and the shares rise to $350, you can exercise your option to buy the shares at $300, immediately gaining $50 per share in value.

Put Options

A put option gives the holder the right to sell the underlying asset at the strike price before the expiration date. Investors buy puts when they expect the price of the underlying asset to decrease.

For instance, if you buy a put option on Apple shares with a strike price of $180 and the shares fall to $150, you can exercise your right to sell shares at $180, protecting yourself from the $30 per share decline.

Options Pricing

Understanding how options are priced is essential. The premium of an option is influenced by several factors:

Intrinsic Value

This is the amount by which an option is in-the-money (ITM). For calls, it's how much the share price exceeds the strike price. For puts, it's how much the strike price exceeds the share price. Options that are out-of-the-money (OTM) have zero intrinsic value.

Time Value

This is the additional value beyond the intrinsic value, reflecting the possibility that the option could gain more intrinsic value before expiration. Time value decreases as expiration approaches—a phenomenon known as time decay.

Basic Options Strategies for Beginners

Here are some straightforward strategies suitable for those new to options trading:

1. Buying Call Options - The Optimistic Approach

When you're confident that a share price will rise, buying a call option can be simpler than buying the shares outright. This strategy limits your risk to just the premium paid, while giving you exposure to potential price increases.

Example: If you believe ABC shares will rise from their current price of $180, you might buy a call option with a strike price of $180 for a premium of $8 per share. If the shares rise to $200, you can exercise your option and gain $12 per share ($200 - $180 - $8).

Key benefit: Limited downside (you can only lose the premium) with unlimited upside potential.

2. Buying Put Options - Insurance for Your Investments

If you already own shares and want to protect them against a potential price decline, buying put options acts like an insurance policy.

Example: If you own 100 shares of XYZ at $200, you might buy a put option with a strike price of $190 for $6 per share. If XYZ shares fall to $170, you can sell them at $190, limiting your loss.

Key benefit: Peace of mind knowing your investments have a floor price, similar to insurance on valuable possessions.

3. Covered Call - Generating Income

If you already own shares and don't expect significant price increases in the near term, you can sell call options against your shares to earn additional income.

Example: If you own 100 shares of LMN trading at $65, you might sell a call option with a strike price of $70 for $2 per share. This immediately earns you $200 ($2 × 100). If the shares remain below $70, you keep both the shares and the premium. If they rise above $70, you'll have to sell at $70, but you've still earned a profit from both the share price increase and the premium.

Key benefit: Enhanced returns on shares you already own, especially in flat markets.

Options Jargon

Bullish: A sentiment shared when it is believed that the price of a specific stock will go up.

Bearish: A sentiment shared when it is believed that the price of a specific stock will go down.

Conclusion

Options offer flexibility and opportunity for investors, but they also come with complexity and risk. By understanding the basic mechanics and starting with simple strategies, you can begin to explore whether options might have a place in your investment approach.

Remember that successful options trading requires ongoing education and careful risk management. Start small, focus on learning through experience, and gradually build your knowledge and confidence over time.