3 Facts You Must Know About Options Before You Invest
One of Johnny Carson's greatest characters was Carnac the Magnificent. Clad in a cape and giant feathered turban, the comic great pretended to prophesy the answers to secret questions.
The act went something like this: Carson holds an envelope to his head, pretends to concentrate, and then sternly says, "Sis boom bah."
Then hethe envelope and reads the question that prompted the answer: "What sound does a sheep make when it explodes?"
If only it were this hilarious and easy to predict the future values of.
It sounds easy, but before youon your own feathered turban, here are a few things you need to know about options.
1. What Are call Options And puts -- And How Do They Work?
The most popular forms of options are puts and calls. A call gives the holder the right, but not the strike price on the 's date. Similar but different is the , which gives the holder the right, but not the , to force the other party to buy 100 of the underlying .
As a quick example of how a options contract represents an interest in 100 underlying of , the actual cost of this be $200 (100 x $2 = $200).makes money, let's say IBM is trading at $100 per share. Now let's say you buy one on IBM at a price of $2 per contract. Note: Because each
Here's whathappen to the value of this under different scenarios:
- When the option expires, IBM is trading at $105: Remember: The call gives you the right to purchase IBM at $100 per share. In this scenario, you use the option to purchase those at $100, then immediately sell those same in the for $105. This option is therefore "in the money." Because of this, the option sell for $5 on the (because each option represents an interest in 100 underlying , this amount to a total price of $500). Because you purchased this option for $200, your net profit be $300.
- When the option expires, IBM is trading at $101: Using the same analysis as shown above, the at the money," because the transaction is essentially a . now be worth $1 (or $100 total). Since you spent $200 to purchase the option, you'll have a of $1 (or $100 total). This option is "
- When the option expires, IBM is trading at or below $100: If IBM ends up at or below $100 on the expiration date, then the contract expire "out of the money." It'll be worthless, so you lose your money (in this case, the $200 you spent for the option).
In a market and the strike price., the tables are turned. This position gives you the right to sell IBM at an agreed-upon price by a certain date. So, if the falls below the strike price, you can exercise your right to sell at the strike price. It's like having an insurance policy, because the writer of the contract has to buy the IBM from you. The is the difference between the cost of IBM in the open
2. How Do Options Get Their Prices?
In our example, it costs $2 to buy an option. But why $2? Why not $5? Or $20? Well, the price of an option is a underlying security -- the IBM stock -- how long you have to exercise the option, how volatile IBM stock tends to be and the strike price.of the current price of the
The most common way to calculate option prices is to use the Black-Scholes model, named after Fischer and Myron Scholes, who developed it in 1973.
The basic idea is to find the probability that an option present value of the exercise price.expire in the money. For example, if IBM stock is volatile, there is more potential for the option to go in the money before it expires. Also, the longer the investor has to exercise the option, the greater the chance the option go in the money. Higher interest rates raise the price of the option because they lower the
3. What Is The Witching Hour?
As we've stated, options expire (usually at the end of a fiscal quarter), and sometimes many of them expire at the same time. Options and other kinds of derivatives -- and options, for example -- generally share simultaneous expirations on the third Friday of every month.
So-called triple-witching days only occur on the third Friday of every March, June, September and December. We call the last hour of these trading days, from 3 to 4 p.m. EST, the triple-witching hour.
On witching days, and especially during witching hours, many investors attempt to unwind their positions in their futures and options contracts before the contracts expire. As a result, stock prices can be volatile on these days, and you should anticipate that if you're going to dabble in options.
The downside risk when used properly. When used improperly, they can also carry tremendous -- even unlimited -- downside risk, which is why it is absolutely imperative to know a about options before .Answer: Despite the fact that there's always some guy in the world who is hawking "a sure thing," there is no way to predict the future price of any . Options can help nervous investors limit their
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