In our last discussion we introduced you to options. As we said, initially we will build a solid foundation, making sure to cover all the details before we get into more advanced concepts. Today we will discuss strike selection and expiration dates.
Remember in the later part of our option definition we stated that, as the buyer of an option you have the right to buy or sell an asset at a specific price, on or before a specific date. Let's talk about the "specific price" for a moment.
Above is a standard option chain for the Ford Motor Company. The calls are labeled on the left column, and the puts are on the right column. The "Strike Price" is labeled right down the middle. In Ford's example you have the opportunity to choose a strike price every $0.50. Some stocks will have $0.50 increments, while others may go all the way up to $5 or even $10 increments. It depends on the price of the underlying stock.
If you were to buy a call with the $15 strike price then this is the price at which you have the "right" to buy the stock. Let's give an example. If, at any point before expiration Ford was trading for $20, then you as the buyer have the right to buy it for $15. In fact you have the right to buy for $15 no matter how high Ford trades. But what happens if Ford declines? As you can see, the $15 call for Ford is trading for around $0.18. As a call buyer you would pay $0.18 *100, or $18 for every 1 contract you buy. As a buyer of anything in life, the most you can lose is what you pay so in this case if Ford drops to $10 you can still only lose $0.18 or $18 per contract.
The next choice an option trader has to make is what they want the expiration date to be. In general, the expiration date for standard monthly options is the Saturday following the third Friday of the month. Most traders just think of it as the third Friday of the month. As a buyer of options you are required to make your final decisions by that day. Remember that as a buyer you have the "right" to either buy or sell the underlying asset. A buyer of calls has the right to buy the stock at the strike price and the buyer of puts has the right to sell, or "put" the stock to someone else on or before the expiration date. After the expiration date those options are worthless and the focus moves to the next expiration date. These "monthly" expirations are the most widely used expiration.
In our next article we will begin to explain scenarios for both buyers and sellers of options. max profit, max loss and directional assumptions.